Gripping GAAP 2015

Gripping GAAP
Sixteenth Edition
Cathrynne Service CA (SA)
BCompt (Hons) (C.T.A.) (UNISA) CA (SA)
Acknowledgements and thanks:

Special thanks must go to:
Khaya Sithole (from the University of the Witwatersrand) who dedicated his boundless
expertise and many precious hours in the mammoth task of editing the brand new chapter on
revenue and assisting in the updating of a further two chapters.
Thanks must also go to:
Professor Dave Kolitz (from the University of Exeter); and
Súne Diedericks and Suzette Snyders (both from the Nelson Mandela Metropolitan University);
for their valuable input, suggestions and special requests.
Sue Ludolph: SAICA Project Director: Accounting

Sandy Van der Walt: SAICA Project Director: Education
Heather de Jongh: KPMG: Director
Tara Smith: KPMG: Director
Juanita Steenekamp: SAICA: Project Director: Governance And Non-IFRS Reporting
Ewald Müller: SAICA: Senior Executive
Thank you for your advice and interpretations in the past.
Chief editing and technical review of this 2015 edition done by:
Khaya Sithole, Troy Halliday, Zaheer Bux, Errol Prawlall, Thivesan Govender,
Deepika Panday, Kamantha Vengasamy, Vidhur Sunichur, Zahra Moorad,
Johannes Rice and Yusuf Seedat
Thank you to a super-dedicated team for your enthusiasm and expertise.
Chief editing and technical review of some of the more recent editions done by:
Tanweer Ansari, Trixy Cadman, Aphrodite Contogiannis, Zaid Ebrahim, Susan Flack, Haseena Latif,
Daleshan Naidoo, Thabo Ndimande,
Dietmar Paul, Kate Purnell, Johannes Rice, Yusuf Seedat and Khaya Sithole
Albertus Louw, Ayanda Magwaza, Trixy Cadman, Carla Tarin,
Jade Archer, Marc Frank and Adrian Marcia
Khaya Sithole, Ruan Gertenbach, Carla Tarin, Jade Archer, Fathima Khan, Susan Flack,
Preshan Moodliar, Prekashnee Brijlall, Nikky Valentine
Ruan Gertenbach, Susan Flack, Gareth Edwardes, Artur Mierzwa,
Nabilah Soobedaar, Nikky Valentine and Prekashnee Brijlall.
Warren Maroun, Byron Cowie, Mahomed Jameel Essop, Nasreen Suleman,
Daveshin Chetty, Steve Carew, Justin Cousins, Jarrod Viljoen and Craig Wallington.
Warren Kemper, Byron Cowie, Gary Klingbiel, Alastair Petticrew, Catherine Friggens,
Kerry Barnes and Shiksha Ramdhin.
Tiffiny Sneedon and Ryan Wheeler.
Dhiren Sivjattan and Clive Kingsley.
Trixy Cadman, Phillipe Welthagen and Tarryn Altshuler.
Maria Kritikos, Lara Williams, Praneel Nundkumar,
Brian Nichol, Pawel Szpak and Craig Irwin.
Editing of layout and formatting: Sue Trollip

Thank you for your expertise and the long, long hours!
i
Gripping GAAP
First edition: 2000
Second edition: 2001
Third edition: 2002
Fourth edition: 2003
Fifth edition: 2004
Sixth edition: 2005
Seventh edition: 2006
Eighth edition: 2007
Ninth edition: 2008
Tenth edition: 2009
Eleventh edition: 2010
Twelfth edition: 2011
Thirteenth edition: 2012
Fourteenth edition: 2013
Fifteenth edition: 2014
Sixteenth edition: 2015
© 2014
ISBN: 978 0 409 11856 8
ebook ISBN: 978 0 409 12092 9
Printed and bound by Interpak Books, Pietermaritzburg
Copyright subsists in this work. No part of this work may be reproduced in any form or by any
means without the publisher’s written permission. Any unauthorised reproduction of this work
will constitute a copyright infringement and render the doer liable under both civil and criminal
law.
Whilst every effort has been made to ensure that the information published in this work is
accurate, the editors, authors, publishers and printers take no responsibility for any loss or
damage suffered by any person as a result of the reliance upon the information contained
therein.
Suggestions and comments are most welcome. Please address these to:
Contacting the authoress: Cathrynne Service Via Facebook:

• Accounting 911 by Kolitz and Service
Via LexisNexis:
• See contact details below
Contacting the publisher: LexisNexis Web address: www.myacademic.co.za
Mobi address: www.myacademic.mobi
Email address:
administrator@myacademic.co.za
Postal address:
LexisNexis
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Disclaimer
This text has been meticulously prepared, but in order for it to be user-friendly, the principles,
application thereof and disclosure requirements have been summarised.
This text should therefore not be used as a substitute for studying the official standards,
interpretations and exposure drafts first-hand.
ii
Gripping GAAP
Dedication
This book is once again dedicated to my very dear family and friends!
Writing it would simply not have been possible without

my parents, Roger and Jillianne,
who continually keep the home fires burning during the endless months of writing, and
my loving sons Roger and Guy
who have been extremely patient and understanding throughout.
And a sincere thanks to Scott for all your support and encouragement!
Too numerous to mention, are the rest of my family and friends,

who have all been subjected to the same boring excuse
‘sorry – I’m busy with my book ’.
And to my team of guardian angels who not only inspired this book but who have
provided me with the guidance and the super-human strength
that it has taken to update each year.
And finally, I wish to dedicate this book to those for whom I wrote it: You!
I sincerely wish that my book sheds the necessary light as you
fervently study towards your ultimate goal of
joining our country’s ranks of
‘counting mutants’
Our country needs you!
(‘counting mutants’ is a quirky reference to accountants in the comedy:

Mr Magorium’s Wonder Emporium)
iii
Gripping GAAP
Foreword
Another ‘Four Words’ to Gripping GAAP
My own lifelong - and appalling - inability to accurately distinguish between debits

and credits suggests that a) I was absolutely right not to consider accounting as a
career, and b) that I have little credibility - oh, let's be honest, no credibility
whatsoever - in being accorded the honour of penning a foreword to "Gripping
GAAP".
While I dread the thought that nepotism could be considered the rationale for such
distinction (I am closely related to the authoress!) I have at least, I hope, established
my monstrous lack of appropriate credentials. However, as a fellow writer, (of fiction -
and is that so very different from latter-day accounting fact?), I feel thus qualified to
commend the work for its lucid and clearly understandable (even to me!) "unpacking"
of the arcane subject of Accountancy.
A sage of old opined that "money is the root of all evil " - a maxim which, like most
others, appears to have stood the test of time. Until recently, of late it would appear
that the accounting of money (on a worldwide basis) has much to answer for.
Hitherto trustworthy multinational financial edifices have been found wanting to an
alarming degree and the tendency to indulge in 'creative accounting' has been rightly
indicted.
The vigour of youth (yours) coupled with a sincere passion to put right what has gone
wrong (also yours, I trust!) is the serious need that "Gripping GAAP" seeks to
advance.
Balzac said "Behind every great fortune there is a crime!". Was he right? Winston
Churchill said "Success is the ability to lurch from failure to failure with no loss of
enthusiasm!". Was he right? Does it matter? Perhaps it does.
Certainly my personal hope is that those who, thousands of years ago, taught us all
to read and write with such fine precision will be the inspiration for your generation of
professionals to deal with an emerging global need to account with similar exactitude.
Carpe Diem!
Dr. Roger Service
iv
Gripping GAAP
A note to you from the author
To all you dear students, planning on joining the ranks of ‘the counting mutants’
South African accountants are all extremely proud as South Africa has just been ranked, yet
again, as the WORLD LEADER in financial reporting and
auditing. This was announced in the World Economic
South Africa has just been
Forum’s recent 2014-2015 Global Competitiveness
ranked the Report. So may I start by congratulating you on choosing
WORLD LEADER in to follow a career in which you can only flourish, given that
auditing and South Africa’s education and training in this field is clearly
financial reporting the very best there is!
for the FIFTH year in a row! That said, accounting is one of the most misunderstood
World Economic Forum’s 2014-2015 disciplines that you could have chosen to study, with the
Global Competitiveness Report general public’s perception being that it is dull and yet
very easy because it is simply about ‘debits and credits’.
And how hard can the principle of ‘debit-credit’ really be?
Well it is safe to say that accounting is currently one of the
fastest changing and complex subjects and is very interesting to those ‘in the thick of it’. The
latest compilation of international financial reporting standards is MANY THOUSANDS of
pages long – and getting longer by the day. It is these standards that Gripping GAAP hopes
to have simplified for you. These standards regulate how we communicate financial
information and are essentially the rules of accounting – and you may be interested to learn
that no-where in the literally thousands of pages is any reference made to debits and credits!
Now, probably the most important thing I can tell you is that the clue to enjoying the study of
any future career may be summed up as follows: knowledge without understanding is much
the same as a vehicle without an engine: you just won’t be going anywhere! So, in order to
help you to understand the many principles, I have included more than 550 examples and
have tried my very best to make the frequently dry subject as easy to read as possible. This
year, in addition to the flowchart summaries, we inserted little grey ‘pop-ups’ throughout the
chapters to help you quickly identify core definitions (pop-ups showing an apple core) and to
help you very quickly assess the essence of certain
paragraphs or to give you other important tips or
interesting facts (these pop-ups show a variety of Please visit my websites!
images from happy faces to warning signs, depending (see page ii for details)
on the pop-up content).
For teamwork and information sharing, there is also a
web site (see web address on page ii) that is available on which you will be able to discuss
both the international standards and Gripping GAAP with other students and from which you
can contact me directly with any queries or comments. I hope to see you there! The more you
all visit, the more you will all benefit!
Support lectures and tutorials As an optional extra, I offer support lectures and
are available – please contact tutorials for those who feel the need for some extra
me for details via the website assistance. Please contact me if you have requests
or queries in this regard by using the same website.
(see page ii for web addresses)
In closing please avoid becoming complacent. I
predict that this year of your studies will be dynamic
and you will probably feel like you are not studying
accounting at all but rather some form of complex law. In a way you are right. So it is at this
crucial start, as you embark upon your journey into the world of ‘GAAP’, that you maintain a
positive attitude and keep your wits about you and keep Gripping GAAP as your guide.
Bon voyage! And remember that with enthusiasm,

commitment and perseverance, success will All you need is
inevitably follow. a positive attitude, enthusiasm,
Wishing you the very best for your studies! commitment, perseverance ...
and Gripping GAAP!
v
Gripping GAAP
Introduction
The ongoing international harmonisation and improvements projects have seen a

proliferation of revised and re-revised standards, interpretations and exposure drafts.
This edition has been updated for all relevant standards in issue to 10 December 2014.
A number of new international standards and interpretations are expected to be issued
during 2015. Please watch my Facebook page for details (see page ii).
Since Gripping GAAP has gained international attention, the text has been updated to
be more country non-specific in terms of tax legislation. In this regard, students may
assume that the business entity is subjected to the following taxes (unless otherwise
indicated):
z A tax on taxable profits at 30%, (referred to as income tax);
z An inclusion rate of 50% for entities when dealing with capital gains tax (part of
income tax);
z A transaction tax levied at 14%, (referred to as VAT or value added tax).
Gripping GAAP uses the symbol ‘C’ to denote an entity’s currency but uses the symbol
‘LC’ for an entity’s ‘local currency’ in any chapter dealing with foreign currencies.
Some chapters (e.g. chapter 1 & 23) include unavoidable reference to South African
legislation. Aspects of these chapters may possibly not be relevant to some of the
countries using this book. All principles are, however, international principles.
Paedagogical philosophy
Gripping GAAP is designed for those who wish to:

• fully understand the concepts and principles of accounting
• be able to study their syllabus without the aid of daily lectures (e.g. students
studying on a distance learning basis);
• qualify as chartered accountants; and
• keep abreast of the changes to international financial reporting standards.
Gripping GAAP can be successfully used with GAAP: Graded Questions by D Kolitz
and C Service and Gripping Groups by C Service and M Wichlinski.
This edition of Gripping GAAP covers an enormous volume of work and is frequently
studied over a two-year period at undergraduate level or a one-year period at post-
graduate level.
The text has therefore been written so as to be as easy-to-read as possible and
includes more than 550 examples as well as both pop-up summaries and flowchart
summaries, thus making it ideal for students studying on a distance basis.
Students need to be able to see the ‘big picture’ and thus flowchart summaries are
provided at the end of each chapter. These flowchart summaries are a good place to
start before reading any chapter or in preparation for lectures and are also good to
read over after having completed the reading of a chapter or after having attended a
lecture.
In order to help one remain focused whilst reading the chapters, which unavoidably
contain copious and complex detail, little grey pop-ups have been inserted to highlight
the relevant core definitions and the essence. These pop-ups have been provided in a
bulleted format to enable quick assimilation of these ‘fast-facts’.
vi
Gripping GAAP
Paedagogical philosophy
• Chapter 1 explains the environment within which a ‘reporting accountant’ finds himself (i.e.
where an accountant is affected by the IASB and various related legislation).
• Chapter 2 explains the Conceptual Framework, which reflects the basic logic underpinning
all other IFRSs.
• Chapter 3 explains how financial statements should be presented.
• Chapter 4 - 6 involve revenue from customer contracts and taxes. Since tax is integral to all
topics, the chapters on tax are included early on in the book. However, before we can
understand the differences between accounting profit and taxable profit, students need to
understand the concept of accrual. An ideal standard to start this is the revenue standard.
Once students understand when to recognise revenue, they have a yardstick to use when
studying the tax and deferred tax chapters, where revenue is used as the initial example
explaining the calculation of taxable profits and the concept of deferred tax.
• Chapters 17 – 13 involve various assets. These chapters are covered after having grasped
deferred tax since these assets have deferred tax consequences. That said, some
institutions prefer to teach the principles involving each of the asset types without these
deferred tax consequences. For this reason, the deferred tax consequences are presented
in a separate section of each of these chapters and examples are shown with deferred tax
consequences and without deferred tax consequences.
We start with non-current assets and proceed to current assets (inventory). Impairment of
assets is also included in this set of chapters but it is inserted after the chapters covering
property, plant and equipment, intangible assets and investment properties but before non-
current assets held for sale and inventories. This is because the standard on impairments
applies to the former assets but not the latter assets.
• Chapter 14 – 17 deal with borrowing costs, government grants and leases. These chapters
may all have an impact on the recognition and measurement of assets.
• Chapters 18 – 19 relate to provisions, contingencies and events after the reporting period
and employee benefits. Both these chapters relate largely (although not exclusively) to
liabilities.
• Chapter 20 – 24: Chapter 20 deals with foreign currency transactions, where it explains
how transacting in a foreign currency can affect the measurement of items. Since foreign
currency transactions frequently require hedging, chapter 21 explains hedging with forward
exchange contracts. Since forward exchange contracts are a type of financial instrument,
chapter 22 explains financial instruments. Share capital involves either equity instruments
or financial liabilities and is best covered after having grasped the various concepts in the
financial instruments chapter and this section is thus contained in chapter 23. Chapter 24
covers earnings per share: this chapter is best covered after studying share capital.
• Chapter 25: Fair value measurement affects numerous prior chapters and is thus best
contained after all the chapters affected by fair value measurements. This chapter may be
referred to whilst studying these other affected chapters.
• Chapter 26: Statements of cash flows are quite distinct from the principles covered in all
prior chapters since it applies the cash concept rather than the accrual concept and is thus
the penultimate chapter.
• Chapter 27: The very final chapter is financial analysis and interpretation since it does not
related to an IFRS at all but simply explains how the financial statements are analysed by
the users thereof.
• Appendix: although definitions relevant to each of the chapters are included in each of
these chapters, the appendix provides a list of all definitions in alphabetical order thus
enabling readers to quickly and easily find definitions.
vii
Gripping GAAP
Contents
Chp. References Title of chapter Page
1 IASB, Companies The reporting environment 1
Act & King III
2 Conceptual The conceptual framework for financial reporting 38
Framework
3 IAS 1 Presentation of financial statements 57
4 IFRS 15 Revenue from contracts with customers 102
5 IAS 12 Taxation: various types and current income tax 204
6 IAS 12 Taxation: deferred taxation 247
7 IAS 16 Property, plant and equipment: cost model 340
8 IAS 16 Property, plant and equipment: revaluation model 393
9 IAS 38 Intangible assets 447
10 IAS 40 Investment property 489
11 IAS 36 Impairment of assets 527
12 IFRS 5 Non-current assets held for sale and discontinued operations 570
13 IAS 2 Inventories 629
14 IAS 23 Borrowing costs 691
15 IAS 20 Government grants and government assistance 716
16 IAS 17 Leases: lessee accounting 752
17 IAS 17 Leases: lessor accounting 803
18 IAS 37; IAS 10 Provisions, contingencies and events after the reporting period 840
19 IAS 19 Employee benefits 878
20 IAS 21, IFRS 9, & Foreign currency transactions 922

IFRS 7
21 IFRS 9, IFRS 7, & Hedging with forward exchange contracts 946
IAS 32
22 IFRS 9, IFRS 7, & Financial instruments 975
IAS 32
23 IFRS 9 & IFRS 7, Share capital 1019
IAS 32 & Co’s Act
24 IAS 33, Circ 3/11, Earnings per share 1042
Circ 3/12
25 IFRS 13 Fair value measurement 1081
26 IAS 8 Accounting policies, estimates and errors 1095
27 IAS 7 Statements of cash flows 1126
28 N/A Financial analysis and interpretation 1158
viii
Gripping GAAP The reporting environment
Chapter 1
The Reporting Environment
Main references: IFRS Foundation Constitution (2013); Due Process Handbook (2013);
www.IFRS.org; Companies Act 2008; Companies Act Regulations, 2011; Companies Act
Amendments, 2011; King III and JSE Listing Requirements (September 2014)
Contents: Page
1. Introduction 3
2. A brief history of accounting 4
2.1 Accounting is a language 4
2.2 Accounting has evolved 4
2.3 The difference between the double-entry system and GAAP 5
2.4 The difference between GAAP and IFRS 5
3. GAAP and IFRSs – the process of internationalisation 6
3.1 A brief history of the internationalisation of GAAP into IFRSs 6
3.2 International Financial Reporting Standards (IFRSs) 7
3.2.1 Overview 7
3.2.2 The meaning of the term: IFRSs 7
3.2.3 The meaning of the term: Standards 7
3.2.4 The meaning of the term: Interpretations 7
3.3 Conceptual Framework for Financial Reporting 8
3.4 Compliance with IFRSs 8
3.4.1 What does compliance with IFRSs involve? 8
3.4.2 Why would one comply with IFRSs? 8
3.4.3 The extent of compliance with IFRSs around the world 9
3.5 Harmonisation versus Convergence 9
3.6 Adoption versus Convergence 11
3.7 Development of IFRSs (standard-setting) 12
3.7.1 Overview 12
3.7.2 Standards developed to date 12
3.7.3 Interpretations developed to date 12
3.7.4 Due Process 12
3.7.4.1 Overview 12
3.7.4.2 Principles of Due Process 13
3.7.4.3 The Basic Development Cycle 13
3.7.4.4 Developing Exposure Drafts 14
3.7.4.5 Developing Standards 14
3.7.4.6 Developing Interpretations 15
3.7.4.7 Developing Annual Improvements 16
Chapter 1 1
3.8 The IASB and the IFRS Foundation: a look at the structure 16
3.8.1 Overview 16
3.8.2 The IFRS Foundation: an organogram 17
3.8.3 The IFRS Foundation 17
3.8.4 The Trustees 18
3.8.5 The Monitoring Board 18
3.8.6 The International Accounting Standards Board (IASB) 19
3.8.7 The IFRS Interpretations Committee (IFRSIC) 19
3.8.8 The IFRS Advisory Council (IFRSAC) 19
3.8.9 The Accounting Standards Advisory Forum (ASAF) 19
4. The Companies Act and the related regulations 19
4.1 Overview 19
4.2 The Companies Act, 2008: some of the big changes 20
4.2.1 What about pre-existing par value shares? 20
4.2.2 What about pre-existing CCs? 20
4.3 The different categories of companies 21
4.4 Legal backing for financial reporting standards 22
4.5 Which financial reporting standards must we use? 23
4.6 Legal backing for differential reporting 25
4.6.1 An overview 25
4.6.2 What is a small and medium-sized entity (SME)? 25
4.6.3 The history of differential reporting in South Africa 25
4.6.4 How do the IFRS for SMEs help? 25
4.7 Does our company need an audit or independent review? 26
4.8 Company records (s24) 27
4.9 Accounting records (s1 and s28) 27
4.10 Financial year (s27) 27
4.11 Financial statements (s29) 28
4.12 Annual financial statements (s30) 28
4.12.1 Timing 28
4.12.2 Audit or independent review 28
4.12.3 Other documents included in the annual financial statements 28
4.12.4 Extra disclosure relating to directors or prescribed officers 28
4.12.5 Approval and presentation 30
5. JSE listing requirements 30
5.1 Overview 30
5.2 Section 3: Continuing obligations 31
5.3 Section 8: Financial information 31
6. King III Report 33
6.1 Overview 33
6.2 King III Report on directors remuneration 33
6.3 King III Report on sustainability reporting 34
6.4 King III Report on integrated reporting 34
7. Summary 37
2 Chapter 1
1. Introduction
Many people think that the work of accountants involves being locked away – alone – in
small dusty rooms, armed with calculators and reams of paperwork. However, the modern
accountant is incredibly important to business and he/she needs to be able to contribute to the
effective functioning of all facets thereof. Thus, accountants need a wide range of skills.
The SA Institute of Chartered Accountants (SAICA) lists the required skills as follows:
Pervasive professional skills. These consist of four skills, which are listed as: business ethics;
management and leadership; personal attributes; and information technology.
Specific skills:
1. Accounting and external reporting; Accounting & external
2. Auditing and assurance; reporting is the ONLY
3. Management decision-making and control; specific skill that is
4. Financial management; compulsory!
5. Internal audit, risk management and governance; and
6. Taxation. Source: CA(SA) Training programme: Implementation guide & Structure of the Programme
If you’re studying towards being a SA Chartered Accountant, the SAICA’s

pervasive skills and the specific skill of ‘accounting and external Strategic Plan:
2014 – 2018
reporting’ are the only two compulsory skills. A further skill from
the list of specific skill needs to be elected. The two compulsory An interesting slide show on
skills and the one elected skill must be mastered at an advanced SAICA’s current strategic
level. According to SAICA’s ‘implementation guide’, you then plan can be found at:
https://www.saica.co.za/Portals/0/ab
simply need ‘basic experience’ in the four remaining specific skills,
out/Strategy/Final%20Version_Memb
the practical skill requirements thus being ‘far less onerous’. er%20Strat%20Presentation.pdf
This textbook focuses on the compulsory, but also exciting and dynamic, skill of ‘accounting
and external reporting’:
‘Accounting’ refers to record-keeping, in other words, the process of documenting the
results of the business activities; and
‘External reporting’ refers to how we convert these records into the ‘story of the
business’, where this story is then told to those interested parties (external users) in a way
that will help them understand what occurred in the business during the period.
Having the specific skill of ‘accounting and external reporting’ requires a thorough
understanding of many related theories, principles and rules, including, for example:
the rules behind the double-entry system;
the accounting and reporting rules referred to as generally accepted accounting practice,
many countries having their own forms thereof (referred to as their national GAAP);
the accounting and reporting rules referred to as International Financial Reporting
Standards (IFRSs), which are essentially a harmonisation of the various forms of national
GAAP and which are a set of rules that are intended to replace these national GAAPs.
This textbook assumes that you have mastered the double-entry system and assumes that your
business will require IFRSs to draft its financial statements. It thus focuses solely on the
application of International Financial Reporting Standards (IFRSs). Each chapter in this
textbook will be dedicated to an IFRS but before we become engrossed in each of these
chapters, this chapter first explains the wider environment affecting accounting and external
reporting. The remaining sections in this chapter are structured as follows:
Section 2: A brief history of accounting
Section 3: GAAP and IFRSs – the process of internationalisation
Section 4: The Companies Act and its related Regulations
Section 5: The JSE Listing Requirements
Section 6: The King III Report
Chapter 1 3
2. A Brief History of Accounting
2.1 Accounting is a language
You may think accounting is dry and boring, but believe it or not, accounting has much in
common with possibly more exciting subjects such as language. If you’ll get back onto your
chair, I’ll explain... Through the ages, many languages developed, such as Latin, English and
Zulu, so that people could communicate with one another effectively. Communicating
effectively is essential! It helps avoid all sorts of unpleasantness.
Accounting is just another language, one Examples of typical users:

that is used by accountants to communicate Shareholders: who may consider increasing
with other accountants and interested parties or decreasing investments,
(called ‘users’). Interested parties want to Lenders: need to assess the risk of continuing to
hear the story of the business – and provide credit,
accountants need to know how to both Suppliers: who may want to assess whether or not to
document the facts (by debiting and continue supplying goods and services,
crediting) and how to tell the story Customers: need to decide who best to give their
(reporting). The language we use depends business to.
on which country we are telling the story to – some countries require us to tell our story in
their national GAAP, whereas others require that we tell the story in international GAAP (i.e.
using IFRSs). The intention is that, in time, there will be one accounting language –
international GAAP.
2.2 Accounting has evolved
The language of accounting has developed over thousands of years (some say more than
10 000 years and some as many as 20 000 years – we will never know for sure) and is
constantly evolving owing largely to a changing environment. The evolution so far:
Accounting first started as a basic recording of items such as cattle and stores of grain,
using notches in clay tablets and sticks.
Over time, this became slightly more detailed where it then involved a written record of
business transactions (i.e. using words and numbers rather than notches).
And then came the double-entry system (i.e. using debits and credits).
The evolution of accounting came about due largely to the The double-entry
system came about
evolution of business. There are many stages that have been
because it:
identified in this business evolution, but two significant stages
gives the detail and
include the introduction of (1) corporations and (2) credit. The checks & balances
arrival of corporations and credit meant that more detail was needed for those users
needed to satisfy those users who were not involved in the day- who are not involved in ‘day-
to-day management of the business: to-day management’.
Initially businesses involved sole proprietors and family-run businesses, where record-
keeping was a relatively simple affair because the owners also managed the business and
were thus intimate with the transactions the business entered into. However, when
businesses grew larger and corporations began appearing on the scene, record-keeping
had to become more detailed since the owners of these corporations were shareholders
who were generally not involved in the day-to-day management of the business.
Initially businesses worked purely on cash. However, when ‘credit’ was introduced,
money-lenders wanted information that would help assess whether or not it was safe to
continue providing credit. Since money-lenders were not involved in the day-to-day
management of the business, they too demanded detailed record-keeping.
In summary, unlike earlier times, users of financial information today are often not involved
in the management process and thus demand more detailed financial information.
4 Chapter 1
2.3 The difference between the double-entry system and GAAP
The double-entry system is a language that is centuries old and as relevant today as it was
back then. Evidence of the first double-entry system comes in the form of two ledgers dating
back to the end of the 13th century: Evidence
a ledger created by Amatino Manucci, a Florentine (Italian) suggests that
merchant, at the end of the 13th century; and the double-
a ledger created by Giovanino Farolfi & Company, a firm entry system started
of Florentine (Italian) merchants and moneylenders, dated of in Italy
in the 13th century!
1299-1300 (called the ‘Farolfi Ledger’).
To communicate properly in any language, we need to obey certain rules. These rules tell us
how to pronounce and spell words and how to string them together in the right order to make
a sentence that someone else will understand. Accounting is no different and thus rules on
how to ‘operate’ the double-entry system were developed.
An Italian, Luca Pacioli, who worked closely with the artist and Pacioli is
genius, Leonardo da Vinci, is often referred to as the ‘father of called:
accounting’. However, Luca Pacioli did not design the double-entry
system (since it had already been in use for roughly 200 years). He the ‘father of
accounting’ – but
simply appeared to be the first to document how the double-entry he did not design the
system worked, explaining it in his mathematics textbook (Summa de double-entry system;
arithmetica, geometria, proportioni et proportionalità, published in ...he simply wrote about
Venice in 1494). Interestingly, however, it seems that there were it!
previous books on the double-entry system and that Pacioli’s book was simply more widely
distributed than these previous books.
Over time, more rules sprung up around this double-entry system. These rules became known
as generally accepted accounting practice (GAAP). Before globalisation, countries operated
very separately, each developing their own unique form of GAAP, in other words, their own
accounting language. Each country’s GAAP is referred to as that country’s national GAAP.
2.4 The difference between GAAP and IFRS
Since the beginning of the industrial revolution,

IFRSs are the result of:
businesses began to grow and expand across borders.
combining the various national Recent technology, such as phones, faxes, email, jet
GAAPs into one global GAAP. engines and the internet, made it possible to
Global GAAP is represented by IFRSs.
communicate instantly with people in countries that
are thousands of miles away. Much of this ‘globe-shrinking technology’ has been around for
many years now, so communication is well underway between accountants of businesses in
countries that, only a few hundred years ago, did not even know each other existed.
This increased global communication between accountants gradually led them to realise that
they were ‘not talking the same language’. In fact, the national GAAP used in one country is
sometimes so different to that used in another country that it is like comparing the languages
of French and Chinese. In other cases, the differences are so minor that it is like comparing
American English with British English, where the words are the same but the accents differ.
However, all differences, no matter how small, will still result in miscommunication. Whilst
miscommunication at a personal level can lead to tragedies ranging from losing your keys to
divorce, miscommunication at a business level often leads to court cases, financial loss,
liquidation and sometimes even prison time for those involved.
The international communication amongst accountants has been growing exponentially over
the last few decades and eventually, in 1993, the effect of the different accounting languages
became painfully clear to the public. Let me tell you the story...
Chapter 1 5
The Daimler-Benz Story:

Once upon a time, back in 1993, the German company ‘Daimler-Benz’ wished to list their
shares on the New York Stock Exchange (NYSE). This was the very first German
company to ever list on the NYSE. Excitement grew amongst US investors after Daimler-
Benz released its financial reports in German GAAP, reporting an exceptional profit of
DM615 million. As a result, US investors eagerly awaited the listing, each hoping to snatch
up shares as the company listed. Finally the day arrived and with it came the required
financial reports, restated in terms of US GAAP. And immediately all excitement
vanished! The financial statements in terms of US GAAP reported a whopping loss of DM1.839 billion ... for the
self-same period. Which was it? An exceptional profit of a few million ... or an even more exceptional loss of a
few billion? Amazingly, both were correct! It depended on whether you ‘spoke’ German GAAP or US GAAP!
Although the gradual development of a single global GAAP had been underway for many
years, the recent and unprecedented surge in globalisation, resulting in examples such as this
‘1993 Daimler-Benz experience’, led to a renewed surge of support for the idea.
Currently, the various forms of national GAAP are in the process of being morphed into a
single global GAAP, referred to as the set of International Financial Reporting Standards
(IFRSs). These IFRSs are currently being developed by the International Accounting
Standards Board (IASB). More about the IFRSs and the IASB can be found in section 3.
3. GAAP and IFRSs – The Process of Internationalisation
3.1 A brief history of the internationalisation of GAAP into IFRSs
As already explained, due to the rapid globalisation and resulting increased communication of
a financial nature, global investors found that they needed a single global accounting
language, a global GAAP, without which comparability of financial results of global
companies seemed impossible.
The idea of this single global accounting language is not new!

The 50’s: In the late 1950’s, calls for global GAAP History behind the
began, due largely to the increasing economic internationalisation:
integration after World War II and the resultant cross-
border flow of capital. Late 1950’s: calls for global GAAP
1967: AISG was formed
The 60’s: In 1966, it was proposed that a group be 1973: IASC was formed
formed to focus on the idea of a global GAAP. As so, 2001: IASB replaced IASC
in 1967, the Accountants International Study Group (AISG) was established, comprising
the United Kingdom, the United States and Canada (represented by the Institute of
Chartered Accountants of England & Wales, American Institute of Certified Public
Accountants and Canadian Institute of Chartered Accountants respectively). This group
studied the differences in accounting practices between various countries, publishing
papers on their findings every few months.
The 70’s: Now that it was clear that a global GAAP was needed, 1973 saw the
establishment of the International Accounting Standards Committee (IASC). It was
tasked with developing and publishing global accounting standards, which they called
International Accounting Standards (prefixed with ‘IAS’).
The 00’s: This committee was re-organised and renamed the International Accounting
Standards Board (IASB) in 2001. This new board adopted all the work done by the
previous IASC and then proceeded to continue publishing global accounting standards.
All standards developed by this board were now called International Financial Reporting
Standards (prefixed with ‘IFRS’).
The process of distilling the world’s various national GAAPs into a single global GAAP (i.e.
IFRS) is referred to as harmonisation. This project is explained in section 3.5.
6 Chapter 1
3.2 International Financial Reporting Standards (IFRSs)
3.2.1 Overview
International Financial Reporting Standards (IFRSs) contain the principles that are applied
by an accountant when:
recording transactions and other financial information (accounting); and when
preparing financial statements for external users (external reporting).
IFRSs are issued by the International Accounting Standards Board. The development of
IFRSs is explained in section 3.7.
3.2.2 The meaning of the term: IFRSs
It is important to realise that the term IFRSs may be used in many ways:
It may be used in a narrow sense to refer to only those standards published by the
International Accounting Standards Board and thus prefixed with ‘IFRS’ (i.e. as opposed
to standards published by the previous International Accounting Standards Committee and
thus prefixed with ‘IAS’).
In its broader and more technical sense, the term is used to refer to the combination of
both standards and interpretations (i.e. it would refer to all the standards, prefixed with
IFRS or IAS, and all their interpretations, prefixed with SIC or IFRIC).
The term IFRSs
However, when we state in a financial report that the financial technically includes:
statements comply with International Financial Reporting Standards; AND
Standards, we are using the term in the broader more technical Interpretations.
sense to refer to both the standards and the interpretations.
3.2.3 The meaning of the term: Standards Standards represent

the set of principles
Standards contain the principles to be applied by accountants. applied by accountants.
These standards are not only issued by the IASB but are also developed by the IASB.
However, the development process follows strict due process procedures that require much
collaboration with national standard-setters from around the Standards are defined
world and other interested parties. as:
Standards issued by the IASB.
As explained in a previous section, the IAS Board adopted all They comprise those prefixed
the work done by the previous IAS Committee and thus some by IFRS and IAS.
of the standards are still prefixed with IAS while those issued Due Process Handbook: Glossary of terms
by the IASB are prefixed with IFRS.
3.2.4 The meaning of the term: Interpretations
It can happen that a standard has complex or ambiguous principles, the application of which
needs some explanation. Where such an explanation is required, the IASB issues a document
called an interpretation.
Interpretations are given the same authority as the standards. Interpretations

explain how to apply standards;
Thus, if a standard comes with an interpretation, this standard have the same authority as
must be read together with its interpretation. standards.
Although interpretations are issued by the IASB, they are actually developed by the IASB’s
Interpretations Committee. As with the development of standards, the development of
interpretations follows strict due process procedures that require much collaboration with
national standard-setters from around the world and other interested parties.
Chapter 1 7
Since the IAS Board adopted all the work done by the previous Interpretations are
IAS Committee, some interpretations are prefixed with SIC and defined as:
some are prefixed with IFRIC: ‘developed by the
The old IASC prefixed their interpretations with SIC, being Interpretations Committee
before being
the acronym for the committee responsible for their ratified & issued by the IASB.
development: Standing Interpretations Committee. Interpretations carry the
The new IASB prefixes interpretations with IFRIC, being same weight as a Standard.’
Due Process Handbook: Glossary of terms
the acronym for the committee that develops them: the
International Financial Reporting Interpretations Committee.
3.3 Conceptual Framework for Financial Reporting
When the IASB considers which principles and practices to The Conceptual
include in each new IFRS (i.e. standard or interpretation), it Framework is not
uses the Conceptual Framework for Financial Reporting. Thus an IFRS!
this Conceptual Framework is used to develop IFRSs, but is The CF is simply used in the
technically not an IFRS. [The CF is covered in chapter 2.] process of developing IFRSs.
3.4 Compliance with IFRSs (adoption)

3.4.1 What does compliance with IFRS involve? Compliance with
IFRSs means
To comply with IFRSs means to have adopted IFRSs. To be compliance with:
able to state in the financial report that the financial statements Standards (IAS/ IFRS); AND
comply with IFRS, they must comply with: Interpretations (SIC/IFRIC).
all IFRSs, and
without any modifications (i.e. adaptations).
Since interpretations have the same authority as standards and are thus to be read together
with the standards, when we make a statement in the financial report that the financial
statements ‘comply with the IFRSs’, we are actually saying they comply with both the:
Standards, whether prefixed with IAS or IFRS; and
Interpretations, whether prefixed with SIC or IFRIC.
When a set of financial statements is prepared in terms of IFRSs, a declaration of this
compliance must be included in the notes to the financial statements (this is a requirement
contained in IAS 1 Presentation of Financial Statements).
3.4.2 Why would one comply with IFRS?
Compliance could
There is no international body forcing compliance with IFRSs. be:
A country’s specific national legislation may, however, require Legislated: due to the
compliance with IFRSs. On the other hand, the national relevant national legislation
legislation of some countries neither requires nor disallows requiring compliance; or
compliance. On the other end of the spectrum, there are some Voluntary: due to the
international credibility that
countries whose national legislation actually disallows
compliance provides.
compliance (see section 3.4.3).
Where the national legislation requires compliance, the answer to ‘why would one comply
with IFRS’ is obvious. However, in situations where compliance is neither required and nor
disallowed, why would entities comply with it? The answer is simply that compliance with
IFRS gives credibility to the financial statements and makes them understandable to
foreigners, thus encouraging foreign investment.
For many years, South Africa’s legislation did not require compliance with IFRSs. Despite
this, the increased credibility gained from complying with IFRSs led many South African
companies to adopt IFRSs. However, a recent revision to South Africa’s legislation now
means that certain companies must comply with IFRSs while other companies may choose to
comply. [More information about the legislation may be found in section 4.]
8 Chapter 1
Apart from a country’s legislative requirements, IAS 1 Presentation of Financial Statements

requires that where companies do comply with IFRSs (the standards and interpretations),
disclosure of this fact must be made in their financial statements.
By implication, those companies that do not comply, may not make such a declaration.
Since compliance with IFRSs lends international credibility to the financial statements, to be
able to make such a statement is desirable to most entities. [IAS 1 is covered in chapter 3.]
3.4.3 The extent of compliance with IFRS around the world
The term ‘International Financial Reporting Standards’ can be a bit misleading at present
since not all countries use them. In other words, these standards are technically not
‘international’ until all countries require the use thereof. The situation is currently as follows:
At least 131 participating countries (as at 11 December 2014) already either permit or
require the use of IFRSs. Examples include South Africa, United Kingdom and all other
member states of the European Union, Australia, New Zealand, Canada, Saudi Arabia etc.
There are a number of countries that do not permit the use of IFRSs. Examples of some of
the larger countries that still do not permit the use of IFRSs include: Cuba, Indonesia,
Iran, Mali, Senegal and Vietnam.
Some countries permit the use of IFRSs for some companies and disallow it for others.
For example, the United States does not permit the use of IFRS by their domestic listed
companies but permits the use of IFRS by their domestic unlisted companies.
World-wide usage of IFRSs
Some countries have adopted the IFRSs word-for-word as
their own national GAAP. Others have adopted IFRSs Some countries:
but with certain modifications that they consider require compliance with IFRSs
permit compliance with IFRSs
necessary due to reasons that are peculiar to that
do not allow compliance with IFRSs.
jurisdiction and which they thus believe have not been
Sometimes countries that state they
dealt with in the IFRSs. Examples include the EU where
support the use of IFRSs are using:
there is a time lag in adopting some of the IFRSs and pure IFRSs,
Uruguay which has adopted IFRSs but together with a modified IFRSs, or
few extra local standards and modifications. national GAAP that has been or is
being converged with IFRSs.
There are yet other countries, however, which are not adopting the IFRSs but are choosing to
converge their national GAAP with the IFRSs instead. Examples of some of the larger
countries that are converging their standards rather than adopting the IFRSs include the
United States, China, India and Singapore.
Thus some countries have adopted IFRS but with modifications and some countries use their
own national GAAP which they argue has been or is being converged with IFRSs. However,
research has found that the difference between using pure IFRSs (i.e. pure adoption) versus
using modified IFRSs or a national GAAP that has been converged with IFRSs can be very
significant, despite claims to the contrary.
As can be seen from the above, the current status of the use of IFRSs is that there is still
relatively divergent practice around the world and the international harmonisation of the
various national GAAP’s into a single global GAAP (IFRSs) has still a long way to go.
3.5 Harmonisation versus Convergence

The Constitution
The process of developing global standards requires close
consultation between the IASB and the national standard- refers only to convergence;
setters and interested parties from all interested countries. does not refer to harmonisation!
Chapter 1 9
In this regard, two terms are commonly used:

harmonisation; and
convergence.
Whereas ‘harmonisation’ was previously the buzz word, ‘convergence’ is now the new focus.
In fact, the Constitution of the IFRS Foundation refers only to the term ‘convergence’.
Ultimately, however, the purpose of both harmonisation and convergence is to create a single
set of high quality, global GAAP to be adopted world-wide.
The process of harmonisation involved the IASB and national standard-setters meeting to
analyse and compare the various principles and practices used across the world in order to:
identify differences/ problems and try to eliminate them;
help guide the development of the international standards (i.e. the IFRS would then
incorporate a combination of best practice and any new and improved ideas that may have
emanated from the process).
Essentially, the purpose of convergence is to try to reduce the differences between the IFRSs
(international GAAP) and the standards of that specific country (that country’s national
GAAP). It involves discussion and collaboration between that country’s standard-setters and
the IASB in order to assess the differences and reach agreement on how to minimise them.
The Constitution of the IFRS Foundation was amended in The IFRS Foundation’s
2010 to make it clear that the ultimate objective is objective:
adoption of IFRSs, and that convergence is simply a is not convergence;
means to achieve adoption. is adoption.
Convergence is simply a means to
Convergence came about as a stepping stone due to achieve adoption.
resistance from some countries to full-scale adoption of the IFRSs.
Although most countries (at least 131 participating countries as at 11 December 20141)
already either permit or require the use of IFRSs (i.e. have adopted IFRSs), there are a few
countries that are still resisting adoption of the IFRSs. The reasons these countries are
resisting vary from country to country, for example:
A common reason given by a country for resisting the adoption of IFRSs is if differences
between that country’s national GAAP and the IFRSs are so vast that the complications
and related cost of converting to IFRSs are expected to outweigh the benefits.
In other cases, the countries that are resisting believe that their national standards are
superior to that of the IFRSs.
The IFRSs are principles-based (in fact, one of the objectives in the development of an
IFRS is to ensure that it is ‘based upon clearly articulated principles’) whereas the United
States, for example, uses US GAAP which, although is intended to be principles-based,
tends to be highly rules-based due to their litigious society (i.e. a society that tends to take
things to court).
The US argues that the pure principles-based approach is unsuitable since it opens the
door to potential litigation, which is less defensible than their relatively rules-based
approach.
It has also been found that more powerful countries appear ‘less willing to surrender
standard-setting authority to an international body’. 2
Where a country believes that it is unable to adopt the IFRSs, convergence is an option.
1
http://www.iasplus.com/en/resources/use-of-ifrs accessed 11 December 2014;
2
Research: Why Do Countries Adopt International Financial Reporting Standards? (2009: Ramanna & Sletten);
10 Chapter 1
3.6 Adoption versus Convergence
Adopt or converge? One country resisting the adoption of

As the IASB’s Director of International Activities IFRSs is the United States. Initially, the
(Mr Wayne Upton) explained: ‘While convergence US was completely opposed to the
may be the necessary preparation for some international standard-setting process,
countries to adopt IFRSs, the simplest, least costly but following numerous US corporate
and most straightforward approach is to adopt the collapses, the US Financial Accounting
complete body of IFRSs in a single step rather than Standards Board (FASB) and the IASB
opting for long-term convergence. Certainly, this is a agreed to a process of convergence.
significant change, but the alternatives may be more
difficult and may be of less benefit to a country in
The convergence between the IASB and
US’s FASB is commonly referred to as
the long run. The main reason why most companies
‘the Convergence Project’. However, it is
want to use IFRSs in their financial statements is
a misconception that convergence refers
the ability to demonstrate to the investor
only to the convergence between the
community that their financial statements are IASB and FASB. Other countries
IFRS-compliant. For that purpose it is not sufficient involved in similar convergence projects
that the standards have converged. The only way to with the IASB include, for example,
make a valid claim is to apply all the standards as China, India, Malaysia and Singapore.
issued by the IASB and make the compliance
representation required by IAS 1. Hence, while However, given that the US economy is
convergence is good, adoption is necessary to be considered to be relatively large (the US
truly able to harvest the benefits of the change.’ 1
economy is the second largest in the
world, with the greatest being the European economy), the convergence project between the
IASB and the US’s FASB is considered to be high profile worth watching carefully.
As mentioned, the US was initially opposed to IFRSs, but eventually, the IASB and the FASB
expressed their commitment to converge their standards. This commitment was documented
in the Norwalk Agreement of 2002.
Although the convergence project between the IASB and the FASB has a long way to go, the
effects of having successfully reduced many differences between the IASB’s IFRSs and
FASB’s US GAAP have already been felt by foreign companies listed in the US since they
are no longer required to prepare the complex and time-consuming reconciliation between
their financial statements, prepared using IFRSs, and the results that would have been
achieved using US GAAP.
The US Securities Exchange Commission (SEC) was expected to decide in 2011 whether it
would allow its domestic companies listed in the US to use IFRSs. This was then postponed to
2012. But in October 2012, the SEC announced that, due to ‘the US Presidential Elections and
other priorities in Washington, it was unlikely that the SEC would return to the topic of
domestic use of IFRSs until early 2013’. 2 Sadly, there appears to have been little/no progress
during 2013 with the last ‘joint IASB and FASB progress report’ having been released in
2012. Although this project seems never-ending, Christopher Cox, the previous Chairman of
the US Securities and Exchange Commission (SEC), vowed it would be complete in 2016.
Despite the difficulties in the convergence between the IASB and FASB, the top 20
economies in the world, (represented by the G20, which includes countries such as the United
States, South Africa, Australia, United Kingdom etc) have given their total support to all
convergence projects and ‘called on international accounting bodies to redouble their efforts
to achieve this objective within the context of their independent standard-setting process. In
particular, they asked the IASB and the US FASB to complete their convergence project’.3
1
http://www.ifrs.org/News/Features/Pages/Adopt-adapt-converge.aspx;
2
http://www.iasplus.com/en/meeting-notes/ - accessed 24 October 2012;
3
http://www.ifrs.org/use-around-the-world/Pages/use-around-the-world.aspx.
Chapter 1 11
3.7 Development of IFRSs (standard-setting)
3.7.1 Overview
IFRSs (standards and interpretations) are issued by the IASB, but the development of the
IFRSs occurs either within the IASB or its IFRS Interpretations Committee. Although the
IFRSs are developed by either the IASB or its IFRSIC, the development process involves
consultation with the various national standard-setters, regulators and other interested parties
from around the world and a careful analysis of the principles and practices contained in the
world’s various national GAAPs. This is to ensure that the IFRSs issued by the IASB are of a
high quality. This development process is required to follow specific procedures referred to
as due process. Due process is explained in section 3.7.4.
3.7.2 Standards developed to date
Standards are prefixed with either IAS or IFRS depending on whether they were developed by
the original International Accounting Standards Committee (IASC) or the current
International Accounting Standards Board (IASB): There are now 41
standards:
The original International Accounting Standards
Committee (IASC) developed 41 global accounting 25 are referenced as IAS 1 –
41 (done by the old IAS
standards, which were called International Accounting Committee) &
Standards (thus prefixed IAS), only 25 of which remain, 15 are referenced as IFRS 1
the rest having been withdrawn; – 15 (developed by the new
IAS Board).
The new International Accounting Standards Board
(IASB) adopted these remaining IAS’s and began developing further standards. So far, the
newly created IASB has developed 15 new standards, referred to as the International
Financial Reporting Standards (IFRS’s).
3.7.3 Interpretations developed to date
Interpretations are prefixed with either SIC or IFRIC depending on whether the committee
responsible for its development belonged to the original IASC or the current IASB.
Interpretations were previously developed by a sub- There are now 24
committee of the original IASC, called the Standing interpretations:
Interpretations Committee (SIC). This committee 7 are referenced as SIC 1 – 34
developed 34 interpretations (SIC1 – SIC34), only 7 of (developed by the old sub-
committee); &
which remain, the rest having been withdrawn as a result
14 are referenced as IFRIC 1 –
of the harmonisation process. 20 (developed by the new sub-
The interpretations are now developed by a sub- committee).
committee of the new IASB. This committee initially called itself the International
Financial Reporting Interpretations Committee (IFRIC), but changed its name in 2010 to
the IFRS Interpretations Committee (IFRSIC). To date, this committee has developed 21
new interpretations (IFRIC 1 – IFRIC 21), 7 of which have already been withdrawn
(IFRIC 3, 8, 9, 11, 13, 15 and 18), leaving only 14 interpretations standing.
3.7.4 Due Process
3.7.4.1 Overview
Due process is concerned with the development of IFRSs (standards and improvements):
New standards;
Amendments to standards that are considered to be major amendments;
Amendments to standards that are considered to be ‘minor or narrow in scope’; and
Interpretations.
This due process is set-out in the Due Process Handbook.
12 Chapter 1
3.7.4.2 Principles of Due Process

Due process is based on the following principles:
1. Transparency: this is achieved by, for example,
meetings of both the IASB and IFRSIC being open to the public and web-cast;
rigorous voting processes; and
various education sessions offered by the IASB.
2. Full and fair consultation: the IASB and IFRSIC solicits support from a variety of
sources including, for example:
various national and regional networks including the Accounting Standards Advisory
Forum and the IFRS Advisory Council; and
the public, through ‘invitations to comment’, as well as public hearings;
individuals such as preparers, auditors or investors, which they approach through the
process of fieldwork (e.g. one-to-one interviews and workshops) and other initiatives.
3. Accountability: in this regard, the IASB is required, for example:
to formally consider the likely ‘effects’ (cost and benefits) of proposed new or revised
standards throughout the development process;
to provide the Basis for Conclusions (i.e. the IASB’s reasoning behind developing or
changing a standard as well as the IASB’s responses to the comments received when
the proposals were exposed);
to provide Dissenting Opinions (where IASB members disagreed with a standard,
they are required to provide reasons).
3.7.4.3 The Basic Development Cycle
Before development relating to standards or interpretations can begin, a mandatory Exposure

Draft (ED) must first be released for public comment. [See section 3.7.4.4]
Before proposing any development, however, the IASB would normally publish a Discussion
Paper (DP) and first carefully consider the comments received from that consultation process.
A DP is not mandatory though, although reasons for not publishing one would need to be
explained to the Due Process Oversight Committee.
Diagram: Basic development cycle: Importantly, public feedback is

obtained at every step of the
Discussion Paper (optional) development cycle. It often happens
that after public feedback, revised
Public consultation Exposure Drafts, for example, may
need to be issued for further public
Proposal comment before continuing with the
next step.
Exposure Draft (mandatory) When entities start applying new or
amended Standards, practical issues in
Public consultation the implementation thereof may arise
that confuse accountants and auditors.
Development: Standard/ Interpretation The issues that may arise can be
roughly categorised as follows:
Public consultation/ problems arise on Minor or narrow-scope issues:
implementation these are then dealt with in the
Annual Improvements; or
Development: Interpretation Major issues: these require either a
revised Standard or an
Interpretation to be issued.
Chapter 1 13
The IASB is responsible for issuing everything IFRS-related but it does not develop
everything. Exposure Drafts and Standards are developed by the IASB. Its sub-committee,
the IFRS Interpretations Committee is responsible for developing Interpretations. Annual
Improvements are normally developed by the IFRS Interpretations Committee but may be
developed by the IASB instead.
Diagram: Summary of who develops what:
IFRS: Previously developed Now developed by

by
Exposure Drafts & IASC IASB

Standards
Improvements & SIC IFRSIC

Interpretations
3.7.4.4 Developing Exposure Drafts
Exposure Drafts (ED) are defined in the Due Process Handbook as follows:
A draft of a proposed Standard, amendment to a Standard or Interpretation.
An Exposure Draft sets out a specific proposal and includes a draft Basis for Conclusions
and, if relevant, alternative views.
An Exposure Draft is a mandatory due process step. Due Process Handbook: Glossary of terms
Exposure Drafts are developed by technical staff of the

Exposure Drafts (EDs)
IASB and are developed in public meetings.
are developed by the IASB.
Once the Exposure Draft is complete, it is checked by are developed before developing
the IASB and must be approved by a supermajority Standards/ Interpretations/ Annual
Improvements.
(defined as: at least 10 of its 16 members, or 9 if the
always include invitations to comment.
membership is 15 or less) before being issued for
must be approved by a ‘super majority’
public comment. see Due Process Handbook Glossary of terms of the IASB.
A published Exposure Draft includes:

opinions of those IASB members who did not approve of the Exposure Draft; and the
basis for the conclusions by the IASB members who did approve of the Exposure Draft.
Exposure Drafts are prepared in the form of the proposed new Standard. Since Exposure
Drafts are ‘the IASB’s main vehicle for consulting the public’ the published Exposure Draft
always includes an invitation to comment. The comment period is normally a minimum of
120 days when exposing a Standard and 90 days when exposing an Interpretation, but with
special approval, may be reduced to 30 days. The public comments received are then
thoroughly investigated. If the issues raised are considered significant enough, the IASB may
decide to issue a revised Exposure Draft for further comment.
After the comments on the Exposure Draft have been satisfactorily resolved, development of
the Standard, amendment to a Standard or Interpretation may begin.
3.7.4.5 Developing Standards
Standards are defined in the Due Process Handbook as follows:

Standards issued by the IASB.
They comprise those prefixed by IFRS and IAS. see Due Process Handbook: Glossary of terms
14 Chapter 1
Before a standard is developed, an Exposure Draft is issued for

Standards
public comment.
are developed by the IASB.
The period for public comment on an Exposure Draft of a are normally exposed for
Standard is generally a minimum of 120 days, but with special comment for 120 days.
approval, this can be reduced to a minimum of 30 days. must be approved by a
‘supermajority’ of the IASB
Once the IASB has reached satisfactory conclusions on all before being issued.
issues arising from comments on the Exposure Draft, the IASB votes to instruct the technical
staff to draft the Standard.
The draft Standard is normally reviewed by the Interpretations Committee (IFRSIC). Then the
near-final standard is posted on the IFRS website for public scrutiny, after which the IASB
votes on the Standard before formally issuing the final version.
This final Standard must be approved by a supermajority of the IASB (defined as ‘at least 10
of its 16 members, or 9 if the membership is 15 or less’) before being issued.
3.7.4.6 Developing Interpretations
Interpretations are defined in the Due Process Handbook as follows:

Interpretations are developed by the Interpretations Committee (IFRSIC) before being
ratified and issued by the IASB.
Interpretations carry the same weight as a Standard. Due Process Handbook: Glossary of terms
After a Standard has been issued, problems in applying it may be identified, such as errors,
ambiguities, omissions and concerns regarding the existence of, for example, too many
options in the standard:
An Interpretation may need to be developed if the problems identified relate to confusion
regarding how a Standard is to be implemented.
A revised Standard may need to be developed if the Interpretations are
problems identified suggest that a major amendment/s to a published:
Standard may be needed. only if the issues are not
An Annual Improvement may need to be issued if the ‘narrow scope/ minor’.
problems identified suggest that a minor and narrow-scope
amendment/s to a Standard may be needed.
Interpretations have the same authority as standards and thus extreme care is exercised when
publishing an interpretation.
The publication of an interpretation follows its own due Annual improvements

process, summarised below. See s7 of the Due Process Handbook, 2013 are published:
for ‘narrow scope/ minor’
Members of the technical staff start by drafting a ‘paper’ that issues.
summarises the matters to be addressed. This is then presented
to the IFRSIC to consider. When the IFRSIC reach agreement on the matters to be addressed,
the technical staff members then present this ‘paper’ to the IASB. In the meantime, the
IFRSIC decides whether the staff should prepare an Exposure Draft of an Interpretation.
If a draft Interpretation is to be prepared, the IFRSIC will be required to vote on the draft
Interpretation (no more than 4 members of this committee may disagree with the draft).
Once this draft Interpretation is passed by the IFRSIC, it is presented to the IASB. The IASB
then votes on the draft Interpretation. On condition that no more than 3 members of the IASB
disagrees with the draft, the draft Interpretation is then issued for public comment.
The period for public comment on an Exposure Draft of an Interpretation is generally 90 days,
but with special approval, this can be reduced to 30 days.
Chapter 1 15
The comments received are then considered by the IFRSIC

Interpretations:
after which the Interpretation is adjusted for any amendments
that may be necessary. If the comments are significant, it are developed by the IFRSIC.
may mean that the Interpretation needs to be re-exposed for
are normally exposed for
public comment. comment for 90 days.
must be approved by a
The final Interpretation must be approved by a supermajority ‘supermajority’ of the IASB
of the IASB (defined as: at least 10 of its 16 members, or 9 if before being issued.
the membership is 15 or less) before being issued.
3.7.4.7 Developing Annual Improvements
The Annual Improvements are defined in the Due Process Handbook as follows:
narrow-scope or minor amendments to Standards or Interpretations
that are packaged together and exposed in one document even though the amendments are
unrelated. Due Process Handbook: Glossary of terms
These amendments are limited to changes that either: Annual Improvements:
clarify the wording in a Standard; or are developed by the IFRSIC

(or IASB).
correct relatively minor unintended consequences,
oversights or conflicts between existing requirements of follow the same due process
used for all other amendments
Standards. IASB Due Process Handbook, 2013: para 6.11 to Standards.
The due process that applies to Annual Improvements is the same that which applies to all
other amendments to Standards. However, due to their relatively minor nature, the level of
consultation and community outreach may be limited to the request for comment letters.
The most recent publication of a set of Annual Improvements came in September 2014 and
the next set of annual improvements is expected to be published in late 2015 or early 2016.
3.8 The IASB and the IFRS Foundation: a look at the structure
3.8.1 Overview
The International Accounting Standards Board (IASB) is the independent standard-setting

body responsible for issuing IFRSs (standards and interpretations). It is represented by many
nations and has its head-office in London.
The IFRS Foundation is the over-arching legal body which exists purely for the purpose of
enabling the IASB to function.
The IFRS Interpretations Committee (IFRSIC) assists the IASB in improving financial
reporting and is responsible for developing interpretations (which are approved and issued by
the IASB).
Both the IASB and its IFRSIC are assisted by technical staff members, who are employed by
the IFRS Foundation.
The Trustees of the IFRS Foundation oversee the operations of the IASB and its IFRSIC.
The trustees report to a Monitoring Board (MB), which is constituted by various

representative public authorities.
The development of the IFRSs requires much collaboration with interested parties. In this
regard, there are two advisory councils: the IFRS Advisory Council (IFRSAC) and the
Accounting Standards Advisory Forum (ASAF).
16 Chapter 1
3.8.2 The IFRS Foundation: an organogram

IFRS Foundation Monitoring Board 1: 1. Public accountability
6 people Members of the MB appoint and monitor the
(membership to be constituted by trustees, meet the trustees once a year.
leaders of 5 bodies plus 1 non-voting Members of the MB are not paid.
formal observer)
2. Governance and oversight:

Representatives of the
Trustees appoint members to IFRSAC, IASB

and IFRSIC; oversee their processes and
standard-setting
ASAF
IFRS Foundation Trustees2 ensure financing. They meet at least twice a

international
year and report to the MB. Trustees are

23 people
community
independent and may not influence the

decisions of the various committees. Trustees
are paid an annual fee, a fee per meeting
and their travel expenses are paid.
the IASB’s work, advise the IASB on their views on major
unpaid. They advise the IFRSF and the IASB: they prioritise
IFRSAC normally meets 3 times pa. IFRSAC members are
There must always be at least 30 members, each appointed for
standards, and give other advice to the IASB and the Trustees.
3. Independent standard-setting and

IFRS Foundation3 related activities
IFRS Advisory Council: +- 48 people
The IASB develop and publish standards,

International Accounting and approve interpretations. They need 9
votes out of 13 to get standards, Exposure
a renewable term of 3 years.
Standards Board (IASB): Drafts and interpretations published. The

14 people (13 voting and 1 non- IASB members are full-time employees, paid
voting chairman) by the IFRS Foundation (a max of 3
members are allowed to be part-time).
The IFRSIC develop interpretations after

getting public comments. Interpretations
IFRS Interpretations Committee must be approved & issued by IASB. Before
applying for final approval from the IASB,
(IFRSIC): the IFRSIC need a quorum of 10 members
15 people (14 voting and 1 non- and must not have more than 4 votes against
voting chairman) the interpretation. The IFRSIC reports to the
IASB. The IFRSIC members are unpaid but
have travel expenses repaid.
Adapted from: http://www.ifrs.org/The-organisation/Pages/How-we-are-structured.aspx
3.8.3 The IFRS Foundation
The IFRS Foundation exists as the legal entity under which the IASB operates. It is described
as ‘an independent, not-for-profit private organisation working in the public interest’.
The IFRS Foundation Constitution details its objectives and the objectives of each of its
bodies (IASB, IFRSIC, the IFRS Advisory Council, the Trustees and the Monitoring Board)
and how each is to operate and how each is governed.
(an extract from its Constitution, published in 2013)
The Objectives of the IFRS Foundation
The objectives of the IFRS Foundation are:

(a) to develop, in the public interest, a single set of high quality, understandable, enforceable and
globally accepted financial reporting standards based upon clearly articulated principles. These
standards should require high quality, transparent and comparable information in financial
statements and other financial reporting to help investors, other participants in the world’s capital
markets and other users of financial information make economic decisions.
(b) to promote the use and rigorous application of those standards.
(c) in fulfilling the objectives associated with (a) and (b), to take account of, as appropriate, the needs
of a range of sizes and types of entities in diverse economic settings.
(d) to promote and facilitate adoption of International Financial Reporting Standards (IFRSs), being
the standards and interpretations issued by the IASB, through the convergence of national
accounting standards and IFRSs.
Chapter 1 17
3.8.4 The Trustees

There are 23 trustees that govern the IFRS Foundation, overseeing the operations of both the
IASB and its IFRSIC. The Constitution sets out the responsibilities of the trustees, some of
their main responsibilities being:
appointing members of the IASB, the IFRSIC and the IFRSAC;
establishing and amending the operating procedures, consultative arrangements and
due process for the IASB, the IFRSIC and the IFRSAC;
reviewing annually the strategy of the IASB and assessing its effectiveness;
ensuring the financing of the IFRS Foundation and approve annually its budget. 1
1: http://www.ifrs.org/The-organisation/Trustees/Trustee-responsibilities/Pages/Trustee-responsibilities.aspx
The Constitution requires that these trustees reflect a mix of professional backgrounds (e.g.
auditors, preparers, users and academics) and geographical areas (one from Africa, one from
South America, six from Europe, six from North America and six from the Asia/ Oceania
region and two from any other area as long as the geographical mix remains balanced). Africa
is represented by a South African, Professor Wiseman Nkuhlu (a SA chartered accountant).
Trustees:
These trustees have a committee called the Due Process
Oversight Committee (DPOC). This DPOC is are selected so that they reflect a mix
responsible for ensuring that the IASB and its IFRSIC of professions and geographic areas.
comply with due process procedures. govern the operations of the IFRS
Foundation (IASB and its IFRSIC), &
The trustees are accountable to the Monitoring Board. use their DPOC to assist in monitoring
compliance with due process.
3.8.5 The Monitoring Board
A further structure, the Monitoring Board, ensures that the IFRS Foundation and the IASB’s
decision-making are independent. According to both the Constitution and the Monitoring
Board’s Charter, the Monitoring Board's main responsibilities include:
ensuring the Trustees discharge their duties as defined by the Constitution;
approving the appointment or reappointment of Trustees;
meeting with the Trustees at least once a year (or more often if appropriate). 1
There are 8 bodies represented on the Monitoring Board, including the Basel Committee on
Banking Supervision as a non-voting formal observer plus 7 bodies with voting power:
the European Commission,
the Japanese Financial Services Agency (JFSA), The Monitoring Board:
the US Securities and Exchange Commission (SEC), Members come from Europe, the US,
the Emerging Markets Committee of International Japan, Brazil, Korea and other
emerging markets.
Organization of Securities Commissions (IOSCO),
which represents the African-Middle East region, the The MB effectively monitors the
Asia-Pacific Region, the European Region and the functioning of the Trustees.
Inter-American Region,
the Technical Committee of IOSCO,
the Brazilian Securities Commission (CVM), and
the Financial Services Commission of Korea (FSC). 2
Admitting further members to the Monitoring Board and selecting its chairman require the
consensus of these existing members. Membership of this board may only include:
authorities responsible for setting the form and content of financial reporting in their
jurisdictions;
those responsible for protecting and advancing public interest; and
those who are strongly committed to the development of high quality IFRSs. 2
1
http://www.ifrs.org/The-organisation/Governance-and-accountability/Pages/Monitoring-Board.aspx
2
Monitoring Board Charter, 2009
18 Chapter 1
3.8.6 The International Accounting Standards Board (IASB)
The International Accounting Standards Board (IASB) is the The IASB:

standard-setting body.
develop & issue IFRSs & EDs; &
It is responsible for issuing Exposure Drafts, Standards and issue Interpretations.
Interpretations but is only responsible for developing Exposure
Drafts and Standards (Interpretations are developed by the IFRS Interpretations Committee).
They use a team of technical staff (employed by the IFRS Foundation) to prepare the IFRSs.
3.8.7 The IFRS Interpretations Committee (IFRSIC)

The IFRSIC develop
the interpretations.
The IFRS Interpretations Committee (IFRSIC) is a committee
within the IASB. It assists the IASB in improving financial
reporting by ‘timeously identifying, discussing and resolving issues regarding financial
reporting’. The IFRSIC is responsible for developing the interpretations.
3.8.8 The IFRS Advisory Council (IFRSAC) The IFRSAC act as

advisors to the IASB
A separate IFRS Advisory Council (IFRSAC) exists as the and the trustees
forum for organisations and individuals interested in
international financial reporting. They are expected to meet at least 3 times per year.
The Constitution states that the IFRSAC must:

advise the IASB on its agenda decisions and help prioritise its work;
inform the IASB of its members’ views on major standard-setting projects; and
give other advice to both the IASB and trustees.
3.8.9 The Accounting Standards Advisory Forum (ASAF)

The ASAF provide
On 19 March 2013, the trustees announced the creation of the technical advice &
Accounting Standards Advisory Forum (ASAF), whose feedback to the IASB
members represent global accounting standard-setters.
The main purpose of the ASAF is to provide technical advice and feedback to the IASB.
The reason behind this new forum is that the IASB was involved with numerous bilateral
communications with each of the various national standard-setters and it became clear that
this communication would be streamlined if it could be handled via a single forum.
4. The Companies Act and the Related Regulations
4.1 Overview
The Companies Act 2008
The Companies Act of 2008 became effective on 1 May
(effective 1 May 2011)
2011, replacing the Companies Act of 1973 and the
must be read together
Corporate Law Amendment Act of 2006.
with the:
Regulations (2011), and
The Companies Act 2008 must be read together with the
Amendment Act (2011).
Companies Regulations 2011. These regulations became
effective on 1 May 2011.
A number of errors and anomalies were discovered in this Companies Act which have since
been corrected via the Companies Amendment Act of 2011. Since the Companies Act of 2008
has not yet been updated for these amendments, the Companies Act of 2008 must be read
together with the Companies Amendment Act of 2011.
Chapter 1 19
The Companies Act of 2008 regulates many aspects of a company’s existence and conduct. It
is separated into nine chapters and five schedules, of which, Chapter 2 and Schedules 2 and 5
are most important to accounting financial reporting. Some of the sections relevant to
accounting from these chapters and schedules will now be discussed.
4.2 The Companies Act, 2008: Some of the big changes
The Companies Act of 2008, together with the Companies Regulations, 2011 includes
provisions that have eradicated some fundamental aspects of the old Companies Act. Some of
the most noticeable changes are the following:
Shares may no longer be issued with a par value; see Companies Act s35
Close corporations (CCs) may no longer be created although existing CCs may choose to
convert to a company or remain as a CC until dissolution or deregistration;
Companies are divided into non-profit companies and profit companies; see Companies Act s8
Financial statements will need to be published within 6 months after the financial year-
end (previously this was 9 months); see Companies Act s30
The Fourth Schedule disclosure requirements fall away; and
Companies now have the contractual powers of a natural person. Therefore so-called
‘ultra vires acts’ will no longer apply (‘ultra vires’ is a Latin term meaning ‘beyond the
powers’ and allowed companies to argue, for example, that they could not be held
responsible for certain acts on the basis that they did not have the relevant power/
authority). see Companies Act s19 and s20
4.2.1 What about pre-existing par value shares? (Co’s Act: Sch 5: s6 and Regulation 31)
Companies may not authorise any new par value shares (also known as shares having a
nominal value) on or after the effective date (1 May 2011). However, what happens to pre-
existing authorised par value shares depends entirely on the situation:
Companies that had authorised par value shares that were already in issue on effective
date are allowed to leave these par value shares in issue, although the company may
choose to convert them instead. See Companies Act Schedule 5 s6(2)
Companies that had authorised par value shares in existence on the effective date that had
not yet been issued by this date, must apply the following rules:
- If none of the authorised par value shares have yet been issued or some have been
issued but all of these have subsequently been re-acquired, then none of these
unissued par value shares may be issued – these shares will first need to be converted
into shares of no par value. See Co’s Regulations 31 (3)
- If some of the authorised par value shares have been issued with some still remaining
unissued, these remaining unissued par value shares may still be issued...but only
until such time as the company chooses to convert these shares into no par value
shares and publishes a proposal to this effect. See Companies Regulations 31 (5)
4.2.2 What about pre-existing CCs? (Companies Act: Schedule 2)
New Close Corporations (CCs) may not be created after the effective date (1 May 2011).
However, CCs that were already in existence on this effective date may either:
Continue as a CC; or
Convert into a company.
The fact that CC’s were given the option to continue as CCs instead of all being forced to
convert to companies is no doubt due to logistical reasons. There are roughly 2 million CCs in
South Africa compared to roughly only 400 000 companies. To cater for the massive
conversion of 2 million CCs into companies would simply not have been possible!
20 Chapter 1
CCs that choose not to convert into a company must note that the Close Corporations Act has
been amended such that CCs will have to comply with most sections of the Companies Act
and related Regulations as if the CC were a company. For example, CCs will be subject to the
same criteria when deciding what reporting standards to use and whether an audit or
independent review is required.
When considering whether or not to convert a CC into a company, one should consider the
effect of such a conversion on their legal status. The following extract from the Companies
Act explains what happens if one opts to convert a CC into a Company:
(1) Every member of a close corporation converted under this Schedule is entitled to become
a shareholder of the company resulting from that conversion, but the shares to be held in
the company by the shareholders individually need not necessarily be in proportion to the
members’ interests as stated in the founding statement of the close corporation concerned.
(2) On the registration of a company converted from a close corporation:
(a) the juristic person that existed as a close corporation before the conversion continues to exist
as a juristic person, but in the form of a company;
(b) all the assets, liabilities, rights and obligations of the close corporation vest in the company;
(c) any legal proceedings instituted before the registration by or against the corporation, may be
continued by or against the company, and any other thing done by or in respect of the close
corporation, is deemed to have been done by or in respect of the company;
(d) any enforcement measures that could have been commenced with respect to the close
corporation in terms of the Close Corporations Act, 1984 (Act No. 69 of 1984), for conduct
occurring before the date of registration, may be brought against the company on the same
basis, as if the conversion had not occurred; and
(e) any liability of a member of the corporation for the corporation’s debts, that had arisen in
terms of the Close Corporations Act, 1984 (Act No. 69 of 1984), and existed immediately
before the date of registration, survives the conversion and continues as a liability of that
person, as if the conversion had not occurred. Companies Act: Schedule 2: s2
4.3 The different categories of companies (Companies Act: s8 and s11)
There are two main categories of company:

profit companies; and
non-profit companies.
Profit companies are then sub-divided into four sub-categories.
The following is a summary comparing the descriptions of all these types of company:
Category of company: Definition and Description:

1. Profit companies Definition: A company incorporated for the purpose of financial
gain for its shareholders Companies Act: s1
1.1 A state-owned company Definition: A company is a state-owned company if it is:
(a) listed as a public entity in Schedule 2 or 3 of the Public
Finance Management Act, 1999; or
(b) owned by a municipality, as contemplated in the Local
Government: Municipal Systems Act, 2000 and similar to a
public entity, as described above. Companies Act s1
Company name: must end with ‘SOC Ltd’. Companies Act: s11
Other interesting facts:
All sections in the Companies Act that refer to public companies
apply equally to state-owned companies, except that the Minister
may grant exemptions from one or more provisions of the Act. s9
Chapter 1 21
Category of company: Definition and Description:

1. Profit companies continued...
1.1 A state-owned company See prior page
1.2 A private company Definition: A company is a private company if:

(a) it is not state-owned company; &
(b) its Memorandum of Incorporation:
Prevents it from offering its securities to the public; and
Restricts the transfer of its securities Co’s Act: s8 (See note 1)
Company name: must end with either ‘Proprietary Limited’ or
‘(Pty) Ltd’ Companies Act: s11
A private company is no longer restricted to 50 members (i.e. a
private company may now have more than 50 members!).
1.3 A personal liability company Definition: A company is a personal liability company if:
(a) it is a private company; and
(b) its Memorandum of Incorporation states that it is a personal
liability company Companies Act: s8
Company name: must end with ‘Incorporated’ or ‘Inc’. Co’s Act: s11
1.4 A public company Definition: A company is a public company if it is:
(a) A profit company that is
(b) not a state-owned company, a private company or a personal
liability company s1
Company name: must end with ‘Limited’ or ‘Ltd’. Co’s Act: s11
2. Non-profit companies Definition: A company is a non-profit company if:
(a) it is incorporated for a public benefit or other object as
required by item 1(1) of Schedule 1; and
(b) its income and property are not distributable to its
incorporators, members, directors, officers or persons
related to any of them except to the extent permitted by item
1(3) of Schedule 1 s1
Company name: must end with ‘NPC’. Companies Act: s11
Some sections of the Companies Act do not apply to non-profit
companies. Companies Act: s10
Note 1: Securities are defined as any shares, notes, bonds, debentures or other instruments,
irrespective of their form or title, issued or authorised to be issued by a profit company for
the purpose of raising capital.
Shares are simply one of the possible types of security and are defined as ‘one of the units
into which the proprietary interest in a profit company is divided’.
4.4 Legal backing for financial reporting standards (Companies Act: s29 and Reg. s27)
For many years, South Africa had both:

a national standard-setter (called the Accounting Practices Board: APB Note 1) which
would publish accounting standards; and
a monitoring panel (originally called the GAAP Monitoring Panel: GMP but recently
renamed the Financial Reporting Investigations Panel: FRIP) which ensured that listed
companies complied with accounting standards.
Unfortunately, the efforts of the GMP and the APB were that of a classic toothless tiger
because there was no legal requirement to comply with these standards. However, the
Companies Act 2008 now requires compliance with financial reporting standards and the
Companies Act Regulations 2011 stipulate what specific standards constitute these so-called
financial reporting standards.
22 Chapter 1
Where the FRS are stipulated to be the IFRSs, the

Financial Reporting Investigations Panel (FRIP), (a joint The Companies Act
initiative between the SA Institute of Chartered states that:
Accountants and the JSE Securities Exchange), any person involved in the
investigates and advises the JSE on alleged cases of non- preparation, approval, dissemination
compliance with IFRSs. or publication
of any financial statements
The Regulations currently state that there are three will be guilty of an offence
different kinds of financial reporting standards, to be used if these f/statements do not
by different companies depending on the nature of the comply with IFRSs when they
company: should comply.
IFRSs: International Financial Reporting Standards,

IFRS for SMEs: IFRSs for Small and Medium-sized Entities; and
SA GAAP: SA GAAP is being withdrawn and may no longer be applied in respect of
financial years commencing on or after 1 December 2012, with the result that the only
standards available in future would be IFRSs and IFRS for SMEs.
Thus, with the new Companies Act, certain companies are now legally required to comply
with IFRSs. Furthermore, by providing for the use of either IFRS or IFRS for SMEs, the new
Companies Act has effectively provided legal backing for what is referred to as differential
reporting in South Africa. Differential reporting is explained in more detail in section 4.7.
Who decides what the Regulations say the financial reporting standards should be in SA?
When drafting the Regulations, the Minister is advised by two legal bodies as to what the financial
reporting standards should be:
the Companies and Intellectual Property Commission; and
the Financial Reporting Standards Council.
The Companies and Intellectual Property Commission (CIPC) is tasked with promoting the reliability of
financial statements by, among other things:
(a) monitoring patterns of compliance with, and contraventions of, financial reporting standards; and
(b) making recommendations to the Council for amendments to financial reporting standards, to secure
better reliability and compliance. Companies Act: s187 (3)
The Financial Reporting Standards Council (FRSC) is the legally constituted South African standard-
setter. It was formed in late 2011. The Council is expected to:
(a) receive and consider any relevant information relating to the reliability of, and compliance with,
financial reporting standards and
adapt international reporting standards for local circumstances and
consider information from the Commission as contemplated in section 187(3)(b);
(b) advise the Minister on matters relating to financial reporting standards; and
(c) consult with the Minister on the making of regulations establishing financial reporting standards,
subject to the requirements set out in section 29(5). Companies Act: s204
The APB is in the process of being replaced by the FRSC

Since the establishment of the FRSC, the reason for the Accounting Practices Board (APB) to exist has
largely fallen away. Thus the APB is expected to commence the process of its voluntary winding up.
4.5 Which financial reporting standards must we use? (Companies Act: s29 and Reg. s27)
The Companies Act states that companies must use Financial Reporting Standards (FRS).
The Regulations explain that what is meant by Financial Reporting Standards depends on the
category of company.
Essentially, in SA, Financial Reporting Standards may refer to IFRS, IFRS for SMEs instead
– or, for a while, SA GAAP. This use of a variation of reporting standards is referred to as
differential reporting (see section 4.6).
Chapter 1 23
The following table summarises which standards are to be used for which SA companies (this
table is extracted and slightly adapted from the Companies Act Regulations, section 27(4)):
Category of company: Financial Reporting Standards

1. Profit companies
1.1 A state-owned company IFRS, but in the case of any conflict with
any requirement in terms of the Public
Finance Management Act, the latter
prevails
1.2 Public companies listed on an exchange IFRS
1.3 Public companies not listed on an exchange One of –
(a) IFRS; or
(b) IFRS for SMEs Note 1
1.4 Profit companies, other than state-owned or public companies One of –
whose public interest score for the particular financial year is (a) IFRS; or
at least 350 OR who holds assets in excess of R5m in a (b) IFRS for SMEs Note 1
fiduciary capacity.
1.5 Profit companies other than state-owned or public One of –
companies, whose public interest score for the particular (a) IFRS; or
financial year is at least 100 but less than 350 (b) IFRS for SMEs Note 1
(c) SA GAAP Note 2
1.6 Profit companies other than a state owned or public One of –
companies, whose public interest score for the particular (a) IFRS; or
financial year is less than 100, and whose statements are (b) IFRS for SMEs Note 1
independently compiled (c) SA GAAP Note 2
1.7 Profit companies other than state owned or public The Financial Reporting Standard
companies whose PIS for the particular financial year is less (FRS) as determined by the company
than 100 and whose statements are internally compiled. for as long as no FRSs are prescribed.
2. Non-profit companies
2.1 Non-profit companies that hold assets in excess of R5m in a IFRS, but in the case of any conflict
fiduciary capacity OR are state or foreign controlled OR with any requirement in terms of the
perform a statutory or regulatory function Public Finance Management Act, the
latter prevails
2.2 Non-profit companies other than those contemplated in the One of –
first row above whose PIS for the particular year is at least (a) IFRS; or
350 (b) IFRS for SMEs Note 1
first row above whose PIS for the particular financial year is (a) IFRS; or
at least 100 but less than 350 (b) IFRS for SMEs Note 1
(c) SA GAAP Note 2
first row above, whose public interest score for the (a) IFRS; or
particular financial year is less than 100, and whose (b) IFRS for SMEs Note 1
statements are independently compiled (c) SA GAAP Note 2
2.5 Non-profit companies other than those contemplated in the The Financial Reporting Standard
first row above whose PIS for the particular financial year is (FRS) as determined by the company
less than 100 and whose statements are internally compiled. for as long as no FRSs are prescribed
Note:
1 Where IFRS for SMEs are an option, these may only be used if the company meets the scoping requirements
outlined in the IFRS for SMEs standard.
2 SA GAAP is being withdrawn. SA GAAP may not be applied to financial statements commencing on or after
1 December 2012. For example: if you are preparing financial statements for the period 1 November 2012 –
31 October 2013, your financial statements may be prepared using SA GAAP; but if your financial period
covers 1 December 2012 – 30 November 2013, you may not use SA GAAP and will need to decide whether
to comply with IFRS or IFRS for SMEs.
24 Chapter 1
4.6 Legal backing for differential reporting
4.6.1 An overview
The Companies Act 2008 has effectively given legal Legal backing for
backing for differential reporting by allowing the use of differential reporting
both IFRSs and IFRSs for SMEs. means that whereas
some companies must use IFRS,
Differential reporting stems from the acceptance that the other companies may choose to use
content of financial statements is driven by the needs of the IFRS for SMEs.
users of financial statements. IFRSs are designed primarily for preparing the financial
statements of public companies. Thus the level of complexities in the IFRSs are often
unnecessary, irrelevant and very costly for non-public companies to implement. This led to
the development of IFRSs for Small and Medium Entities (IFRS for SMEs), which provides a
simpler set of international standards.
4.6.2 What is a small and medium-sized entity (SME)?
What distinguishes a SME from another entity is that it has SMEs are entities
no public accountability but yet it still produces general
purpose financial statements for external users. with no public accountability, but
that
Circular 02/2009 explains that an entity has public produce general purpose financial
accountability if: statements for external users.
(a) its debt or equity instruments are publicly traded (or it is in the process of issuing such
instruments); or
(b) one of its primary businesses is to hold assets in a fiduciary capacity (i.e. having the legal
authority and duty to make financial decisions) for a broad group of outsiders.
Examples of entities that have public accountability include banks, credit unions, insurance
companies, securities brokers/dealers, mutual funds and investment banks.
Please note that if your entity has no public accountability but is a subsidiary:
whose parent uses full IFRSs, or
forms part of a consolidated group that uses full IFRSs on consolidation,
you may choose to use IFRS for SMEs for your own entity’s financial statements.
4.6.3 The history of differential reporting in South Africa South Africa was
the first country in
Although the Companies Act of 2008 has only recently allowed the world to adopt
differential reporting, the South African Accounting Practices IFRS for SMEs!
Board (APB) had already approved differential reporting in 2007. Circular 09/2007 (now
replaced by Circular 02/2009) announced that the APB, given the extreme pressure placed on
smaller companies to comply with complex IFRSs, had approved the IASB’s Exposure Draft
entitled IFRSs for Small and Medium-sized Entities (SMEs). South Africa adopted this
Exposure Draft verbatim and was the very first country in the world to adopt this Exposure
Draft (SAICA press release 3 October 2007).
The final IFRS for SMEs has since been released (i.e. replacing the Exposure Draft) and it too
has been adopted word-for-word by the South African APB.
4.6.4 How do the IFRS for SMEs help?
Small and medium sized entities (SMEs) do not have the need for certain complexities that
are covered in the IFRSs and generally do not have the complex systems needed to provide
the information needed for recording and presenting some of the more complex aspects. Thus
the IFRS for SMEs was created.
Chapter 1 25
The IFRS for SMEs is a selection of simplified IFRSs to be used by SMEs and which:
provides disclosure relief (i.e. less detail needs to be provided in the financial statements);
simplifies many recognition and measurement criteria;
removes choices for accounting treatments; and
eliminates certain topics that are generally not relevant to SMEs.
4.7 Does our company need an audit or independent review? (Co’s Act: s30; Reg: 28-29)
Some companies must be audited, some simply require an independent review and some
require nothing at all. Apart from state-owned and public companies, which must always be
audited, whether an audit or independent review is required for the remaining categories of
companies depends on that company’s public interest score (PIS) and other factors. The table
below summarises the factors to consider when deciding if a company needs an audit,
independent review or neither (note: if the Act does not require an audit, an audit would still
be needed if a company’s Memorandum of Incorporation states that an audit is required).
Category of company: Audit? Who?

1. Profit companies
1.1 State-owned companies Audit RA
1.2 Public companies Audit RA
1.3 Profit co’s, other than state-owned or public companies, that: Audit RA
hold assets in excess of R5m in a fiduciary capacity; Note 1 OR
have a PIS for the particular financial year of at least 350.
1.4 Profit co’s other than state-owned or public companies, whose:
PIS for the particular financial year is at least 100 but less
than 350 and:
a) AFS is internally compiled: Audit RA
b) AFS is independently compiled and company is not owner- Independent review RA/ CA
managed
c) AFS is independently compiled and company is owner- No audit or independent review -
managed and can apply the s30 (2A) exemption for – just prepare the AFS
owner-managed companies
1.5 Profit co’s other than state-owned or public companies whose:
PIS for that financial year is less than 100 and:
a) is not owner-managed Independent review RA/ CA/ AO
b) is owner-managed and can apply the s30 (2A) exemption No audit or independent review -
for owner-managed companies – just prepare the AFS
2. Non-profit companies
2.1 Non-profit companies that: Audit RA
hold assets in excess of R5m in a fiduciary capacity; Note 1 OR
are state or foreign-controlled; OR
perform a statutory or regulatory function; OR
have a PIS for the year of at least 350
2.2 Non-profit co’s other than those referred to in 2.1 above, whose:
PIS for the particular financial year is at least 100 but less
than 350 and:
a) AFS is internally compiled: Audit RA
b) AFS independently compiled Independent review RA/ CA
2.3 Non-profit co’s other than those referred to above whose: Independent review RA/ CA/ AO
PIS for the particular financial year is less than 100
Acronyms used in the table:
CA: Chartered Accountant CA(SA) RA: Registered auditor AO: Accounting officer PIS: Public interest score
Reference: A table produced by the SA Institute of Chartered Accountants; reproduced and adapted with their kind permission.
Note 1: Assets held in a fiduciary capacity must be held in the ordinary course of the company’s primary business, (not
incidental thereto), on behalf of third parties not related to the company. Fiduciary capacity implies being able to make decisions
over the use of the assets but that third parties have the right to reclaim the assets.
26 Chapter 1
4.8 Company records (Companies Act: s24)

Company records
must:
Section 24 deals with company records in general. Company
records include accounting-related records. The requirements be in writing (or be able to
be converted into writing)
specific to accounting-related records include:
all company records (including accounting records) must be be kept for at least 7yrs.
in writing or in a form that is convertible into writing within a reasonable period of time
(e.g. electronic form);
all company records must be kept for a period of 7 years:
- annual financial statements: for 7 years after the date of issue*;
- accounting records: for the current year plus the previous 7 completed years*, and
- reports presented at an annual general meeting: for 7 years after the meeting*.
*: Or shorter period if the company has existed for a shorter period.
4.9 Accounting records (Companies Act: s1 and 28)
Section 1 defines accounting records as:

Information in written or electronic form
Concerning the financial affairs as required in terms of this Act,
Including but not limited to: purchase and sales records, general and subsidiary ledgers
and other documents and books used in the preparation of financial statements.
Section 28 requires that accounting records:

must be accurate and complete;
may be produced in any one of the country’s official languages;
that are prescribed, must be kept in the prescribed manner and form;
must be in a form that enables the financial statements to be prepared in accordance with
this Act or any other law; and
must be kept at, or be available from, the company’s registered office.
4.10 Financial year (Companies Act: s27)
Financial statements of companies reflect the financial information arising over the course of
its financial year (also referred to as its accounting or reporting period). This financial year
(i.e. a period of 12 months) ends on the reporting date.
Each company must decide what its reporting date will be. This reporting date must be
decided upon when the company is incorporated and must be stipulated in the company’s
Notice of Incorporation.
A financial year ends
Although it is possible to subsequently change the reporting on the reporting date
date set out in the company’s Notice of Incorporation, it may (RD).
not be changed: Each co must state its RD in
without filing a notice of that change; its Notice of Incorporation.
more than once during any financial year; RDs may be changed.
to a date that precedes the date on which the notice is filed; A financial year is normally 12
if it will result in the very next financial period being months but may end up longer
more than 15 months. or shorter, but may never
exceed 15 months.
A financial year is normally 12 months but this is not always the case. For example: in the
very first year of operation, a company’s accounting period starts on the date of incorporation
and ends on the reporting date set out in the company’s Notice of Incorporation. In this case,
unless the company’s date of incorporation is exactly 365 days prior to the reporting date, the
company’s first financial year will not be a perfect 12 months. The financial year may,
however, never exceed 15 months because a financial period of more than 15 months will
delay the release of its financial statements which would disadvantage the users. Another
example of when a financial year will not be 12 months is if the reporting date is changed.
Chapter 1 27
4.11 Financial statements (Companies Act: s29 and Reg. 27)

Financial statements must:
Satisfy the Financial Reporting Standards, where these have been prescribed;
May be compiled internally or independently Reg. 27 Persons involved in the
Fairly present the company’s state of affairs and preparation, approval,
dissemination or
business; publication of any f/statements,
Explain the company’s transactions & financial position; will be guilty of an offence
Show the company’s assets, liabilities, equity, income if these financial statements (or
and expenses and any other prescribed information; summaries thereof)
- do not comply with s29 or
Include the date they were produced; - are materially false/misleading.
Include the accounting period to which they apply;
Include, on the first page:
- a notice indicating whether or not the statements have been audited or independently
reviewed in compliance with this Act, and
- the name, and professional designation, if any, of the individual who prepared, or
supervised the preparation of, those statements.
4.12 Annual financial statements (Co’s Act: s30 & Reg. 38)
4.12.1 Timing Annual Financial
Annual financial statements must be prepared within 6 Statements
months of the financial year-end (or a shorter period to must be prepared within at least
provide adequate notice for an annual general meeting). 6m after year-end;
may need to be audited or
4.12.2 Audit or independent review independently reviewed;
The annual financial statements of: must contain an auditors’ report
state-owned and public companies must be audited. (if applicable), a directors’ report
and details relating to directors
other companies may need an audit, independent and others holding a prescribed
review or neither. (See section 4.4) office in the company.
4.12.3 Other documents included in the annual financial statements

Annual financial statements (as opposed to financial statements) must also include an
auditor’s report (where applicable), a directors report and details relating to directors or
individuals holding any prescribed office in the company.
4.12.4 Extra disclosure relating to directors or prescribed officers
For audited financial statements, further particulars must be disclosed where they relate to:
directors, or
individuals holding any prescribed office of the company:
The Companies Act allows the Minister to make any office a prescribed office.
Prescribed officers are defined as having:
general executive control over and management of a significant portion of the
company; or
regularly participates therein to a material degree. Regulation 38
The particulars to be disclosed: D and PO NOTE 1 Disclose the: Reference:

remuneration NOTE 2 and NOTE 3 current Amounts
S30(4)(a)
benefits paid or payable NOTE 2 current Amounts

S30(4)(a)
pensions paid or payable current and past Amounts

S30(4)(b)(i)
payments to pension funds on behalf thereof current and past Amounts

S30(4)(b)(ii)
compensation for loss of office paid current and past Amounts

S30(4)(c)
securities issued current and number issued;

S30(4)(d)
their relatives class issued;

amt received by the co in
exchange for the securities
service contracts current the details
S30(4)(e)
28 Chapter 1
Remuneration includes: D and PO Reference:

directors fees for services to or on behalf of the company: amount Current
S30(6)(a)
salary, bonuses and performance-related payments: amount Current

S30(6)(b)
expense allowances for which the director need not account: amount Current
S30(6)(c)
contributions to any pension scheme not otherwise needing separate current and past
S30(6)(d)
disclosure: amount
options or rights given directly or indirectly: the value thereof current, past, future
S30(6)(e)
and all relatives

financial assistance for the subscription of options or securities or the current, past, future
S30(6)(f)
purchase of securities: amount and all relatives

any loans (including loans made by third parties where the company current, past, future
S30(6)(g)
is a guarantor) and any other financial assistance: the amount being: and all relatives
- the interest deferred, waived or forgiven; or
- the difference between the:
- reasonable and market-related interest in an arm’s length
transaction, and the
- interest actually charged
Acronyms used in the tables: D and PO: Directors and Prescribed Officers
Notes: Note 1: the details relating to directors and prescribed officers must be separately disclosed. S30(4)
Note 2: the remuneration and benefits must be disclosed separately for each director. S30.4(a)
Note 3: the term ‘remuneration’ includes a variety of items – these are detailed in the table below. S30(6)
The disclosure of the abovementioned remuneration and benefits paid or payable to directors or
prescribed officers of the company must include the remuneration and benefits for:
services as director of the reporting company;
services while being a director of the reporting company and providing:
- services as director of other companies within the group, and
- other services to the reporting company and to other group companies. S 30(5)
What is interesting here is that the amount of remuneration that is recognised in a company’s
financials differs from the amount that is disclosed in the company’s financials.
For example: a director of Co A may also be involved as a director in a subsidiary company,

say Co B. This would then mean that when preparing the financial statements for Co A:
the amount recognised as an expense in company A’s statement of comprehensive
income will include only the amount incurred by company A; but
the amount disclosed as directors remuneration in company A’s notes to the financial
statements will include the amount paid to the director by company A and by company B
since company B is in the same group as company A. See Companies Act: s30(5)
It is clear that the Companies Act requires disclosure of certain details relating to directors,
but it is just one of 4 documents demanding the director-related disclosure:
the Companies Act 2008: s30: see above (section 4.8.6.4);
the JSE Securities Exchange (JSE) Listing Requirements: see section 5 of this chapter;
the King III Report: see section 6 of this chapter; and
IAS 24 on related parties: this standard is not covered in Gripping GAAP.
The discussion regarding the director-related disclosure requirements of the JSE Listing
Requirements and the King III Report are best covered in each of these relevant sections.
However, it is interesting to compare the disclosure requirements relating to ‘executive and
non-executive’ at this junction:
the Companies Act 2008 does not require that particulars relating to directors be split
between executive and non-executive; but
the JSE Listing Requirements does require companies to distinguish separately between
executive and non-executive [section 8.63(k)]. This requirement obviously only affects
those companies wishing to be listed on the JSE.
Chapter 1 29
The definitions of executive and non-executive directors are provided in both the JSE Listing
Requirements [section 3.84 (f)] and the King III Report (annex 2.2 and 2.3 of chapter 2 of the
King Report). However, these definitions differ!
The JSE Listing Requirements defines:
executive directors as: directors that are involved in the management of the company
and/or in full-time salaried employment of the company and/or any of its subsidiaries;
non-executive directors as: directors that are:
- not involved in the day to day management of the business; or
- not full-time salaried employees of the company and/or any of its subsidiaries.
The King III Report defines:
executive directors as: directors involved in the day-to-day management of the
company or are in the full-time salaried employment of the company (or its
subsidiaries) or both [Annexure 2.2 of Chapter 2 of the King Report]; and
non-executive directors as: directors that are not involved in the management of the
company [Annexure 2.3 of Chapter 2 of the King Report].
King III then explains that non-executive directors are independent of management on all
issues including strategy, performance, sustainability resources, transformation, diversity,
employment equity, standards of conduct and evaluation of performance (extract from
Annexure 2.2 of Chapter 2 of the King Report).
King III and the JSE listing requirements now define a third category of director (i.e. over and
above executive directors and non-executive directors). This third category, which the JSE
refers to as independent directors [section 3.84 (f) (iii)] and which King III refers to as
independent non-executive directors, is a category that is not required for purposes of
disclosing the directors’ emoluments, but simply relates to the composition of the Board of
Directors. Independent directors are thus not discussed in this chapter.
4.12.5 Approval and presentation
Financial statements must be:

approved by the board and signed by an authorised director; and
presented to the first shareholders’ meeting after approval thereof. There is an exemption,
however: it need not be presented at this first shareholders’ meeting if every person who
is a holder of, or has a beneficial interest in, any securities issued by the company is also a
director of the company.
5. JSE Listing Requirements
5.1 Overview
JSE Listing requirements are very detailed. The purpose of this section is to simply give you a
general understanding of how these requirements may affect the annual financial statements.
The objective of the JSE is to provide facilities for the listing of securities (including
securities issued by both domestic and foreign companies) and to provide the JSE users with
an orderly market place for trading in such securities and to regulate the market accordingly.
The Listing Requirements of the JSE is made up of 22 sections containing the rules and
procedures governing new applications, all corporate actions and continuing obligations
applicable to issuers of securities (including specialist securities). Thus they aim to ensure that
the business of the JSE is carried on with due regard to the public interest.
There are two main areas/ sections of the JSE Listing Requirements that affect our financial
statements, on which we will now focus our attention:
Section 3: Continuing obligations; and
Section 8: Financial Information. Refer overleaf.
30 Chapter 1
5.2 Section 3: Continuing Obligations
Section 3 of the JSE Listing Requirements lists the continuing obligations that an issuer has
once any of its securities have been listed on the JSE. This section is divided into a variety of
paragraphs dealing with a variety of areas. The continuing obligations that involve the area of
our annual financial statements are provided in paragraphs 3.19 – 3.22.
Probably the most significant to us as financial accountants is paragraph 3.19, which

stipulates when the financial statements are due to be published.
Paragraph 3.19 states that every issuer shall, within 6 months after each financial year-end
and at least 15 business days before the date of the company’s annual general meeting,
distribute to all holders of securities and submit to the JSE both:
(i) a notice of the AGM; and
(ii) the annual financial statements for the relevant financial year-end (where these financial
statements must have been reported on by the auditors of the company).
5.3 Section 8: Financial Information
Section 8 of the JSE Listing Requirements sets out the financial information that must be
included in a prospectus/ pre-listing statement/ circular. It also sets out continuing obligations
relating to matters of a financial nature.
The following issues are dealt with in this section:

reporting historical financial information,
pro-forma financial information,
profit forecasts and estimates,
reporting accountant’s report,
minimum content of interim reports,
preliminary reports,
provisional annual financial statements and abridged annual financial statements,
minimum contents of annual financial statements, and
Financial Reporting Investigations Panel (FRIP).
The main issue that we will focus on is contained in paragraph 8.62:

minimum contents of annual financial statements.
Paragraph 8.62 requires that the annual financial statements (AFS) of a company must:
a) be drawn up in accordance with the national law applicable to a listed company;
b) be prepared in accordance with IFRS and the AC500 Standards as issued by the APB;
c) be audited in accordance with International Standards on Auditing (ISAs), or in the case
of foreign companies in accordance with national auditing standards that are acceptable to
the JSE;
d) be in consolidated form if the listing company has subsidiaries, unless the JSE otherwise
agrees, although the listed company’s own financial statements must also be published if
they contain significant additional information; and
e) fairly present the financial position, changes in equity, results of operations and cash flow
of the group.
Paragraph 8.63 requires that the annual report must:

include a statement of compliance with Corporate Governance (including all details that
are listed in paragraph 3.84 of the JSE Listing Requirements);
comply with International Financial Reporting Standards (IFRSs)
comply with s30 of the Companies Act; and
include certain extra minimum disclosures.
Chapter 1 31
The extra minimum disclosures include:

certain statements regarding the compliance with King III para 8.63 (a)
headline earnings per share para 8.63 (b)
disclosures of directors’ interests, including those directors who may have resigned during
the reporting period para 8.63 (c)
a description of the spread of shareholders (e.g. number of public and non-public
shareholders) para 8.63 (d)
details of the major shareholders including their percentage shareholding para 8.63 (e)
details of any share incentive schemes para 8.63 (f)
profit forecasts para 8.63 (g)
unlisted securities para 8.63 (h)
details of any special resolutions para 8.63 (i)
details of any issues of securities during the period that were made for cash para 8.63 (j)
details of each individual director’s remuneration and benefits, including those of any
director who resigned during the reporting period. para 8.63 (k)
Paragraph 8.63 (k) of the JSE Listing Requirements requires disclosure to be made:
of an analysis of the director’s remuneration and benefits (including those who resigned
during the reporting period);
paid by the company (in respect of the current and prior financial year) or receivable by
the director,
in his capacity as director or in any other capacity,
distinguishing separately between executive and non-executive directors, and
analysing the remuneration and benefits in aggregate and per individual director.
Section 8.63 (k) also lists the individual types of remuneration and benefits as:
(i) fees for services as a director;
(ii) management, consulting, technical or other fees paid for such services rendered, directly or
indirectly, including payments to management companies, a part of which is then paid to a
director of the company;
(iii) basic salary;
(iv) bonuses and performance-related payments;
(v) sums paid by way of expense allowance;
(vi) any other material benefits received, with an explanation as to what this includes;
(vii) contributions paid under any pension scheme;
(viii) any commission, gain or profit-sharing arrangements; and
(ix) in respect of share options or any other right given which has had the same or a similar effect in
respect of providing a right to subscribe for shares (“share options”):
(1) the opening balance of share options, including the number of share options at each
different strike price;
(2) the number of share options awarded and their strike prices;
(3) the strike dates of differing lots of options awarded;
(4) the number of share options exercised and at what prices;
(5) the closing balance of share options, including the number of share options at each
different strike price;
(x) any shares issued and allotted in terms of a share purchase/option scheme for employees (or
other scheme/structure effected outside of the issuer which achieves substantially the same
objectives as a share purchase/option scheme), usually held as a pledge against an outstanding
loan to an employee in a share purchase scheme trust, which have not been fully paid for,
including the number so issued and allotted, the price of issue and allotment, the release periods
applicable to such shares and any other relevant information;
32 Chapter 1
(xi) without derogating from the generality of 8.63 (k) (i) to (x) above, the directors remuneration
and benefits disclosed in accordance with 8.63 (k) (i) to (x) above must include disclosure of all
remuneration and benefits received or receivable from the following entities:
(1) the issuer’s holding company;
(2) the issuer’s subsidiaries and fellow subsidiaries;
(3) associates of 8.63 (k) (xi) (1) and (2) above;
(4) joint ventures of the issuer or of 8.63 (k) (xi) (1) to (3) above; and
(5) entities that provide management or advisory services to the company or any of 8.63 (k)
(xi) (1) to (4) above.
It is important to note that above section 8.63(k)(xi) makes it clear that the disclosure of the
remuneration and benefits must not only include remuneration and benefits from the
company, but all companies in the group and also to entities providing management or
advisory services to the company.
6. King III Report
6.1 Overview
The King III Report, effective from 1 March 2010, came about primarily due to the
promulgation of the Companies Act 2008 as well as changing trends in corporate governance.
King III is designed for all entities regardless of the manner and form of incorporation.
That said, there is no legal requirement forcing companies to comply with the King III
Report, but since it forms part of the JSE Listing Requirements, all companies wishing to be
listed on the JSE Securities Exchange must comply with the recommendations in this report.
The Key Aspects of King III revolve around leadership, sustainability and corporate
citizenship. These key aspects create the fundamentals that make a company a good corporate
citizen, which is achievable if the company’s Board of Directors directs its strategy and
operations on the society and environment and not just on
its surrounding economy. King III deals with:
Ideally King III should be applied to all entities. It Leadership

follows an ‘apply or explain’ approach meaning that Sustainability
entities are encouraged to either apply the King III Corporate citizenship
principles or provide justification for not applying them. King III:
has no legal backing; but
is a JSE Listing Requirement.
The King III Report is very detailed so we will simply
focus on the following aspects:
Disclosure of remuneration to directors and senior executives: It is interesting to compare
these disclosure requirements in the King III report with the disclosure requirements
relating to directors in the Companies Act and JSE Listing Requirements;
Sustainability reporting: This topic is discussed since it is a topic that has growing local
and international interest.
Integrated Reporting: Whereas sustainability reports were presented separately to the
financial report, integrated reporting suggests that the issues of sustainability and financial
results are inextricably linked and should thus be combined into one report.
6.2 King III Report on Directors Remuneration
The King III Report states that companies should disclose the remuneration of each individual
director and prescribed officer (Principle 2.26).
Chapter 1 33
The importance here is that King III requires the disclosure on a per director basis (congruent
with the 2008 Companies Act and the JSE Listing Requirements) and also requires disclosure
of the remuneration of each prescribed officer as well (see definition in Regulation 38, given
in section 4.12.4).
King III on directors: Principle 2.26 continues to state that there should be full
King requires detaileddisclosure:
disclosure of the of the remuneration of each individual executive
remuneration earned by each and every: and non-executive director and for each prescribed
director; and officer,
prescribed officer. giving details as required in the Act of ‘base pay,
bonuses, share-based payments, granting of options
or rights, restraint payments and all other benefits (including present value of existing
future awards)’.
6.3 King III Report on Sustainability Reporting
There has been growing local and international attention King III emphasizes the
importance of
to sustainability with many companies opting to publish
sustainability by:
Sustainability Reports. King III has emphasised the
importance of sustainability reporting by taking it further introducing the Integrated Report,
and introducing integrated sustainability reporting. Since which involves the integration of
the JSE Listing Requirements include compliance with sustainability reporting with its
financial and other reports
King III, it means that, whereas in most countries
sustainability reports are ‘nice to have’, King III makes sustainability reports a ‘need to have’
for all South African listed companies.
A sustainability report involves the practice of measuring, disclosing and being accountable to
both internal and external stakeholders for organizational performance towards the goal of
‘sustainable development’.
According to the Brundtland Report, the goal of sustainable development is:

‘to meet the needs of the present
without compromising the ability of future generations to meet their own needs’.
There are various guidelines available to draw up a Sustainable Report, including:

The GRI Reporting Framework:
This framework is intended to serve as a generally accepted framework for reporting on
an organisation’s economic, environmental and social performance.
It is designed for use by any organisation and contains general and sector-specific content
that has been agreed by a wide range of global stakeholders to be generally applicable for
reporting on an organisation’s sustainability performance.
Sustainable Reporting Guidelines:
These guidelines consist of Principles for defining report content, and ensuring the quality
of reported information.
It also includes Standard Disclosures made up of performance indicators.
6.4 King III Report on Integrated Reporting
King III defines integrated reporting as ‘a holistic and

integrated representation of the company’s performance King III defines
integrated reporting as:
in terms of both its finance and its sustainability’.
a holistic and integrated
The reasoning behind the introduction of an integrated representation
report is that annual reports had become exceedingly of the company’s performance in
terms of both its
long (including financial statements, sustainability
finance and its
reports, audit reports, directors reports etc). sustainability
34 Chapter 1
The length and the lack of cohesion between the information presented in the various
documents within an annual report made it difficult to bring all the relevant information
together in order to make informed decisions. The reasoning is that informed decisions are
really only possible when one can view the company in a holistic way. Financial information
presents only part of the business story whereas there are other important forward-looking
issues regarding strategies of sustainability relating to social and environmental issues.
The integrated report is intended to be one that provides a holistic view of the future of the
company by bringing all the information together into one central and primary report from
which all other more detailed reports flow (e.g. annual financial statements and sustainability
reports). A useful analogy used by SAICA in explaining the integrated report is an octopus:
‘the head is the integrated report and each arm is a detailed report or detailed information set
(eg governance information).’
King III suggests the following with regard to an integrated report:

The integrated report should be an annual report that should cover all material matters
affecting the company, combining all areas of performance including reporting on the
triple bottom line (i.e. economic, social and environmental issues facing the entity).
Statutory financial information and sustainability information should be integrated
The integrated report should have sufficient information to record how the organisation
has affected the economic life of the community - positively and negatively;
The integrated report should contain forward-looking information - on how the board
feels it can enhance the positive aspects and negate the negative aspects;
Integrated reporting requires more than just an add-on of sustainability information -
sustainability reporting should be integrated with other aspects of the business process
and managed throughout the year. Sustainability should be embedded in the organisation.
Integrated reporting should focus on substance over form.
The board's audit committee must establish a formal process of assurance on
sustainability reporting. It should recommend to the board the need to engage an external
assurance provider to provide assurance over material elements of the sustainability part
of the integrated report. It should oversee sustainability issues in the integrated report,
ensure the sustainability information is reliable, and that no conflicts or differences arise
when compared to the financial results.
There is no legal requirement in the Companies Act for companies to provide an integrated
report but, because compliance with the King III Report forms part of the JSE Listing
Requirements, all companies wishing to be listed on the JSE Securities Exchange must
produce an integrated report or explain why it is missing.
An integrated report typically contains:

Annual financial statements; Risk disclosures;
Directors’ report; IT reporting;
Directors’ statement of responsibility Remuneration report;
Management and directors’ commentary; Statement by the company secretary;
Report of the audit committee; Terms of reference of committees; and
Sustainability report; Ethics statement.
King III states that although an integrated report should ideally be presented as one document
(remember the analogy of the octopus), it may also be presented in more than one document
on condition that these documents be disclosed together.
The idea of integrated reporting is still in its infancy. In this regard, 2010 saw the launching of
both the South African Integrated Reporting Committee (IRC) and the International
Integrated Reporting Council (IIRC), both of which are chaired by the South African Judge
Mervyn King.
Chapter 1 35
South Africa’s IRC issued a discussion paper on integrated reporting in January 2011. This
was followed by an international discussion paper released by the international committee
(IIRC) in September 2011. Following these discussion
papers, public comment and robust debate, the first South Africa is at
the forefront of
International Integrated Reporting Framework was
Integrated Reporting,
published in December 2013 – referred to as the with:
‘International <IR> Framework’. The following are Judge Mervyn King (a South
selected key extracts from the world’s very first framework African) heading up the
on integrated reporting. International Integrated
Reporting Council (IIRC); &
This Framework clarifies that an Integrated Report may SA listed companies already
either be: having to produce Integrated
Reports.
‘a standalone report’; or
‘included as a distinguishable, prominent and accessible part of another report or
communication’. See IIRFramework: Executive summary
An Integrated Report is defined as: The International

a concise communication <IR> Framework
about how an organization’s strategy, governance, is freely available on the
IIRC website:
performance and prospects, www.theiirc.org
in the context of its external environment,
lead to the creation of value over the short, medium and long term.
The aim of Integrated Reporting is to

Improve the quality of information available to providers of financial capital to enable a
more efficient and productive allocation of capital
Promote a more cohesive and efficient approach to corporate reporting that draws on
different reporting strands and communicates the full range of factors that materially
affect the ability of an organization to create value over time
Enhance accountability and stewardship for the broad base of capitals (financial,
manufactured, intellectual, human, social and relationship, and natural) and promote
understanding of their interdependencies
Support integrated thinking, decision-making and actions that focus on the creation of
value over the short, medium and long term. See IIRFramework: About Integrated Reporting (extract)
The Framework explains that the purpose of having a framework:

is to establish ‘Guiding Principles’ and ‘Content Elements’
that govern the overall content of an integrated report, and
to explain the fundamental concepts that underpin them.
The Framework:
- Identifies information to be included in an integrated report for use in assessing the
organization’s ability to create value; it does not set benchmarks for such things as the
quality of an organization’s strategy or the level of its performance
- Is written primarily in the context of private sector, for-profit companies of any size
but it can also be applied, adapted as necessary, by public sector and not-for-profit
organizations. Extract from IIRFramework: Executive summary (extract)
36 Chapter 1
7. Summary
About IFRSs
IFRSs:
We’re moving slowly towards global GAAP: Include: standards & interpretations.
IFRSs
Are issued by the IASB (the IASB’s legal body
Some countries have adopted IFRSs is the IFRS Foundation).
Development follows strict due process.
Some countries are resisting the adoption of Standards: developed by the IASB.
IFRSs – some of these have agreed to a Interpretations: developed by IFRSIC.
process of convergence (e.g. the US) Annual improvements: developed by either
the IASB or its IFRSIC.
Other topics covered (i.e. in addition to the 2008 Companies Act)
IFRSs for SMEs: an overview of differential reporting
JSE Listing requirements: an overview of the paragraphs affecting

annual financial statements,
King III: a brief overview of:
the requirements relating to remuneration and benefits to
directors and senior executives
the presentation of sustainability reports
the presentation of an integrated report
The 2008 Companies Act
Some of the big changes in the 2008 Act Certain selected sections
No further CC’s There are many sections, however, some of the

No further PV shares main sections affecting financial reporting include:
New company categories S8: Categories of companies
Legal backing for IFRS S24: Company records
Legal backing for differential reporting S27: Financial year
Fourth Schedule disclosure falls away S28: Accounting records
S29: Financial statements
S30: Annual financial statements
Other topics covered (i.e. in addition to the 2008 Companies Act)
IFRSs for SMEs: an overview of differential reporting

JSE Listing requirements: an overview of the paragraphs affecting annual
financial statements,
King III: a brief overview of:
the requirements relating to remuneration and benefits to directors
and senior executives
the presentation of sustainability reports
the presentation of an integrated report
Chapter 1 37
Gripping GAAP The conceptual framework for financial reporting
Chapter 2
The Conceptual Framework for Financial Reporting
Reference: The Conceptual Framework for Financial Reporting (2010) (including any
amendments up to 10 December 2014)
Contents: Page
1. Introduction 39
1.1 What is the Conceptual Framework? 39
1.2 The history and current status of the Conceptual Framework 39
2. The objective of general purpose financial reporting 40
2.1 Overview 40
2.2 Economic resources and claims against these resources: 40
2.3 Changes in economic resources and claims 41
3. Qualitative characteristics and constraints 42
3.1 Overview 42
3.2 Fundamental qualitative characteristics 42
3.2.1 Relevance (which involves materiality) 42
3.2.2 Faithful representation 43
3.2.2.1 Complete 43
3.2.2.2 Neutral 43
3.2.2.3 Free from error 44
3.2.3 Applying the fundamental qualitative characteristics 44
3.3 Enhancing qualitative characteristics 44
3.3.1 Comparability 44
3.3.2 Verifiability 45
3.3.3 Timeliness 45
3.3.4 Understandability 46
3.3.5 Applying the enhancing qualitative characteristics 46
3.4 The cost constraint on useful information 46
4. Underlying assumption: going concern 46
5. Elements 47
5.1 Overview 47
5.2 Definitions of each of the elements 47
Example 1: An inflow – income or liability? 48
6. Recognising the elements 48
Example 2: Recognising the elements 49
Example 3: Recognising expenses 50
7. When an element is not to be recognised 51

8. Recognition versus disclosure 51
9. Measuring the elements 52
10. Concepts of capital and capital maintenance 53
10.1 Capital 53
10.2 Capital maintenance and determination of profit 53
11. Answering discussion type questions 53
Example 4: Recognition: Staff costs – an asset? 54
12. Summary 55
38 Chapter 2
1. Introduction
1.1 What is the Conceptual Framework?
The Conceptual Framework for Financial Reporting (CF) forms the foundation of all IFRSs.
You need a thorough understanding of all its concepts in order to be able to correctly apply
the various IFRSs. It is so important that I refer to it as one of the ‘two pillars of accounting’,
a very important area, without which the next ‘floor’ of your knowledge cannot be built. The
other pillar is IAS 1 Presentation of Financial Statements (see chapter 3).
The status of the CF is that it is technically not an IFRS

(i.e. it is neither a standard nor an interpretation) but Status of the CF
rather the foundation for all IFRSs. There are a few cases
where the CF actually conflicts with an IFRS. In such not an IFRS!
cases, the CF may not override any IFRS. Such conflicts forms the basis of IFRSs.
have arisen because the CF is relatively outdated. As a may not override an IFRS.
result, it is in the process of being revised (see section 1.2 below) and it is thus expected that
the number of such cases will reduce over time.
The purpose of the CF is to set-out the various concepts

The main purpose of the
that underpin financial reporting in order to assist: CF is to:
1. the IASB in developing new IFRSs, evaluating assist the IASB
existing IFRSs and by providing a basis that enables it to develop & evaluate IFRSs.
to reduce the number of alternatives currently allowed
in the IFRSs;
2. the various national standard-setters to develop national standards;
3. preparers of financial statements in interpreting and applying difficult IFRSs or in
creating their own policies where existing IFRSs do not provide guidance or do not cater
for the topic;
4. auditors when assessing whether financial statements comply with IFRSs;
5. users in interpreting financial statements that comply with IFRSs;
6. other parties interested in how the IASB develop IFRSs.
Concepts currently contained in the CF include the:
objective of general purpose financial reporting;

underlying assumption inherent in a set of financial statements;
qualitative characteristics of useful financial statements;
definitions of elements in the financial statements (assets, liabilities, equity, income,
expenses);
recognition criteria to be met before the element may be recognised;
measurement bases that may be used when measuring the elements; and
concepts of capital and capital maintenance.
1.2 The history and current status of the Conceptual Framework
The original Framework was first published in 1989 (by the IAS Committee). Then, in 2004,
the IASB and the FASB (the US body) began working jointly to develop a new and improved,
common framework. This project is referred to as the Conceptual Framework Project.
The aim of this project is to ‘update and refine the existing concepts to reflect the changes
in markets, business practices and the economic environment that have occurred in the
two or more decades since the concepts were first developed’.1
The overall objective of this project is ‘to create a sound foundation for future accounting
standards that are principles-based, internally consistent and internationally converged’. 1
Chapter 2 39
The final CF will consist of 4 chapters. The IASB and

FASB succeeded in completing 2 of these chapters The structure of the CF:
(chapters 1 and 3) in September 2010. The remaining 2
unfinished chapters (chapters 2 and 4) are more complex Ch1: The objective of general
purpose financial reporting (new);
and contentious. Thus in late 2010, given that there Ch2: The reporting entity (empty);
were more important standards needing addressing, the Ch3: Qualitative characteristics of
IASB and FASB decided to temporarily pause this joint useful financial information (new);
project. As a result, chapter 2 is currently empty and Ch4: Still to be named, (contains the
text of the old Framework):
chapter 4 currently contains the remaining wording of
Underlying assumption
the pre-existing Framework (1989), which sets out the
Elements
underlying assumptions, elements of the financial
Recognition
statements and the recognition and measurement thereof, Measurement
concepts of capital and capital maintenance. Capital maintenance.
In September 2012, the IASB resumed working on the project, but decided that it will no
longer be a joint project with the FASB as it was ‘no longer appropriate to conduct this
project as a joint project with one single national standard setter’. 2
1 http://www.ifrs.org/Current-Projects/IASB-Projects/Conceptual-Framework/Pages/Conceptual-Framework.aspx
2 Staff paper – September 2012 (Agenda Ref 14)
2. The Objectives of General Purpose Financial Reporting (CF: Chapter 1)
2.1 Overview
The objective of general purpose financial statements is The objective of general

not to provide all possible users with all possible kinds purpose financial
of information that they may need. Instead, the objective reporting is:
clarifies that general purpose financial statements: to provide financial information
about the reporting entity
are primarily designed for 3 primary users: investors,
that is useful to existing and
lenders and creditors; potential investors, lenders and
will only provide financial information. other creditors
in making decisions about providing
Decisions that these 3 primary users may need to make, resources to the entity. CF: Ch1: OB2
involve whether to buy, sell or hold the entity’s equity or
debt instruments or provide or require settlement of loans or credit.CF: Ch1:OB 2(slightly reworded)
Although general purpose financial statements are aimed at the 3 primary users, there are
other types of users who may find them useful, but who are not catered for, for example:
management, since they already have access to internal financial information; and
tax authorities, since they are provided with other information based on tax legislation.
Of importance is simply that the information must be useful to the 3 targeted primary users.
Usefulness of the financial statements is ensured by complying with the qualitative
characteristics. These qualitative characteristics are explained in section 3.
The financial information to be provided is split between information regarding the entity’s:
economic resources and claims against these resources See CF: Ch1: OB 13-14
changes in economic resources and claims. See CF: Ch1: OB 15-21
2.2 Economic resources and claims against these resources:
The net effect of economic resources (assets) and claims against these resources (liabilities)
refers to the entity’s financial position and thus this information is found in the statement of
financial position. Information about economic resources (assets) and claims against these
resources (liabilities) helps users assess, for example, the entity’s financial strengths and
weaknesses as well as its liquidity and solvency at the reporting date and in the future.
40 Chapter 2
2.3 Changes in economic resources and claims:
Changes in economic resources and claims are considered to be caused by:

the entity’s financial performance and
other reasons (e.g. transactions with capital providers).
The changes caused by financial performance and by other reasons need to be separated so
that users are able to better understand why changes occurred and to help predict the future
cash net inflows of the entity. This is achieved by presenting these changes in a variety of
statements:
financial performance on the accrual basis: in the statement of comprehensive income;
financial performance on the cash basis: in the statement of cash flows;
other reasons for changes in economic resources (e.g. transactions with capital
providers): in the statement of changes in equity and the notes to the financial statements.
Information regarding financial performance is important because it helps users understand

the return made through the use of an entity’s economic resources and helps them assess how
well management has carried out its responsibility to make good use of these resources (e.g.
whether or not the net economic resources increased). By providing information about what
makes up the return (e.g. sales income, interest income, etc.) it also helps users to predict
future returns and assess the extent of uncertainty regarding future cash flows.
As already mentioned, the financial performance is presented using two methods: the accrual
and the cash methods. Each method has its advantages and disadvantages.
Accrual accounting is achieved by recording elements (assets, liabilities, income, expenses

and equity) when the definitions and recognition criteria are met.
The accrual basis is used in all components of a set of financial statements except in the
statement of cash flows. The CF explains that the extensive use of the accrual system in the
financial statements is because the accrual system ‘provides a better basis for assessing the
entity’s past and future performance than information solely about cash receipts and payments
during that period’.CF: Ch1: OB17(extract)
Despite the CF’s preference for the accrual system, it admits that the cash basis does provide
users with useful information by, for example, helping users:
to understand how the entity receives and uses its cash,
to assess the entity’s liquidity and solvency, and
understand and evaluate its separate activities of operations, financing and
investing. CF: Ch1: OB20(reworded)
Apart from the admission that the cash flow basis provides additional useful information,
many users argue that the accrual system has inherent problems that allow management to
manipulate profits through the use, for example, of various accounting policies and
measurement methods.
Comparison of the two methods of accounting:

The accrual basis depicts: The cash flow basis entails recording:
the effects of transactions and other events cash receipts and cash payments
and circumstances in the periods in which they occur.
on a reporting entity’s economic resources and The CF admits that the cash flow
claims basis provides additional useful
in the periods in which those effects occur, information, but many users argue
even if the resulting cash receipts and that the accrual system is inherently flawed
payments occur in a different period. CF: OB17 because it allows, for example, the manipulation
of profits through using various accounting
policies and measurement methods.
Chapter 2 41
3. Qualitative Characteristics and Constraints (CF: Chapter 3)
3.1 Overview
In order for a set of financial statements to be useful to its users, it must have certain
qualitative characteristics. There are a number of characteristics that affect the quality of a set
of financial statements. The CF separates these characteristics into:
Fundamental qualitative characteristics; and
Enhancing qualitative characteristics.
Fundamental qualitative characteristics are those that are absolutely essential if the financial
statements are to be useful. Enhancing qualitative characteristics enhance this usefulness.
The CF then explains how to apply these characteristics and also explains how to deal with
the cost constraint facing an accountant in doing so.
3.2 Fundamental qualitative characteristics (CF: Chapter 3: QC5-18)
For financial statements to be considered useful, they must Fundamental QCs (2):
have the two fundamental qualitative characteristics of
being relevant and faithfully represented. Relevance; &
Faithful representation.
3.2.1 Relevance (which involves materiality) (CF: Chapter 3: QC6-11)
When deciding what is relevant, we must consider whether it could make a difference in
users’ decision-making.
Information is capable of making a difference if it has either of the following or both:

Predictive value: Financial information need not
include predictions or forecasts but must simply offer Relevant information is:
information that users can use as inputs in their own
predictions and forecasts. ‘capable of making a difference
in the decisions made by users’.
Confirmatory value: Financial information is CF:Ch3:QC6(extract)
confirmatory if it provides feedback regarding users’ Relevant information must have:

previous evaluations (for example: by providing Predictive value; and/or
information about revenue in the current year will Confirmatory value. See CF:Ch3:QC7
assist users to assess whether their previous predictions
were accurate or not).
Incidentally, information that is confirmatory can also be predictive. For example:

information about revenue in the current year not only helps confirm the predictions made in
the prior but also helps to predict the future.
Relevance is obviously affected by materiality. Materiality is a term that you will encounter
very often in your accounting studies and is thus important for you to understand.
Materiality is not a qualitative characteristic but is used in

assessing what is relevant. Instead, materiality is simply a Information is material
if:
‘threshold’ or ‘cut-off point’ to help in deciding what may
be useful to users.
the decisions of the users
This ‘materiality threshold’ is considered for both about a specific reporting entity
quantitative (amount) and qualitative (nature) aspects of could be influenced
the information. if it were misstated or omitted
from its financial information.
CF:Ch3: QC11 (slightly reworded)
The materiality threshold is specific to each entity (entity-
specific) and thus has to be determined using your professional judgement.
42 Chapter 2
Worked example: Entity-specific quantitative materiality

Entity A is small and considers all revenue types above C100 000 to be material and thus A
discloses each revenue type separately, but entity B is larger and only considers revenue to
be material if it exceeds C1 000 000.
Conclusion: The quantitative materiality level referred to above is entity-specific. Qualitative
materiality would also be entity-specific.
3.2.2 Faithful representation (CF: Chapter 3: QC 12-16)
In order for a set of financial statements to be useful, it must Faithful representation

be both relevant and faithfully represented. An absolutely means:
faithful representation of the financial information means that complete,
the information should be complete, neutral and free from neutral and
error.See CF:Ch3: QC12 free from error. CF:Ch3:QC12
Interestingly, information that is faithful represented does not automatically mean it is useful.
Worked example: A faithful representation with relevance

The government may have given us land at no cost. We could faithfully represent it at a nil
cost, but this information on its own is not very useful. We could make it useful by
disclosing extra relevant information such as its fair value.
Conclusion: faithful representation + relevance = useful information See CF:Ch3: QC16
Worked example: A faithful representation without relevance

We may have damaged one of our machines with the result that its carrying amount had to
be impaired (reduced). This impairment could be a faithful representation, assuming we
applied the correct process in determining the estimate (free from error and neutral), described it clearly
as an estimate and explained all the uncertainties involved in making the estimate (complete).
However, if there was a very high level of uncertainties involved in making the estimate, the relevance
of this information may be questionable, in which case it may not actually be useful (although if there
is no other representation possible, it may still be the ‘best available information’!).
Conclusion: This is an example of a faithful representation that is not relevant:
See CF:Ch3: QC16
faithful representation – relevance ≠ useful information
3.2.2.1 Complete (CF: Chapter 3: QC 13)
Financial statements should be complete. Completeness means giving all information (words
and numbers) necessary for the user to understand the phenomenon depicted. For example,
the phenomenon could be assets, in which case, we should:
Complete means
describe the nature of the assets (e.g. land, machines);
depicting:
give relevant numerical information (e.g. depreciation);
describe what the numbers mean (e.g. depreciated cost); all information
explain how we got to these amounts (e.g. depreciated necessary for a user to
cost is calculated at cost less depreciation calculated understand the phenomenon
using a nil residual value and a ten-year useful life). CF: Ch3: QC13 (slightly reworded)
3.2.2.2 Neutral (CF: Chapter 3: QC 14)

Neutral means:
For financial statements to be neutral, they must be free from
bias in the selection and presentation of information. free from bias. CF: QC14
Bias is :
Bias is the manipulation of information so that your
manipulation to get a response
information is received by users in a favourable or that is either
unfavourable way (i.e. to achieve a ‘pre-determined result or favourable/ unfavourable.
outcome’ in order to influence users’ decisions). See CF: Ch3:QC14
Chapter 2 43
3.2.2.3 Free from error (CF: Chapter 3: QC 15)

Free from error
Free from error means that there are no errors or omissions in:
means:
the description of the phenomenon
no errors/ ommissions in
the selection and application of the processes used to description of phenomena &
produce the information. See CF: Ch3: QC15 selection & application of
processes used to produce
It does not mean perfectly accurate in all respects. This is theinformation.
CF: Ch3:QC15(reworded)
because, for example, our financial information includes
estimates (e.g. a provision for costs relating to a lawsuit) that Free from error does not mean:
can never be said to be accurate or inaccurate. perfect.
Estimates can, however, be said to be free from error if the financial information:
describes it as an estimate,
describes the nature and limitations involved in making the estimate (e.g. we explain that
a provision relates to a legal claim where the court case is still in progress and therefore
we are relying on our lawyer’s estimations), and
if there are no errors in the selection and application of the process used to develop them.
3.2.3 Applying the fundamental qualitative characteristics (CF: Chapter 3: QC 17-18)
The information cannot be useful if it is relevant but not a faithful representation or vice
versa. It must be both. The CF explains that the best way of achieving both is to:
Step 1 Identify the economic phenomenon that has the potential to be useful to the user.
Step 2 Identify what type of information would be most relevant.
Step 3 Determine whether the information is available and can be faithfully represented.
If the information is available and can be faithfully represented, you will have satisfied the
fundamental qualitative characteristics. If not, then identify another economic phenomenon
that has the potential to be useful to the users and repeat the process.CF:Ch3: QC18(reworded)
3.3 Enhancing qualitative characteristics (CF: Chapter 3: QC19-34)
Once information is both relevant and faithfully represented

(fundamental qualities), we have useful information. Enhancing QCs (4):
Comparability
We then try to enhance this usefulness by ensuring that the
Verifiability
information is comparable, verifiable, understandable and Timeliness
produced on a timely basis. These characteristics are referred UnderstandabilityCF: Ch3:QC19
to as the enhancing qualitative characteristics. See CF:Ch3:QC19
Information that does not have the fundamental qualities is not useful and cannot be made
useful simply by ensuring that it has enhancing qualitative characteristics. However,
enhancing characteristics can help decide how to depict useful information that is able to be
depicted in multiple ways, each of which are equally relevant and faithfully represented.
3.3.1 Comparability (CF: Chapter 3: QC20-25)
Comparability allows users to identify similarities and Comparability enables

differences among items. Being able to compare items will users to:
assist users in choosing how to proceed with their decisions
(e.g. whether to invest in one entity or another entity). ‘ identify & understand
similarities in items &
differences among items ’.
Consistency is not the same as comparability. Consistency CF: Ch3: QC21(extract)
simply helps achieve the goal of comparability. See CF:Ch3:QC22
44 Chapter 2
Comparisons require at least two items whereas

consistency refers to the same methods being Comparability ≠ consistency.
applied to a specific item, either:
in a single entity across multiple periods; or Comparability is the goal;
Consistency helps achieve the goal.CF: Ch3:QC22
across multiple entities in a single period.
Information about an entity is more useful if it can be compared:

from one entity to the next: entities should all comply with the same standards, so that
when comparing two entities a measure of
comparability is guaranteed (e.g. this would Comparability should
be useful to potential investors who are enable comparisons:
deciding which entity to invest in); and between multiple entities; and
See CF: Ch3: QC20
between multiple periods.
from one year to the next: transactions of a
similar nature should be recognised, measured and presented in the same way that they
were in prior years (e.g. this would be useful to creditors who may want to assess the
trend in profitability and liquidity with the aim of deciding whether they can increase or
should decrease credit limits).
3.3.2 Verifiability (CF: Chapter 3: QC26-28)
Verifiability helps assure users that the information

has been independently assessed by knowledgeable Verifiability means that:
observers and found to be faithfully represented.
Thus verifiability provides users with a measure of ‘different knowledgeable and independent
observers
confidence in the information presented. could reach consensus, although not
necessarily complete agreement,
Amounts need not be exact to be verifiable – there that a particular depiction (e.g.
could be a range of possible amounts and description/ amount) is a faithful
probabilities that could be verified instead. representation’. CF: Ch 3: QC26(extract)
Some information may not be verifiable (e.g. predictions and certain explanations). Where
information is not verifiable, it should be clearly identified as such so that users can decide
whether to use this information in their decision-making or not. See CF: Ch3:QC28
Verification could be direct or indirect:

Direct verification means verifying something (e.g. an amount) through direct
observation: for example, a bank balance can be verified by checking the bank statement;
Indirect verification means verifying something (e.g. an amount) by checking inputs and
recalculating the outputs: for example, an inventory balance can be verified by checking
the inputs (number of units on hand and cost per unit), checking the correct process to be
applied (e.g. the first-in-first-out formula) and recalculating the balance. See CF:Ch3:QC27
3.3.3 Timeliness (CF: Chapter 3: QC29)

Timeliness means information is
Information needs to be available in time for users
to be able to use it in their decision-making. Most ‘available to decision-makers
information needs to be available soon after year- in time to CF: be capable of influencing their
Ch3: QC29(extract)
end to be useful. For example: the 1999 financial decisions’.
statements of a business are generally not relevant to a user in 2014 who is trying to decide
whether or not to invest in that business. However, old information could still be useful for
users who are looking at trends.
Interestingly, this race against time may impair other qualities (e.g. rushing the publication of
financial statements may result in faithful representation being adversely affected).
Chapter 2 45
3.3.4 Understandability (CF: Chapter 3: QC30-32)
Since our ultimate objective is usefulness, it makes sense Understandable

that information must be understandable. For information information is:
to be understandable, it must be clear and concise.
Classified, characterised &
However, some information, by its very nature, may be presented
difficult to understand. We may not simply leave it out Clearly & concisely. CF: QC30 (reworded)
on the basis that it is not easily understandable. This is because this would mean that the
financial statements would not be complete and thus potentially misleading. Thus, if
something is difficult to understand, we simply need to take extra care in how we present it
and give extra disclosure if we believe it may improve the understandability thereof.
Regarding inherently difficult information, the CF allows us to assume that the user:
has a reasonable knowledge of business and economic activities; and
will diligently (carefully) review and analyse the financial information provided; and
would obtain assistance from an advisor for complex issues. CF:Ch3:QC32( reworded)
3.3.5 Applying the enhancing qualitative characteristics (CF: Chapter 3: QC33-34)
Enhancing qualitative characteristics should be maximised to the extent possible. This process
will involve a balancing act, since to apply one enhancing qualitative characteristic may mean
that another qualitative characteristic is diminished. For example:
for information to be a faithful representation, it may mean that it is not as timely as one
would have hoped; and
comparability may need to be temporarily reduced in order that a new standard be
applied prospectively, where this new standard will improve relevance in the long-term.
3.4 The cost constraint on useful information (CF: Chapter 3: QC35-39)
There are often huge costs involved in reporting financial information. These costs obviously
increase as one tries to achieve perfection in the financial statements. We therefore need to be
careful that the benefit justifies the cost. At the same time, however, we must also bear in
mind that if we, as the providers of financial information, do not incur these costs then our
users would bear extra costs by having to obtain missing information from elsewhere.
Financial reporting that is relevant and a faithful representation allows users to make
decisions with confidence. This in turn improves the overall economy (e.g. via more efficient
functioning of capital markets and a lower cost of capital for the economy as a whole).
When the IASB created the various IFRSs, it first considered the expected costs involved in
applying these standards by consulting with providers and users of financial information,
auditors, academics and others. Thus, in general, the cost of providing information required
by IFRSs will normally be justified by the benefit. This is, however, a subjective issue due to
the peculiarities of each entity, the individuals assessing the cost-benefit question and the size
of the entity (what may be cost-effective for one entity may be too expensive for another).
Professional judgement is thus necessary to decide if the benefit justifies the cost.
4. Underlying Assumption: Going Concern (CF: Chapter 4: 4.1)
Users may assume that the financial statements relate to a going concern that plans to
continue operating for the foreseeable future. In other words, the entity does not intend or
need to liquidate or materially curtail (downsize) its operations. If this assumption is
inappropriate, this fact plus the basis upon which the financial statements were then prepared
(e.g. measuring assets at liquidation values instead of fair values) must be disclosed.
46 Chapter 2
5. Elements (CF: Chapter 4: 4.2-4.36)
5.1 Overview
The elements:
There are only five elements that make up the entire double-entry
accounting system: Assets
The assets, liabilities and equity relate to financial position Liabilities
(shown in the statement of financial position). Equity
Income and expenses relate to financial performance (shown in Income
the statement of comprehensive income). Expenses
To decide what element we are dealing with, we look to see which definition is met. In
deciding which definition is met, we must assess the substance of the transaction rather than
simply its legal form. See CF Ch 4: 4.6
5.2 Definitions of each of the elements (CF: Chapter 4: 4.4 & -4.36)
Asset Liability
CF Chp4.4(a); see also 4.8-4.14 CF Chp4.4(b); see also 4.15-4.19 & NOTE 1
Resource Present obligation Note 1

Controlled by the entity Of the entity
As a result of a past event As a result of a past event
From which future economic benefits The settlement of which is expected to
are expected to flow to the entity result in an outflow from the entity of
resources embodying economic benefits
Equity
CF Chp4.4(c) see also see also 4.20-4.23
The residual interest in the assets

After deducting all liabilities
Income Expense
CF Chp4.25; see also 4.29-4.32 & NOTE 2 CF Chp4.25; see also 4.33-4.35 & NOTE 3
An increase in economic benefits A decrease in economic benefits

During the accounting period During the accounting period
In the form of increases in assets or In the form of decreases in assets or
decreases in liabilities incurrence of liabilities
Resulting in increases in equity Resulting in decreases in equity
Other than contributions from equity Other than distributions to equity
participants participants
Note 1 A liability represents a ‘present obligation’ - not a ‘future commitment’!
Note 2 The term ‘income’ includes both:

revenue (defined as income from sales, services, interest, royalties and dividends); and
gains (defined as all other types of income).
Note 3 The term ‘expenses’ includes both:

expenses in the ordinary course of business (e.g. cost of sales and wages); &
losses (defined as other types of expense).
Chapter 2 47
Example 1: An inflow – income or liability?

Alfa Limited received C80 000 in cash on 20 December 20X4 from Romeo Limited in
return for having provided financial advice during the 20X4 financial year.
Required:
A. Explain, with reference to the relevant definitions, which elements should possibly be recognised
in the 20X4 financial year.
B. Briefly identify whether and/ or how your answer would change if the cash received had been
received for financial advice to be provided in the 20X5 financial year.
Solution 1: An inflow – income or liability?

Part A:
Income definition: Income is defined as:
an increase in economic benefits during the accounting period
in the form of increases in assets or decreases in liabilities
resulting in increases in equity
other than contributions from equity participants.
Asset definition: The essence of the definition of income requires that there is either an increase in
assets or a decrease in liabilities that results in an increase in equity during the year. The transaction
involves the receipt of cash (asset). Thus we will assess whether the transaction has increased our
assets. The definition of an asset is:
a resource controlled by the entity
as a result of a past event
from which future economic benefits are expected to flow to the entity.
Discussion of the asset definition: The cash is a resource controlled by the entity (it is secured in Alfa’s
business account and thus controllable). The cash was received in exchange for financial advice and
since this advice was provided during the 20X4 year, this event represents a past event at reporting
date. The cash is able to be used to generate future income and thus future economic benefits are
expected to flow to the entity from the use of this asset. The cash thus meets the definition of an asset.
Discussion of the income definition: The receipt of the cash during 20X4 meets the definition of an
asset and thus represents an increase in assets. Since there was neither a concomitant increase in
liabilities (Alfa has not obligations as a result of this receipt of cash) or decrease in assets, the receipt of
this asset will have increased equity (using the equation: A = E + L). This increase in equity is not a
contribution from equity participants (e.g. it is not the receipt of cash in exchange for an issue of equity
shares). Thus the receipt of cash meets the definition of income.
Conclusion: The receipt of cash in return for services rendered leads to an asset and income in 20X4.
Part B:
If cash was received in 20X4 for services to be provided in 20X5, the asset definition would be met but
the income definition would not be. This is because although there is an increase in assets, it would not
lead to an increase in equity: the cash receipt would lead to an obligation to provide services, which
would meet the liability definition. An increase in both assets and liabilities results in a nil effect on
equity. NOTE: A full discussion of the liability definition would have had to be included in the solution
if we had been required to discuss this fully – but the question asked simply for a brief explanation.
6. Recognising the Elements (CF: Chapter 4: 4.37-4.53)
Recognition means to actually recording (journalise) a Recognise = Journalise

transaction or event in the ledger.
An element may only be recognised if it
Transaction and events involve elements (e.g. assets and meets both the relevant:
liabilities). Before these elements may be recognised in Definition; and
the accounting records, the definition of the elements
Recognition criteria. See CF: Ch4: 4.37
and the recognition criteria must be met.
Thus when deciding whether to recognise a transaction or event, we first identify the elements
and check they meet the definitions and secondly we ensure they meet the recognition criteria.
48 Chapter 2
Worked example: Recognising an asset and a liability

A transaction involving the credit purchase of a machine involves two elements: an asset
(machine) and a liability (credit purchase). If the machine meets the definition of an asset
and the recognition criteria and if the credit purchase meets the definition of a liability and the
recognition criteria, the elements must be recognised. To recognise them, a journal entry must be
processed debiting the asset and crediting the liability accounts. Once the transaction is journalised, the
two elements involved in the transaction (asset and liability) will appear in the ledger, trial balance and
ultimately the financial statements.
Conclusion: Since the relevant asset and liability definitions and recognition criteria are met, both the
asset and liability are recognised.
The two recognition criteria are as follows:

the flow of future economic benefits caused by this element must be probable; and
the element must have a cost/value that can be reliably measured.
For an asset or liability to be recognised, both criteria Recognition criteria:

must be met. Interestingly, however, because the
definition of an income or expense requires that there be flow of future economic benefits
a flow of economic benefits, the recognition criterion must be probable; and
that requires that the future flow of economic benefits be
cost or value must be reliably
probable (see the first of the two recognition criteria measurable. CF: Ch4:4.38 (slightly reworded)
shown above) is obviously not relevant when deciding
whether to recognise an income or expense.
Thus for an income or expense to be recognised only one criteria must be met:
the element must have a cost/ value that can be reliably measured.
It is important to read the definition of income and expense again and note how, by definition,
these two elements may only be recognised when there is a change in the carrying amount of
an asset or liability. For example, an income arises if there is an increase in assets whereas an
expense arises if there is a decrease in assets. This means that for an item of income or
expense to be recognised, the definition of asset or liability would first need to be met and
then we would need to be able to prove that the carrying amount thereof had changed. For
example, if we tried to prove that income existed, we would first have to prove either that:
an asset existed (i.e. a recognised asset) and that its carrying amount had increased; or
a liability existed (i.e. a recognised liability) and that its carrying amount had decreased.
Example 2: Recognising the elements

This example is a continuation of example 1, repeated here for your convenience:
Alfa Limited received C80 000 in cash on 20 December 20X4 from Romeo Limited in
return for having provided financial advice during the 20X4 financial year.
Required:
Discuss with reference to the relevant recognition criteria whether the income and asset (whose
definitions were proved to be met: see example 1) may be recognised in the 20X4 financial year.
Solution 2: Recognising the elements

Recognition criteria:
The flow of future economic benefits must be probable; and
The cost or value must be reliably measurable.
Discussion of the recognition criteria: Both the asset and income meet the recognition criteria (note
that the income only has to meet the second of the two recognition criteria).
The use of cash in a business that is a going concern will undoubtedly lead to future income and
thus the inflow of future benefits is probable.
The value of both the asset and income is reliably measurable at C80 000.
Conclusion: Since the asset meets the asset definition and both the recognition criteria and the income
meets the income definition and the second recognition criteria, both the asset and income must be
recognised (debit: cash and credit: income from services rendered).
Chapter 2 49
Generally an expense that has a causal nexus (direct link) to an income is recognised in the
same period as that income. This is commonly referred to as the matching concept. The
matching concept is no longer one of the concepts in the CF, and thus although matching is
allowed, the CF does not allow this practice to result in the recognition of assets and liabilities
that have not met the definitions. See CF: Ch4: 4.50
If the expense has no causal nexus (no direct link) to income and will result in the earning of
economic benefits (income) over several periods, then we recognise the expense on a
systematic/ rational basis over the relevant accounting periods. See CF: Ch4: 4.51
Example 3: Recognising expenses

The 20X3 accounting records were audited during January 20X4. The audit is a legal
requirement. An invoice for C3 000 for this audit work was received in February 20X4.
The 20X3 annual financial statements have not yet been finalised and the accountant wishes to know if he
should recognise this invoice in the 20X3 financial statements as it is the cost of auditing these 20X3
financial statements.
Required:
A. Briefly explain whether you think the cost of the audit should be recognised as an expense in 20X3. You
need only refer to the aspects of the definitions that affect your argument.
B. Give an example of an expense that has a direct link to income and which is often recognised in a way
that matches the expense with the income.
C. Give an example of an expense that has no direct link with income and which is thus recognised in a
systematic / rational basis over the relevant accounting periods .
Solution 3: Recognising expenses

Part A:
The cost of the audit should not be recognised as an expense in 20X3. The reason lies in the combination of
the expense and liability definitions.
The definition of an expense requires that there is a decrease in economic benefits (either a decrease in
assets or increase in liabilities) during the accounting period.
The definition of a liability requires that an obligation arises as a result of a past event.
Although an obligation has arisen due to the audit work having been performed, this audit work had not been
performed before reporting date and thus, at reporting date, there had not been a past event and thus there
was no obligation at reporting date. Thus the liability definition is not met in 20X3. Since the liability did
not arise in 20X3, the expense definition also fails in 20X3: there is no decrease in economic benefits during
the 20X3 accounting period.
Alternative answer: Interestingly, there are those who hold a different opinion: an expense and liability
should be recognised (debit: audit fee expense and credit: accounts payable). They argue that the event is
‘trading whilst there is a legal requirement to have the audit done’ i.e. not the actual physical audit. The
argument is that the combination of the fact that the business operated during 20X3 together with the fact
that the law requiring an audit was effective at 31 December 20X3, means that, at reporting date, the event
(trading whilst there is this legal requirement) is a past event which leads to a legal obligation to have an
audit. Since there is thus a legal obligation at 31 December 20X3, the liability definition is met at
31 December 20X3. An increase in liabilities in 20X3 (with no equal but opposite increase in assets), means
there is a decrease in equity in 20X3 and thus the cost of the audit will also meet the definition of an expense
in 20X3.
A very important point for you to remember: Such a question often has more than one answer. The
importance is more often than not simply how you get to your conclusion, rather than what your conclusion
is. Your approach to a discussion question, such as the one above, is to first consider each aspect of the
relevant definition/s. Once a definition is met, conclude that an element exists. Then consider the recognition
criteria for that element and conclude whether or not the element must be recognised.
Part B:
Cost of sales is the cost of inventory being expensed in a way that matches the period in which the income
from the sale is recognised, being an example of an expense directly linked to income.
Part C:
Depreciation on plant is the cost of plant being expensed on a systematic/ rational basis over the relevant
accounting periods, being an example of an expense not directly linked to income.
50 Chapter 2
7. When an Element is not to be Recognised
Elements that do not meet the relevant definitions and recognition criteria in full may not be
recognised in the financial statements. Information about them may, however, still be
considered to be ‘relevant’ to the user, in which case it should be disclosed in the notes.
8. Recognition versus Disclosure
As mentioned earlier, the term ‘recognition’ means the actual recording (journalising) of a
transaction or event. Once recorded, the element will be included in the journals, trial balance
and then channelled into one of the financial statements presented on the accrual basis:
statement of comprehensive income,
statement of changes in equity, or Disclosure gives
statement of financial position; detail about items:
as well as the financial statement presented on the cash basis: Already recognised;
statement of cash flows. Not recognised but still
considered relevant.
The term ‘disclosure’ means giving detail about specific transactions or events that are either:
already recognised in the financial statements; or
not recognised in the financial statements but yet are considered relevant to the users of
the financial statements.
Some items that are recognised may require further disclosure. Where this disclosure involves
a lot of detail, this is normally given in the notes to the financial statements.
Other items that are recognised may not need to be disclosed. For example, the purchase of a
computer would be recorded in the accounting records and the statement of financial position.
Unless this computer was particularly unusual, however, it would be included in the total of
the non-current assets on the face of the statement of financial position, but would not be
separately disclosed anywhere in the financial statements since it would not be relevant to the
user when making his economic decisions.
Conversely, some items that are not recognised may need to be disclosed. This happens where
either the definition or recognition criteria (or both) are not met, but yet the information is still
expected to be relevant to users in making their economic decisions. For example: a lawsuit
against the entity which has not been recognised because the entity has not been able to be
reliably measure the financial impact thereof (i.e. the recognition criteria were not met) may
still need to be disclosed because this information may be considered useful to users in
making their economic decisions.
Recognition of elements
(that have met the definitions)
Asset and liability Income and expense

Future economic benefits probable Reliably measurable
Reliably measurable
Recognition criteria met?
Yes No
Recognise; and where applicable Is the item material to the user?
Disclose separately (if required by a
IFRS or if considered necessary for fair Yes No
presentation)
Disclose Ignore
Chapter 2 51
9. Measuring the Elements (CF: Chapter 4: 4.54-4.56)
As already explained, if an item meets the definition of an element and meets the necessary
recognition criteria, we will need to recognise the elements. This involves processing a
journal entry. To do this, we need an amount. The term measurement refers to the process of
deciding or calculating the amount to use in this journal entry and the term measurement base
refers to the method used to measure it. The part of the CF dealing with measurement is
currently very weak, simply listing some possible measurement bases, including for example:
The historical cost method
- measures an asset at the actual amount paid for it at the time of the acquisition; and
- measures the liability at the amount of cash (or other asset) received as a loan or at
the actual amount to be paid to settle the obligation in the normal course of business.
The present value method
- measures an asset at the present value of the future cash inflows (i.e. discounted) to
be derived from it through the normal course of business; and
- measures liabilities at the present value of the future cash outflows (i.e. discounted)
expected to be paid to settle the obligation during the normal course of business.
The realisable value method
- measures an asset at the cash amount for which it can be currently sold in an orderly
disposal; and
- measures liabilities at the actual amount of cash (undiscounted) that would be
required to settle the liability during the normal course of business.
The current cost method
- measures an asset at the amount that would currently have to be paid if a similar asset
were to be acquired today; and
- measures liabilities at the actual amount of cash (undiscounted) that would be
required to settle the liability today.
The measurement of assets and liabilities are dictated by the requirements set out in the
specific IFRSs. These measurement requirements generally reflect a combination of the ideas
underlying the measurement bases listed in the CF. For example:
Assets that are purchased with the intention of resale are measured in terms of IAS 2:
Inventories, which states that inventories should be initially measured at ‘cost’ and
subsequently measured at the ‘lower of cost or net realisable value’.
Assets that are purchased to be used over more than one period are measured in terms of
IAS 16: Property, Plant and Equipment, which requires that the asset be initially
measured at cost and subsequently measured using historical cost or fair value, where the
fair value is determined in accordance with a discounted future cash flow technique (i.e.
present value), or in terms of an active market (i.e. current cost).
As can be seen from the above, the IFRSs generally separate measurement into:
Initial measurement; and
Subsequent measurement.
Where choices are provided, it seems that most companies still choose to measure assets at
depreciated historic cost. However, there is a definite push towards fair value accounting,
where present values and current costs are considered more appropriate than historic cost. In
fact, there are those who argue that the historic cost basis should be abandoned entirely and
replaced by fair value accounting since the generally rising costs caused by inflation means
the historic amount paid for an item has no relevance to its current worth. A problem with fair
value accounting, however, is that its potentially subjective and volatile measurements could
reduce the comparability of financial statements. Obtaining fair values can also be very
costly, which could be why most entities still use historic costs whenever IFRSs permit it.
52 Chapter 2
10. Concepts of Capital and Capital Maintenance (CF: Chapter 4: 4.57-4.65)
10.1 Capital (CF: Chapter 4: 4.57-4.58)
There are two possible concepts of capital:

Financial concept of capital: capital relates to the net assets or equity of the company.
This concept is adopted by most entities in preparing their financial statements.
Physical concept of capital: capital is regarded as the productive capacity of the entity, for
example 500 units of output per day.
The choice between these concepts depends on the users. If users are more interested in the
net worth of the company, then the financial concept makes more sense. If users are more
interested in the production capability, then the physical concept would be more appropriate.
10.2 Capital maintenance and determination of profit (CF: Chapter 4: 4.59-4.65)
Capital and profits are inter-linked. Each affects the other. The measurement of profits is
affected by the measurement of capital. Only the net inflows of assets that exceed the amounts
needed to maintain the capital base are regarded as profit. Thus, if the capital is bigger at the
end of the year compared to the beginning, a profit has been made. How one measures this
capital growth will thus affect the measurement of the profit (or loss):
Financial capital maintenance: a profit is earned if the financial (money) amount of the
net assets is greater at the end of the period than at the beginning of the period, after
excluding any distributions to, or contributions from, owners during the period (e.g.
dividends and share issues). This can be measured in normal monetary units or units of
constant purchasing power.
Physical capital maintenance: a profit is earned only if the physical productive capacity of
the entity (or the resources or funds needed to achieve that capacity) at the end of the
period exceeds the capacity at the beginning of the period, after excluding any
distributions to, or contributions from, owners during the period.
11. Answering Discussion Type Questions
When answering a discussion type question involving the recognition of the elements, it is
generally advisable to structure your answer as follows:
Discussion question
quote the definition of the relevant element/s and then structure :
discuss each aspect of it in order to ascertain whether or not
Definition:
the definition/s is met;
- quote & discuss
quote the relevant recognition criteria and then discuss Recognition criteria:
whether the element meets the recognition criteria; and - quote & discuss
conclude by stating which element’s definition the item Conclude
meets (e.g. asset, liability, income, expense or equity) and then whether or not this
element should be recognised (based on the recognition criteria).
The structure of an answer depends on the wording of the requirements. If it asks us to:
discuss the recognition of an element: it is generally a good idea to first quote both the
definition/s and recognition criteria of the relevant element and then discuss them (unless
your question tells you not to quote them).
discuss what element arises: we discuss the definition/s but not the recognition criteria.
prove that the debit or credit entry is a certain element (e.g. that a credit is a liability): we
simply discuss the definition relevant to that certain element.
discuss which element a debit (or credit) entry represents: we generally discuss both the
asset and expense definitions, (if a credit entry: discuss the liability, income and perhaps
even the equity definitions).
Chapter 2 53
If a question asks us to discuss issues relating to measurement, we would not discuss the
definition and recognition criteria at all and we must remember that calculations of the
amounts may also be required.
Use the mark allocation as a guide in deciding how detailed your discussion should be. Also
watch for the words used: discuss normally means a full discussion is needed; explain and
briefly explain generally mean that an in-depth discussion is not required – instead we just
explain relevant aspects (e.g. we might explain why something does not meet a definition by
simply discussing the aspect/s of the definition that are not met); identify generally means no
discussion is needed at all.
Example 4: Recognition: Staff costs – an asset?
Companies often maintain that their employees constitute their biggest asset. However, the
line-item ‘employees’ is never seen under ‘assets’ in the statement of financial position.
Required: Explain why employees are not recognised as assets in the statement of financial position.
Solution 4: Recognition: Staff costs – an asset?

In order for ‘employees’ to appear in the statement of financial position as an asset, both the following
need to be satisfied:
the definition of an asset; and
the recognition criteria.
First consider whether an ‘employee’ meets the definition of an ‘asset’.
Is the employee a resource?
A staff member is a resource – a company would not pay a staff member a salary unless he/ she
were regarded as a resource. In fact, employees are generally referred to as ‘human resources’.
Is the employee controlled by the entity?
Despite the existence of an employment contract, there would always be insufficient control due to
the very nature of humans.
Is the employee a result of a past event?
The signing of the employment contract could be argued to be the past event.
Are future economic benefits expected to flow to the entity as a result of the employee?
It can be assumed that the entity would only employ persons who are expected to produce future
economic benefits for the company.
Since control over the employee is considered questionable, it can be argued that the employee does
not meet the definition of an asset. But even if one argues that there is a certain degree of control and
thus that an asset does exist, the recognition criteria require that:
the flow of future economic benefits to the entity must be probable; AND
the asset has a cost/value that can be reliably measured.
It is probable that future economic benefits will flow to the entity because the entity would not
otherwise have hired the employee.
The problem arises when one tries to reliably measure the cost/value of each employee. How would
one value one employee over another? Perhaps one could calculate the present value of their future
salaries, but there are two reasons why this is unacceptable. Think about the following:
Can we reliably measure the cost of an employee? If we were to use future expected salaries and
other related costs, consider the number of variables that would need to be estimated: the period
that the employee will remain employed by the entity, the inflation rate over the expected
employment period, the future performance of the employee and related promotions and bonuses.
You will surely agree that a reliable measure of their cost is really impossible.
Since we cannot reliably measure the cost of an employee, can one reliably measure their value?
The value of an employee to an entity is the value that he or she will bring to the entity in the
future. It is surely obvious that there would be absolutely no way of assessing this value reliably!
Employees are thus not recognised as assets in the statement of financial position for two main reasons:
there is insufficient control over humans; and
it is not possible to reliably measure their cost or value.
54 Chapter 2
12. Summary
Conceptual Framework for Financial Reporting

objective of general purpose financial reporting
underlying assumption: going concern
qualitative characteristics: fundamental & enhancing
the elements
recognition of the elements
measurement of the elements
concepts of capital and capital maintenance
Objective of general Underlying Qualitative Recognition &

purpose financial assumption characteristics measurement of
reporting elements
provide financial info Going concern Fundamental: Recognition:
about the entity Relevance. Something is meet definition
that is useful to the relevant if it makes a meet recognition
users * difference to user’s criteria
in making decisions about decision-making, which
providing resources to will be the case if it has: Measurement:
the entity predictive value historical cost
confirmatory value current cost
* Users (primary) = Relevance is related to present values
existing and potential materiality (which is fair values
investors, lenders and entity-specific) liquidation values
other providers of capital Faithful representation etc
Complete Can be a mixture of
Neutral measurement methods
Free from error e.g. initial measurement
Enhancing: at cost and subsequent
Comparability measurement at fair
Verifiability value
Timeliness
Understandability
Elements in the financial statements
Assets Liabilities
Resource Present obligation
Controlled by the entity Of the entity
As a result of a past event As a result of a past event
From which future economic benefits are From which future economic benefits are
expected to flow to the entity expected to flow from the entity
Equity
Assets less
Liabilities
Income Expenses
An increase in economic benefits A decrease in economic benefits
During the accounting period During the accounting period
In the form of increases in assets or decreases In the form of decreases in assets or increases
in liabilities in liabilities
Resulting in increases in equity Resulting in decreases in equity
Other than contributions from equity participants Other than distributions to equity participants
Chapter 2 55
Recognition of elements
(that have met the definitions)
Asset and liability Income and expense

Future economic benefits probable Reliably measurable
Reliably measurable
Recognition criteria met?
Yes No
Recognise; and where applicable Is the item material to the user?

Disclose separately (if required by a IFRS
or if it is considered necessary for fair
presentation)
Yes No
Disclose Ignore
56 Chapter 2
Gripping GAAP Presentation of financial statements
Chapter 3
Presentation of Financial Statements
Reference: IAS 1, IAS 10 and IFRIC 17 (including amendments to 10 December 2014)
Contents: Page
1. Introduction 59
2. Objective of IAS 1 and Objective of Financial Statements 59
3. Scope of IAS 1 59
4. Complete set of financial statements 60
5. General Features 60
5.1 Overview 60
5.2 Fair presentation and compliance with IFRSs 60
5.2.1 Achieving fair presentation 60
5.2.2 Compliance with IFRSs 61
5.2.3 Departure from IFRSs 61
5.2.3.1. When departure from an IFRS is required and allowed 61
5.2.3.2. When departure from an IFRS is required but not allowed 62
5.3 Going concern 62
5.4 Accrual basis of accounting 63
5.5 Materiality and aggregation 63
5.5.1 Accountancy involves a process of logical summarisation 63
5.5.2 Deciding whether an item is material and needs to be segregated 64
Example 1: Items with different natures 64
Example 2: Items with different nature, but immaterial size 64
Example 3: Items that are material in size, but not in nature or function 65
5.5.3 What to do with immaterial items 65
5.6 Offsetting 65
Example 4: Offsetting - discussion 66
Example 5: Offsetting - application 66
5.7 Frequency of reporting 67
5.8 Comparative information 67
5.8.1 Minimum comparative information 67
5.8.2 Voluntary additional comparative information 68
5.8.3 Compulsory additional comparative information 68
Example 6: Reclassification of assets 69
5.9 Consistency of presentation 70
6. Structure and content: financial statements in general 70
7. Structure and content: statement of financial position 70
7.1 Overview 70
7.2 Current versus non-current 71
7.3 Assets 71
7.3.1 Current assets versus non-current assets 71
Example 7: Classification of assets 72
7.4 Liabilities 72
7.4.1 Current liabilities versus non-current liabilities 72
Example 8: Classification of liabilities 73
7.4.2 Refinancing of financial liabilities 73
Example 9: Loan liability and a refinancing agreement 74
Example 10: Loan liability and the option to refinance 74
7.4.3 Breach of covenants and the effect on liabilities 75
Example 11: Loan liability and a breach of covenants 75
7.5 Disclosure: In the statement of financial position 76
Example 12: Presenting further line-items 77
Chapter 3 57
Contents continued ... Page

7.6 Disclosure: either in the statement of financial position or notes 77
7.6.1 Overview 77
7.6.2 Disclosure of possible extra sub-classifications 77
Example 13: Presenting further sub-classifications 77
7.6.3 Further disclosures for share capital and reserves 78
7.7 A typical statement of financial position 78
8. Structure and content: statement of comprehensive income 79
8.1 Total comprehensive income, profit or loss and other comprehensive income 79
8.2 Presentation: One statement or two statements 80
8.2.1 Overview 80
8.2.2 Single statement layout 80
8.2.3 Two statement layout 81
Example 14: Statement of comprehensive income: two layouts compared 81
8.3 Line items, totals and sub-headings needed 82
8.3.1 Overview 82
8.3.2 Minimum line items for: P/L 83
8.3.3 Minimum line items for: OCI 83
8.4 Analysis of expenses 84
8.4.1 Overview 84
8.4.2 Nature method 84
8.4.3 Function method 85
8.5 Material income and expenses 85
8.6 Reclassification adjustments 86
8.6.1 Explanation of reclassification adjustments 86
8.6.2 Disclosure of reclassification adjustments 87
Example 15: Statement of comprehensive income: reclassification adjustments 87
8.7 Adjustments to a prior year profit or loss 88
8.8 A sample statement of comprehensive income 88
8.9 A consolidated SOCI: the ‘allocation section’ 89
9. Structure and content: Statement of changes in equity 90
9.1 Overview 90
9.2 General presentation requirements 90
9.3 Dividend distributions 91
9.4 Retrospective adjustments 91
9.5 A sample statement of changes in equity 91
9.6 A consolidated statement of changes in equity 92
10. Structure and content: statement of cash flows 93
11. Structure and content: notes to the financial statements 93
11.1 Overview 93
11.2 Structure of the notes 93
11.3 Basis of preparation 94
11.4 Significant accounting policies 95
11.3.1 Overview 95
11.3.2 Measurement bases 95
11.3.3 Significant accounting policies are those that are relevant 95
11.5 Judgements made in applying accounting policies 96
11.6 Judgements involving estimates: sources of estimation uncertainty 97
11.7 Capital management 98
11.8 Puttable financial instruments classified as equity instruments 98
11.9 Unrecognised dividends 99
11.9.1 Disclosure of unrecognised dividends 99
11.9.2 Why are some dividends not recognised? 99
11.10 Other disclosure required in the notes 99
12. Summary 100
58 Chapter 3
1. Introduction
This chapter deals with IAS 1 Presentation of Financial

IAS 1 only explains how to
Statements. IAS 1 is the first IFRS in the suite of IFRSs. present f/statements:
It is such an important standard that I refer to it as one of
the ‘two pillars of accounting’. The other ‘pillar’ is the recognition, measurement and
Conceptual Framework of Financial Reporting (CF), disclosure are explained in the
which is covered in chapter 2. remaining IFRSs.
With presentation in mind, IAS 1
I call the CF a pillar since it is essential to the sets out the:
understanding of all other standards (IFRSs). Similarly, objective of IAS 1;
IAS 1 is the other pillar because it applies to the purpose of f/statements;
presentation of all general purpose financial statements. statements that make up a complete
set of f/statements;
Please read both these chapters well, since the rest of this structure & minimum content of
each of these statements;
book assumes you have a thorough knowledge of them.
general features of f/statements.
Some of the ideas raised in the CF appear again in this chapter on IAS 1. The reason is that
the CF is actually not a standard but the foundation for all standards and interpretations and
thus it makes sense to see these concepts appearing in the standards and interpretations.
2. Objective of IAS 1 and Objective of Financial Statements (IAS 1.1 & 1.9)
The objective of IAS 1 is to help us present general-purpose financial statements so that

comparability is achieved between the entity’s financial statements and:
its own financial statements in previous periods; &
other entities’ financial statements. Interesting observation:
Comparability appears in:

With this in mind, it sets out: IAS 1 as the ultimate objective
overall requirements for presentation; for setting out the presentation
guidelines for the structure of financial statements; & requirements and guidelines.
minimum requirements for content contained therein. The CF as a enhancing qualitative
characteristic.
The objective of financial statements is to be a:
structured representation
of an entity’s financial position and performance and cash flows;
that is useful to a wide range of users in making economic decisions; and
showing the results of management’s stewardship of the resources entrusted to it.
3. Scope of IAS 1 (IAS 1.2 to IAS 1.6)
IAS 1 is designed for general-purpose financial General purpose

statements, and is ideally suited for entities: f/ statements are defined
whose share capital is equity; as those intended to:
that are profit-oriented. meet the needs of users
who are not in a position to
If an entity that does not have share capital, the require an entity to prepare
presentation of owner’s interest will need to be adapted. reports tailored to their
particular information needs.IAS1.7
If the entity is not profit-orientated, they may need to
amend certain descriptions.
IAS 1 is not designed for interim financial statements although certain of the general features
set out in IAS 1 do still apply. Interim financial statements are covered in IAS 34 (this is not
covered in this textbook).
Chapter 3 59
4. Complete Set of Financial Statements (IAS 1.10 and .10A)
There are five main statements in a complete set of financial statements, where each statement
must reflect information for at least the current year and the prior year (comparative year):
the statement of financial position (SOFP); Note 1
the statement of comprehensive income (SOCI); Note 2, Note 3
the statement of changes in equity (SOCIE);
the statement of cash flows (SOCF); and
the notes to the financial statements (Notes).
Note 1. The SOFP normally includes balances as at the end of the current period and end of
the prior period. However, it must reflect the balances at the beginning of the prior
period if there is a retrospective change in accounting policy, restatement of items or
reclassification of items. This would mean 3 columns of information to be provided
in the SOFP. This is covered in more depth in the chapter on ‘Accounting policies,
changes in accounting estimates and errors’. IAS 1.10(f)
Note 2. Comprehensive income can be presented either
in a single statement: the statement of comprehensive income (this may be called
the statement of profit or loss and other comprehensive income); or
in two separate statements (one called the statement of profit or loss and the other
called the statement of comprehensive income): see section 8.2 for more
information.
We use a single statement approach in this textbook and refer to it as the statement of
comprehensive income (SOCI).
5. General Features (IAS 1.15-.46)
5.1 Overview
IAS 1 lists eight general features to consider when The 8 general features:
producing financial statements. As you read through the
descriptions of these general features, you will notice that fair presentation & compliance with
they often refer to concepts referred to in the CF. For IFRS;
example, fair presentation is a general feature listed in going concern;
IAS 1 that requires faithful representation, a qualitative accrual basis;
characteristic listed in CF. Going concern is listed as a materiality and aggregation;
general feature in IAS 1, whereas this is presented as the offsetting;
underlying assumption in the CF. See if you can spot any frequency of reporting;
comparative information; and
other concepts from the CF appearing in IAS 1.
consistency of presentation.
5.2 Fair presentation and compliance with IFRSs (IAS 1.15-24)
5.2.1 Achieving fair presentation (IAS 1.15 and 1.17)

Fair presentation is
generally achieved by:
Financial statements must fairly present the financial
position, performance and cash flows of an entity. application of the IFRSs, with
IAS 1 states that fair presentation is presumed to be extra disclosure if needed. IAS1.15
achieved by ‘the application of IFRSs, with additional disclosure when necessary.' It then
goes on to explain that additional disclosure is necessary when, despite the IFRS requirements,
it is thought that users may still not be able to understand the financial position and
performance. The requirement for ‘additional disclosure when necessary’ puts the burden of
ensuring that the financial statements are a fair presentation squarely on the accountant’s
shoulders. In other words, compliance with the IFRSs may not necessarily be enough.
60 Chapter 3
To this end, IAS 1 reminds us that, when in doubt, we should always refer back to the
Conceptual Framework: ‘fair presentation requires faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the framework’. IAS 1.15: extract
Fair presentation (a general feature) is more than faithful representation (a qualitative

characteristic): fair presentation is the goal and faithful representation (i.e. complete, neutral
and free from error) is one of the characteristics needed in order to achieve this goal.
Fair presentation needs:
Although IAS 1 states upfront that fair presentation is compliance with IFRSs and
presumed to be achieved if there is compliance with extra disclosure where
IFRSs together with additional disclosures where needed, but it also needs:
necessary, it emphasizes the importance of one particular Application of the CF’s definitions
IFRS: IAS 8. In this regard, it reminds us to use IAS 8 and recognition criteria;
when selecting and applying accounting policies and to Faithful representation (complete,
also use the hierarchy of guidance contained in IAS 8 if neutral and free from error);
there is no suitable IFRS for an item. Reliability, relevance, comparability
IAS 1.15 & 1.17(b)
and understandability.
DID YOU NOTICE?

IAS 1 explains that in addition to IFRS compliance and
Fair presentation (IAS1) giving extra disclosure where needed, fair presentation
needs:
also needs us to present the information in a way that
1 fundamental QC: faithful ensures relevant, comparable, understandable and
representation; & reliable information. All of these, except reliability, are
3 enhancing QCs: relevance, enhancing qualitative characteristics per the CF.
comparability & understandability.
5.2.2 Compliance with IFRSs (IAS 1.16)
Disclosure regarding compliance with the IFRS must be made in the financial statements if
absolutely all standards and interpretations have been complied with in full.
5.2.3 Departure from IFRSs (IAS 1.19 - 1.24)
In very rare circumstances, management may believe that

applying an IFRS will make the financial statements so
misleading as to no longer meet the objective of financial Although very rare, compliance
reporting (the essence of which is usefulness: see the CF). with IFRS may actually lead to
In coming to such a decision, management must consider: information that is so misleading
why the objective of financial statements is not that it conflicts with the objective
of financial reporting (i.e. the
achieved in the entity’s situation; and information is no longer useful)!
how the entity’s circumstances differ from those of other entities that have successfully
complied with the IFRS’s requirement/s. IAS 1.24: reworded
If management believes that the application of an IFRS would make the financial statements
misleading, the obvious solution would be to depart from the IFRS, but this is not always
allowed. The process to follow when departure from an IFRS is allowed and when departure
from an IFRS is not allowed is explained below.
5.2.3.1 When departure from an IFRS is required and allowed (IAS 1.19-22)
An entity shall depart from an IFRS:

if compliance with the IFRS is expected to result in financial statements that are so
misleading that the objective of financial statements won’t be met (i.e. the financial
information won’t be useful), and
if the relevant regulatory framework (e.g. the legislation of the relevant country) requires
or otherwise does not prohibit such a departure. See IAS 1.19
Chapter 3 61
The following extra disclosure is required when departure Departure from IFRS:
from an IFRS is allowed: If compliance will be so
misleading that it conflicts
management’s conclusion that the financial with the objective of
statements ‘fairly present the entity’s financial financial reporting:
position, financial performance and cash flows’; depart from the IFRS; unless
a declaration that the entity ‘has complied with the relevant regulatory framework
applicable IFRSs except that it has departed from a prohibits departure. IAS 1.19 & 1.23
particular requirement in order to achieve fair If you depart, extra disclosure will
presentation’; be needed to explain the departure.
the name of the IFRS from which there has been If you do not depart, extra
departure; disclosure will be needed to explain
the nature of the departure, including the treatment why you felt you should depart and
the adjustments you would have liked
that was required by the IFRS; to make but didn’t.
the reason why the treatment was considered to be so misleading;
the alternative treatment adopted; and the financial impact of the departure on each item
for each period presented that would otherwise have had to be reported had the IFRS been
properly complied with. See IAS 1.20
These disclosures (with the exception of management’s conclusion and the declaration
referred to above) are required every year after the departure where that departure continues
to affect the measurement of amounts recognised in the financial statements. See IAS 1.21-.22
5.2.3.2 When departure from an IFRS is required but not allowed (IAS 1.23)
It may happen that although departure from an IFRS is necessary for fair presentation, the
regulatory framework in that jurisdiction does not allow departure from IFRSs. In such
situations, since the objective of financial reporting remains the provision of useful financial
information, the lack of fair presentation must be remedied by disclosing:
the name of the IFRS that is believed to have resulted in misleading information;
the nature of the specific requirement in the IFRS that has led to misleading information;
management’s reasons for believing that the IFRS has resulted in financial statements that
are so misleading that they do not meet the objective of financial statements; and
the adjustments management believes should be made to achieve faithful representation
for each period presented.
5.3 Going concern (IAS 1.25-26)
Management has the responsibility to assess whether the Going concern (GC):
entity is a going concern (GC). This assessment: Management must assess
is made when preparing the financial statements; whether the entity is a
is based on all available information regarding the going concern. It may
conclude that:
future (e.g. budgeted profits, debt repayment
schedules and access to alternative sources of the entity is a going concern
financing); and the entity is not a going concern
includes a review of the available information relating there is significant doubt as to
to, at the very least, one year from the end of the whether the entity will be able to
reporting date. continue as a going concern or not.
If the entity has a history of profitable operations and ready access to funds, management
need not perform a very detailed analysis.
The entity is considered to be a going concern unless management:
voluntarily or involuntarily (i.e. where there is no realistic alternative):
plans to:
- liquidate the entity; or
- cease trading. See IAS 1.25
62 Chapter 3
Results of management’s assessment of whether the entity is a going concern (GC): (see IAS 25)
If the entity is a going concern: If the entity is not a GC: If the entity is a GC but there is
significant doubt that it will be
continue operating as a GC:
The financial statements: The financial statements: The financial statements:
are prepared on the GC basis. are not prepared on the GC basis; are prepared on the GC basis;
must include disclosure of the: must include disclosure of the:
the fact that it is not a GC; the material uncertainties
the reason why the entity is causing this doubt.
not considered to be a GC;
the basis used to prepare the
financial statements (e.g. the
use of liquidation values).
5.4 Accrual basis of accounting (IAS 1.27-28)
The accrual basis means recognising elements (assets, The accrual basis
liabilities, income, expenses and equity) when the Is used for all statements
definitions and recognition criteria are met. Transactions making up the set of
and events are thus recorded in the periods in which they financial statements with
occur rather than when cash is received or paid. the exception of the statement of
cash flows, which uses the cash basis.
5.5 Materiality and aggregation (IAS 1.29-31)
5.5.1 Accountancy involves a process of logical summarisation
Simply speaking, the financial process starts with a To summarise information,

transaction or event that is first documented onto a source is to combine (aggregate)
document. This document is then journalised (in items that we believe are
subsidiary journals). This journal is then posted into the not material enough to
show separately.
ledger (subsidiary ledger and general ledger). The ledger
is summarised by listing the various ledger accounts’ totals and balances. This listing is
referred to as the trial balance. This trial balance is summarised into the detailed set of
financial statements, which are used by internal users (e.g. management). These detailed
financial statements are then further summarised into what is referred to as the published set
of annual financial statements.
Published financial statements are not as detailed since they are meant for a variety of
external users for whom too much information is irrelevant to their decision-making.
Diagram: Summary of the accounting process:

Transaction/ event
Source document
Journal
Ledger
Trial balance
Unabridged financial statements
Detailed statement of financial position Detailed statement of comprehensive income
Published financial statements
Summary statement of financial position Summary statement of comprehensive income
Chapter 3 63
5.5.2 Deciding whether an item is material and needs to be segregated (IAS 1.29-31)
Materiality is a term that you will encounter very often

Items are material: in your accounting studies and is thus important for
you to understand. Both the CF and IAS 1 define items
if the decisions of the users as being material if the economic decisions of the users
could be influenced could be influenced if they were misstated or omitted.
if they were misstated or omitted, It is entity-specific and must be considered in terms of
individually/ collectively. the item’s nature or size, or both. It is often used as a
Materiality depends on the size/ threshold to help identify the amount at which a
nature/ both. A reworded extract from IAS 1.7 particular class of items may be considered material.
For example, an entity may have a materiality threshold for revenue of C100 000, with the
result that any revenue types that exceed C100 000 will need to be separately disclosed.
IAS 1 explains that materiality is applied to classes of items. Items are analysed into classes
based on their nature or function:
Each class of similar items that is material should be separately disclosed (segregated).
Each dissimilar item that is material should be segregated and separately disclosed;
Each dissimilar item that is immaterial may be aggregated with another class of items.
A class of items that is very material may require disclosure separately on the face of the
financial statements whereas another class of items, although material, may only require
separate disclosure in the notes. It is a subjective decision requiring professional judgement.
So in summary, when considering whether to segregate (present separately) or aggregate an
item (present as part of another line item), consider:
its class, (being its nature or function), and
if you think that knowledge of it:
would affect the economic decisions of the user, then the item is material and should
be disclosed separately (i.e. should be segregated); or
would not affect the economic decisions of the user, then the item is not material and
should not be disclosed separately (i.e. should be aggregated).
Example 1: Items with different natures
An entity has two assets:
inventory; and
property, plant and equipment.
Required: Explain whether or not these assets should be separately disclosed.
Solution 1: Items with different natures

The function of inventory is to be sold at a profit whereas the function of property, plant and equipment
is to be kept and used by the entity. The natures of these two assets are so different that each is a
separate class. If the amounts of each class are sufficiently material, each class must be disclosed
separately (segregated) on the face of the statement of financial position.
Example 2: Items with different nature, but immaterial size

The carrying amount of furniture is C100 000, and the carrying amount of plant is C50 000.
The company’s materiality limit is C300 000 for items of property, plant and equipment.
Required: Explain whether or not the furniture and plant should be disclosed separately.
Solution 2: Items with different nature, but immaterial size

Furniture and plant are two different classes of ‘property, plant and equipment’ since their functions are
so different: one functions in the office and the other in the factory. However, the carrying amount of
each of these classes is below the relevant materiality limit and thus these two classes may be
aggregated. However, professional judgement is needed since materiality does not only relate to size
(i.e. monetary values). If knowledge of the nature of these two classes of assets may affect the user’s
decisions, then each class would be considered material and require separate disclosure (segregation).
64 Chapter 3
Example 3: Items that are material in size, but not in nature or function
A company’s materiality limit is C300 000 and the total carrying amount of its:
factory plant is C500 000, including machine A, with a carrying amount of C450 000;
furniture is C300 000; and
office equipment is C310 000.
Required: Explain whether or not:
A. machine A should be disclosed separately from other machinery based on size; and
B. office furniture should be separately disclosed from office equipment based on the carrying amount
of each relative to the materiality limit; and
C. these assets should be aggregated on the face of the statement of financial position or in the notes.
Solution 3: Items that are material in size, but not in nature or function
A. Machine A and the other machinery:

Although machine A is material in size, machine A should not be separately disclosed since, with
reference to most user’s needs, this is not material in function or nature (a description of each machine
would be technical information rather than financial and would mean very little to most general users).
B. Furniture and office equipment:
Similarly, despite the materiality of the individual sizes of the carrying amounts involved, furniture and
office equipment should be aggregated due to their common function or nature: office use.
C. Aggregation or segregation on the face or in the notes:
Although furniture and office equipment versus factory machinery represent two dissimilar classes
based on their different functions (office versus factory use), they should be aggregated on the face of
the statement of financial position because, at this overall level of presentation, the individual class of
asset becomes immaterial. What is more important on the face, is that different categories of assets,
(e.g. ‘property, plant and equipment’ and ‘inventory’) are separated. The segregation of the material
classes within the categories of property, plant and equipment and inventory are included in the notes.
It should be noted, that where functions (office equipment versus factory machinery) are materially
different but sizes are immaterial, it may still be necessary to disclose separately in the notes, this being
a matter of judgement, once again.
5.5.3 What to do with immaterial items (IAS 1.30-31)
Immaterial items are aggregated with other items. Furthermore, if an IFRS requires certain
disclosures for an item but the item is immaterial, you may ignore these disclosure
requirements.
Worked example: Aggregation of immaterial items

The amounts spent on each item of furniture is not listed separately but are
aggregated with one another into a line item called ‘furniture’. This is because
they are so similar in nature that users would not find segregated information useful. Instead,
users may find the total spent on furniture to be more useful. The ‘furniture’ line item, if
immaterial in size, could be further aggregated with another line item such as ‘office
equipment’, with the combined line item called ‘office furniture and equipment’.
5.6 Offsetting (IAS 1.32-35)
The process of offsetting means subtracting an expense from an income or subtracting a

liability from an asset, and showing the net amount.
Measuring one of these items (e.g. an asset) net of its valuation allowances (e.g. a debtors
balance being presented net of a doubtful debt allowance) is not considered to be offsetting.
Chapter 3 65
Offsetting should not occur unless an IFRS:

requires offsetting; or
permits offsetting and this offsetting will reflect the substance of the transaction. See IAS 1.32-.33
Example 4: Offsetting – discussion
Offsetting is only allowed if permitted or required by an IFRS and ultimately results in
reflecting the substance of the transaction or event.
Required: Give an example of:
A. Offsetting of income and expenses that is required;
B. Offsetting of income and expenses that is allowed;
C. Offsetting of income and expenses that is not allowed;
D. Offsetting of assets and liabilities that is allowed; and
E. Offsetting of assets and liabilities that is not allowed.
Solution 4: Offsetting – discussion

A. Setting-off of income and expenses that is required (you possibly wouldn’t know this
example unless you had studied IFRS 15 Revenue from contracts with customers): If
when earning income from a sale in the course of the entity’s ordinary activities (in which
case the income is called revenue), we are required to measure the revenue at the amount
of consideration that the entity expects to receive. This means that if we offer a discount
or rebate (expense), then the revenue from the sale (income) must be reflected net of the
discount or rebate (expense). This is a requirement of IAS 15 Revenue from contracts
with customers.
B. Setting-off of income and expenses that is allowed: If you sell a non-current asset (i.e. a
sale that is incidental to the entity’s ordinary activities (i.e. an activity that is not ordinary)
and thus where the income is not called revenue), the amount of consideration from the
sale (income) may be set-off against the carrying amount of the asset (now expensed), to
reflect the profit or loss on the sale since this reflects the substance of the transaction.
C. Setting-off of income and expenses that is not allowed: When earning revenue from the
sale of inventory (income), the related cost of the sale (expense) may not be offset since,
in terms of the relevant standard (IAS 1 Presentation of financial statements), revenue
must be disclosed separately.
D. Setting-off of assets and liabilities that is allowed: If a person buys from us on credit (i.e.
a debtor) and also sells to us on credit (i.e. a creditor), we could offset the receivables
(asset) and the payable (liability) if by offsetting these balances, we were showing the
substance of the transactions. Offsetting of these balances would reflect the substance if,
for example, we had an agreement that gives us the legal right of set-off (i.e. only the net
balance need be paid to or received from this person).
E. Setting-off of assets and liabilities that is not allowed: If we owe the tax authorities an
amount of VAT (i.e. VAT payable, a liability) but the tax authorities owe us a refund of
income tax (i.e. income tax receivable, an asset), we are not allowed to offset these
liability and asset balances unless the tax legislation allows VAT and Income Tax to be
paid on a net basis. Since this is not allowed in South Africa, the offsetting of these
balances is not allowed in SA since it would not reflect the substance of the transactions.
Example 5: Offsetting – application

Don Limited sold a machine during 20X2:
the machine was a non-current asset with a carrying amount of C20 000
the selling price was C30 000.
Required: Disclose the above transaction in the statement of comprehensive income assuming:
A. the machine was inventory;
B. the machine was an item of property, plant and equipment.
66 Chapter 3
Solution 5: Offsetting – application

Don Limited Part A Part B
Statement of comprehensive income
For the year ended ….. (extracts)
20X2 20X2
Calculations C C
Revenue from sale of inventory A: given 30 000 xxx
Cost of sales A: given (20 000) xxx
Other income
- Profit on sale of machine B: 30 000 – 20 000 xxx 10 000
Comment:
Part A: Since the sale of machines is part of the entity’s ordinary activities (i.e. the machine would be
‘inventory’), the disclosure of the income would be governed by IFRS 15 Revenue from
contracts with customers, and must thus be shown gross (i.e. not net of expenses).
Part B: Since the sale of the machine is not part of (i.e. are incidental to) the entity’s ordinary
activities, the income may be disclosed net of the expense – since this still represents the
substance of the sale.
5.7 Frequency of reporting (IAS 1.36-37)
Entities are required to produce financial statements at least annually. Entities are allowed, for
practical reasons, to report on a 52-week period rather than a 365-day period.
Sometimes, however, an entity may change its year-end, with the result that the reporting
period is either longer or shorter than a year. The entity must then disclose:
The reason for the longer or shorter period; and
The fact that the current year figures are not entirely comparable with prior periods.
Interestingly, amounts in the current year’s statement of financial position would still be
entirely comparable with the prior year’s statement because this statement is merely a listing
of values on a specific day rather than over a period of time. On the other hand, the amounts
in the current year’s statement of comprehensive income would not be comparable with the
prior year since the amounts in each of these statements would reflect different periods.
5.8 Comparative information (IAS 1.38-44)
Comparative information comes in three forms:
Minimum comparative information;
Voluntary additional comparative information; and
Compulsory additional comparative information.
5.8.1 Minimum comparative information (IAS 1.38-38B)
Minimum comparative info:
For all statements in a set of financial statements, a We must show prior year
minimum of one year of comparative information is information (for numerical and
required. Thus there would be two columns of figures narrative information).
in, for example, a statement of financial position: one Prior year info for narrative info is only
for the current year and one for the prior year. needed if relevant.
Comparisons may be needed in reverse....
The requirement for comparative information applies equally to both numerical information
(i.e. the amounts) and narrative information. However, in the case of narrative information,
comparative narrative information need only be given if it is relevant to understanding the
current period financial statements.
Comparative information can also be required in reverse! In other words, comparative
information doesn’t always refer to the need for prior period information to support current
period information. Current year information may be needed to support prior year
information when prior year narrative information continues to be relevant in the current year.
Chapter 3 67
Worked example:
If the prior year financial statements disclosed information regarding an unresolved court
case, then the current year information must include details regarding how this court case
was resolved in the current year or, if not yet resolved, the status of the unresolved dispute at the end of
the current year. This would enhance the usefulness of the financial statements.
5.8.2 Voluntary additional comparative information (IAS 1.38C - .38D)

If an entity wishes to provide extra comparative Voluntary comparative
information (i.e. 2 or more years of comparative information:
information instead of just the minimum 1 prior year), it
may do so on condition that this extra comparative Extra comparative years can be
information is also prepared according to IFRSs. given if we wish (e.g. 2 prior
periods (PP) instead of just the
minimum 1 PP).
Interestingly, the comparative information need not be
provided for each and every statement. In other words, an We can give extra comparatives for:
entity may give extra comparative information in its - just 1 statement if we wish, but
statement of financial position but decide not to provide - the notes supporting this
statement must include all PPs.
comparatives in its statement of comprehensive income.
All PPs must comply with IFRS.
If extra comparative information is provided in a statement (e.g. if a third column is included
in the statement of financial position to show the period prior to the prior period), then all the
notes supporting the statement of financial position must also include the extra comparative
information for the period prior to the prior period.
5.8.3 Compulsory additional comparative information (IAS 1.40A-44)
Sometimes an entity needs to make adjustments that change prior year amounts. These are
called retrospective adjustments.
Compulsory comparative
Restrospective adjustments can arise when: information:
retrospectively applying a new accounting policy;
retrospectively restating prior figures in order to An extra comparative year must be
correct an error which occurred in a prior year; or given if a ‘material retrospective
retrospectively reclassifying an item/s. adjustment’ is made.
This extra comparative year refers
to the opening balances of the prior
Obviously, if we find a material error in a prior year, we period (i.e. the closing balances of
must correct that prior year (i.e. retrospective the period prior to the prior
adjustment). period).
This extra comparative year:
Similarly, retrospective adjustments are needed for only applies to the SOFP; but
changes in accounting policy and reclassification of does not apply to the notes.
items. The reason these must be accounted for retrospectively is in order to maintain
comparability between the current and prior year figures:
we may not simply change the accounting policy in the current year and leave the prior
year figures calculated using the old policy since this would prevent comparability; and
we may not classify certain items in a certain way in the current year and use different
classifications in the prior year since this would prevent comparability.
If a retrospective adjustment is material, the statement of financial position must include an

extra column of comparatives to show the adjusted balances at the beginning of the prior year
(i.e. showing the prior year opening balances after being adjusted for any correction, new
policy or reclassification). Thus there would be three columns in the statement of financial
position: current period, prior period (PP) and the period prior to the prior period (PPP).
Please note that this third column in the SOFP (i.e. the period prior to the prior period: PPP)
does not need to be supported by notes.
68 Chapter 3
If the entity already voluntarily gives extra comparative periods, this third column would
already be provided. E.g. if the entity voluntarily gives two comparative periods, it will
automatically include both the minimum and compulsory comparatives (the PP and the PPP).
In addition to the third column, the following additional disclosure will also be required.
These additional disclosures depend on what the retrospective adjustment relates to. If the
retrospective adjustment is due to:
a restatement to correct a prior error or the application of a changed accounting policy,
then the extra disclosure needed is in terms of IAS 8 Accounting policies, changes in
accounting estimates and errors; and
a reclassification, then the extra disclosure needed is in terms of IAS 1 and includes:
the nature of the reclassification;
the amount of each item or class of items that is reclassified;
the reason for reclassification.
If there is a reclassification but reclassifying the prior periods’ figures is impracticable, IAS 1
requires the following to be disclosed instead:
the reason for not reclassifying; and
the nature of the changes that would have been made had the figures been reclassified.
Example 6: Reclassification of assets

May Limited’s nature of business changed in 20X3 such that vehicles that were previously
held for use became stock-in-trade (i.e. inventory). The unadjusted property, plant and
equipment balances were:
20X1: C120 000 (C70 000 being machinery and C50 000 being vehicles)
20X2: C100 000 (C60 000 being machinery and C40 000 being vehicles)
20X3: C150 000 (C80 000 being machinery and C70 000 being vehicles).
Required: Show the statement of financial position and reclassification note at 31 December 20X3.
Solution 6: Reclassification of assets

May Limited
Statement of financial position
As at 31 December 20X3 (EXTRACTS)
20X3 20X2 20X1
Notes C C C
Restated Restated
Property, plant and equipment 8 80 000 60 000 70 000
Inventory 8 70 000 40 000 50 000
May Limited
Notes to the financial statements
For the year ended 31 December 20X3 (EXTRACTS)
20X2 20X1
8. Reclassification of assets C C
Previously vehicles were classified as part of property, plant and Restated Restated
equipment whereas it is now classified separately.
The reason for the change in classification is that the nature of the
business changed such that vehicles previously held for use are now held
for trade.
IAS 2: Inventories requires inventories to be classified separately on the
face of the statement of financial position.
The amount of the item that has been reclassified is as follows:
Inventory 40 000 50 000
Comment:
The 20X1 and 20X2 columns are headed up as ‘restated’ but the column for 20X3 is not restated. This is because
the 20X3 column is being published for the first time (we can’t restate something that has never been stated before).
The note only gives detail for 20X3 and 20X2 as notes are not required for the third column (20X1).
Chapter 3 69
5.9 Consistency of presentation (IAS 1.45-46)
Items should be presented and classified consistently Consistency refers to:

(in the same way) from one period to the next unless: presentation/classification
the current presentation/classification is no longer of items being the same
the most appropriate (due either to a significant from one period to the next.
change in the nature of the operations or due to a It is essential for comparability.
review of its financial statements); or Thus, if presentation or classification must
an IFRS requires a change in presentation; change, it is accounted for as a
and reclassification (see section 5.8.3 and 8.6).
the revised presentation and classification is likely to continue; and
the revised presentation and classification is reliable and more relevant to users.
Consistency is obviously necessary to ensure comparability. Thus, if the presentation in the

current year changes, the comparative information must be treated as a reclassification with
relevant disclosures provided (see section 5.8 on comparative information).
6. Structure and Content: Financial Statements in General (IAS 1.47-.53)
An annual report includes:

the financial statements (including the five main statements listed under section 4); and
a variety of other documents, which may or may not be required.
Other documents may be included in the annual report

voluntarily (e.g. a value-added statement), due to legal
requirements (e.g. an audit report) or simply in response
Annual reports include:
to community concerns (e.g. an environmental report). f/statements + other information.
Since IFRSs only apply to financial statements, each IFRSs only apply to f/statements
statement (e.g. statement of financial position) in the thus they must be clearly identified!
financial statements must be clearly identified from the IAS 1 gives the structure & content
other documents. for all f/statements except the
statement of cash flows!
In addition to the identification of each statement, other items must be prominently displayed:
the name of the entity (and full disclosure of any change from a previous name);
the fact that the financial statements apply to an individual entity or a group of entities;
relevant dates: date of the end of the reporting period for the statement of financial
position or the period covered for other statements (e.g. statement of cash flows);
presentation currency (e.g. pounds, dollars, rands); and the
level of rounding used (i.e. figures in a column that are rounded to the nearest thousand,
such as C100 000 shown as C100, should be headed up ‘C’000’).
These other items may need to be repeated (e.g. on the top of each page) to help make the
endless pages of financial statements easier to understand.
7. Structure and Content: Statement of Financial Position (IAS 1.54-.80)
7.1 Overview Remember....
The statement of financial position summarises the The CF explained that the
entity’s financial position is
entire trial balance into the 3 main elements (assets, reflected by its:
liabilities and equity), and presented under 2 headings:
economic resources; and the
assets;
liabilities and equity. claims against the resources.CF:OB12
70 Chapter 3
7.2 Current versus non-current (IAS 1.60-65)
Distinguishing assets and liabilities between those that are current and non-current gives users
an indication of how long it will take for an asset to be used up or converted to cash and how
long before a liability must be settled. For this Current and non-current:
reason, assets and liabilities are then generally
separated into two classifications: We can separate As and Ls into:
current; and current and non-current; or
non-current. list them in order of liquidity instead (if
this is reliable & more relevant).
Instead of separating assets and liabilities into current and non-current, we could simply list
them in order of liquidity if this gives reliable and more relevant information.
No matter whether your statement of financial position separates the assets and liabilities into
the classifications of current and non-current or simply lists them in order of liquidity, if the
item includes both a portion that is current and a portion that is non-current, then the non-
current portion must be separately disclosed somewhere in the financial statements. This may
be done in the notes rather than in the statement of financial position. (See example 7).
Where the assets and liabilities are monetary assets or liabilities (i.e. financial assets or
liabilities, such as accounts receivable and accounts payable) disclosure must be made of their
maturity dates. Examples of monetary items include:
A monetary asset: an investment in a fixed deposit;
A monetary liability: a lease liability.
Where the assets and liabilities are non-monetary assets or liabilities, disclosure of the
expected dates of realisation is not required unless these are considered useful in assessing
liquidity and solvency. For example:
A non-monetary asset: inventory that is not expected to be sold within a year should be
identified separately from inventory that is expected to be sold within a year;
A non-monetary liability: the expected date of settlement of a provision may be useful.
7.3 Assets (IAS 1.66-68)
7.3.1 Current assets versus non-current assets
An asset is classified as a current asset if any one of Non-current assets are those:
the following criteria are met: that are not current assets.
If it is expected to be realised within 12 months
Current assets are those:
after the reporting date;
we expect to realise within 1yr of RD;
If it is held mainly for the purpose of being we hold mainly to trade;
traded (e.g. some financial assets that meet the
we expect to use/realise/ sell within
definition of held for trading); operating cycle; or
If it is expected to be sold, used or realised that are cash/ CE (unless restricted).
(converted into cash) as part of the normal
RD: reporting date; CE: cash equivalents
operating cycle (where ‘operating cycle’ means
the period between purchasing the asset and
converting it into cash or a cash equivalent); or
If it is cash or a cash equivalent, unless it is restricted from being used or exchanged
within the 12 month period after the reporting date. For example, cash received by way of
donation, a condition to which is that it must not be spent until 31 December 20X9, may
not be classified as a current asset until 31 December 20X8 (12 months before).
Non-current assets are simply defined as those assets that:
are not current assets.
Chapter 3 71
Example 7: Classification of assets

Era Limited has the following two assets at its financial year ended 31 December 20X4:
Inventory: this is slow-moving and is expected to be sold during 20X6;
Fixed deposit: this matures on 30 June 20X6.
Required: Explain whether these assets are current or non-current at year-end.
Solution 7: Classification of assets

Both assets are expected to be realised in 20X6 which is well after the 12 month period from reporting
date of 31 December 20X4:
However, the inventory would be classified as current because inventory forms part of the
operating cycle and thus it meets one of the criteria to be classified as current.
The fixed deposit is cash but since it only matures in 20X6, it is restricted from being used within
the 12 month after the reporting date. It is not expected to be realised within 12 months of
reporting date, it is not held mainly for the purpose of being traded and it is not held within the
normal operating cycle. Thus the fixed deposit fails to meet any of the 4 criteria to be classified as
current and must thus be classified as non-current.
7.4 Liabilities (IAS 1.69-76)
7.4.1 Current liabilities versus non-current liabilities (IAS 1.69-73)
A liability is classified as a current liability if any one A non-current liability is one:

of the following criteria are met: that is not current.
If it is expected to be settled within 12 months
Current liabilities are those:
after the reporting period;
we expect to settle within 1yr of RD;
If it is expected to be settled within the normal we hold mainly to trade;
operating cycle (operating cycle: the period
we expect to settle within the OC; or
between purchasing materials and converting
NOTE 1 we don’t have an unconditional right to delay
them into cash/ equivalent); settlement beyond 1 yr from RD.
If it is held mainly for trading purposes; or RD: reporting date; OC: operating cycle
If the entity does not have an unconditional right to delay settlement beyond the 12 month
period after the reporting period. NOTE 2
Non-current liabilities are simply defined as those liabilities that:
are not current liabilities.
Note 1 It is interesting to note that liabilities that are considered to be part of the normal operating
cycle (e.g. trade payables and the accrual of wages) would always be treated as current
liabilities since they are integral to the main business operations – even if payment is
expected to be made more than 12 months after reporting period.
Examples of liabilities that are not part of the normal operating cycle include dividends
payable, income taxes, bank overdrafts and other interest bearing liabilities. For these to be
classified as current liabilities, settlement thereof must be expected within 12 months after
the reporting period.
Note 2 IAS 1 has been amended to include clarification that if you have a liability, the terms of
which allow the counterparty (i.e. the person you owe) to choose that you pay by way of an
issue of equity instruments (shares) instead of cash, this will not have any effect on the
classification as current or non-current.
Example: We receive cash from the issue of 10 000 debentures. We must repay this cash in
20 year’s time. However, the terms of this issue allow the debenture-holder to demand, at
any time (i.e. even now) that we issue ordinary shares to him, thus foregoing the future cash
repayment. The fact that he can demand shares now will not make this a current liability: it
will be non-current (expected settlement in 20 years). The fact that we may settle by way of
shares instead of cash will not influence whether a liability is current or non-current.
72 Chapter 3
Example 8: Classification of liabilities

Pixi Limited has a bank loan of C500 000 at 31 December 20X3, payable in two
instalments of C250 000 (the first instalment is payable on 31 December 20X4).
Required: Present the loan in the statement of financial position and related notes at
31 December 20X3 (ignoring comparatives) assuming that Pixi presents its assets and liabilities:
A In order of liquidity;
B Using the classifications of current and non-current.
Solution 8A: Liabilities in order of liquidity
Pixi Limited
As at 31 December 20X3 (extracts)
Notes 20X3
C
Bank loan Comment: This format requires a note to be included to show the 8 500 000
bank split between current and non-current
Pixi Limited
For the year ended 31 December 20X3 (extracts)
20X3
8. Bank loan C
Total loan 500 000
Portion repayable within 12 months 250 000
Portion repayable after 12 months 250 000
Solution 8B: Liabilities using current and non-current distinction
Pixi Limited
Notes 20X3
Non-current liabilities C
Bank loan 250 000
Current liabilities
Current portion of bank loan 250 000
7.4.2 Refinancing of financial liabilities (IAS 1.72-76)
Refinancing a financial liability means postponing the due date for repayment.
When a liability that was once non-current (e.g. a 5-year bank loan) falls due for repayment
within 12 months after reporting period, it should now be classified as current. If it is possible
to refinance this liability resulting in the repayment being delayed beyond 12 months after the
end of the reporting period, then the liability could possibly remain classified as non-current.
There are, however, only two instances where the possibility of refinancing may be used to
avoid having to classify a financial liability as a current liability, being when:
the existing loan agreement includes an option to refinance or roll-over the obligation (i.e.
to delay repayment of) where:
- the option enables a delay until at least 12 months after the reporting period, and
- the option is at the discretion of the entity (as opposed to the bank, for example), and
- the entity expects to refinance or roll over the obligation; IAS 1.73
an agreement is obtained before year-end that allows repayment of the loan to be delayed
beyond the 12-month period after the reporting period. By analogy from IAS 1.75
Chapter 3 73
If an agreement allowing repayment to be delayed beyond 12 months from the reporting date
is obtained, but it is obtained after the reporting date but before approval of the financial
statements, this would be a ‘non-adjusting post-reporting period event’ and could not be used
as a reason to continue classifying the liability as non-current. Thus:
details of agreement obtained after reporting date would be disclosed in the notes; but
the liability would have to remain classified as current.
Example 9: Loan liability and a refinancing agreement

A loan of C100 000 is raised in 20X1. This loan is to be repaid in 2 instalments as follows:
C40 000 in 20X5; and
C60 000 in 20X6.
An agreement is reached, whereby payment of the C40 000 need only be made in 20X6.
Required: Present the loan, classified into current and non-current, in the statement of financial
position at 31 December 20X4 (year-end) assuming that:
A the agreement is signed on 5 January 20X5;
B the agreement is signed on 27 December 20X4.
Solution 9A: Loan liability not refinanced in time
Entity name
As at 31 December 20X4
20X4 20X3
LIABILITIES AND EQUITY C C
Non-current liabilities 60 000 100 000
Current liabilities 40 000 -
Note: although the instalment of C40 000 has to be classified as current, a note should be included to
disclose the fact that the current liability of C40 000 has since been refinanced (during the post-
reporting period) and is now technically a non-current liability.
Solution 9B: Loan liability is refinanced in time
Entity name
20X4 20X3
LIABILITIES AND EQUITY C C
Non-current liabilities 100 000 100 000
Example 10: Loan liability and the option to refinance

Needy Limited has a loan of C600 000, payable in 3 equal annual instalments.
The first instalment is due to be repaid on 30 June 20X4.
Required: Present the loan in Needy’s statement of financial position at 31 December 20X3 (year-end)
assuming that the existing loan agreement:
A gives the entity the option to refinance the first instalment for a further 7 months and the entity
plans to utilise this facility;
B gives the entity the option to refinance the first instalment for a further 4 months and the entity
plans to utilise this facility
C gives the entity the option to refinance the first instalment for a further 7 months but the entity
does not plan to postpone the first instalment
D gives the bank the option to allow the first instalment to be delayed for 7 months and the entity
plans to request the bank to allow this delay.
74 Chapter 3
Solution 10: Loan liability and the option to refinance

Entity name
Ex 10A Ex 10B Ex 10C Ex 10D
20X3 20X3 20X3 20X3
LIABILITIES AND EQUITY C C C C
Non-current liabilities 600 000 400 000 400 000 400 000
Current liabilities 0 200 000 200 000 200 000
Comment:
Option A: The entity has the option to delay payment of the first instalment to a date beyond 12 months from
reporting date and the entity intends to make use of this option, thus the liability is non-current.
Option B: The entity has the option to delay payment of the first instalment but this only extends the
repayment to 31 October 20X4 and not beyond 31 December 20X4, thus the liability remains current.
Option C: The entity has the option to delay payment of the first instalment to a date that is beyond 12 months
from reporting date but the entity does not intend to utilise this option, thus the liability remains current.
Option D: The option to allow a delay in the payment of the first instalment is at the discretion of the bank
and thus the entity does not have control over this, and thus the liability remains current.
7.4.3 Breach of covenants and the effect on liabilities (IAS 1.74-76)
Covenants are sometimes included in the loan agreement. A covenant in a loan agreement is
essentially a promise made by the borrower to the lender. Depending on the terms of the
agreement, the breaching of a covenant (breaking a promise) may enable the lender to
demand repayment of a portion of the loan, or even the entire amount thereof. For example: a
loan could be granted on condition that the borrower keeps his current ratio above 2:1; and if
it ever drops below 2:1, then the entire loan becomes repayable.
If a covenant is breached and this breach makes all or part of a liability payable within 12
months, this portion must be classified as current unless:
the lender agrees prior to the end of the reporting period to grant a period of grace to
allow the entity to rectify the breach;
the period of grace lasts for at least 12 months after the reporting period; and
the lender may not demand immediate repayment during this period.
If such an agreement is signed after the end of the reporting period but before the financial
statements are authorised for issue, it would be a ‘non-adjusting post-reporting period event’:
this information would be disclosed in the notes but
the liability would have to remain classified as current.
Example 11: Loan liability and a breach of covenants

Whiny has a loan of C500 000, repayable in 20X9, on condition that total widgets sold by
31 December of any one year exceeds 12 000 units, failing which 40% of the loan becomes
payable immediately. At 31 December 20X3 unit sales were 9 200. Whiny reached an
agreement with the bank that the bank would grant a period of grace to boost sales.
Required: Present the loan in the statement of financial position at 31 December 20X3 assuming that
the financial statements are not yet authorised for issue and the agreement with the bank was signed on:
A 31 December 20X3, giving the entity a 14-month period of grace during which the bank agreed not
to demand repayment;
B 31 December 20X3, giving the entity a 14-month period of grace (although the bank reserved the
right to revoke this grace period at any time during this period and demand repayment);
C 31 December 20X3, giving the entity a period of grace to 31 January 20X4 during which the bank
agreed not to demand repayment. At 31 January 20X4, the breach had been rectified;
D 2 January 20X4, giving the entity a 14-month period of grace during which the bank agreed not to
demand repayment.
Chapter 3 75
Solution 11: Loan liability and a breach of covenants

Entity name
20X3 20X3 20X3 20X3
LIABILITIES AND EQUITY C C C C
Non-current liabilities 500 000 300 000 300 000 300 000
Current liabilities 0 200 000 200 000 200 000
Comment:
Scenario C: Although the agreement was obtained on/before reporting date, the period of grace
was not for a minimum period of 12 months and thus the C200 000 must be classified as current.
However, a supporting note should state that agreement was obtained on/before reporting date
providing a short grace-period and that the breach was rectified during this period from which
point the loan may be considered to be non-current.
Scenario D: a note should be included to say that a period of grace had been granted after the end
of the reporting period that was more than 12 months from reporting date.
7.5 Disclosure: in the statement of financial position (IAS 1.54-55)
The following line items must be presented in the

Minimum disclosure on the
statement of financial position:
SOFP face:
property, plant and equipment;
investment property; IAS1.54: lists line items that must always
appear on the face of the SOFP.
intangible assets;
Extra disclosure on the SOFP face:
financial assets;
investments accounted for using the equity IAS 1.55: judgement is needed to decide if
method (this is a financial asset but one that further line items, headings & totals are
relevant to users understanding.
requires separate disclosure);
biological assets (e.g. sheep);
inventories;
trade and other receivables (a financial asset but one that requires separate disclosure);
cash and cash equivalents (a financial asset but one that requires disclosure separate to the
other financial assets);
assets (including assets held within disposal groups held for sale) that are held for sale in
terms of IFRS 5 Non-current Assets Held for Sale;
liabilities that are included in disposal groups classified as held for sale in terms of
IFRS 5 Non-current Assets Held for Sale;
financial liabilities;
trade and other payables (a financial liability but one that requires separate disclosure);
provisions (a financial liability but one that requires separate disclosure);
tax liabilities (or assets) for current tax;
deferred tax liabilities (or assets);
minority interests (presented within equity);
issued capital and reserves attributable to the owners of the parent. Reworded from IAS 1.54
Whether or not to present extra line items, headings or subtotals on the face of the statement
of financial position requires judgement. In this regard consider:
whether or not it is relevant to the user’s understanding; IAS 1.55 and
in the case of asset and liability line items, you should consider the following:
- Assets: the liquidity, nature and function of assets;
- Liabilities: the amounts, timing and nature of liabilities. IAS 1.58
76 Chapter 3
Example 12: Presenting further line-items

The accountant of Logi Limited has presented you will the following list of items:
- cash in bank and a 15-month fixed deposit;
- property, plant and equipment and intangible assets;
- inventory and intangible assets;
- a long-term loan, 20% of which is repayable within 12 months of reporting date;
- provisions and tax payable.
Required: For each of the items listed above, indicate whether they need to be presented as separate
line items and the logic behind why separate presentation is relevant (i.e. refer only to IAS 1.58).
Solution 12: Presenting further line-items
Items: Present as separate Reason:

line items?
Cash & the Fixed deposit Yes Different liquidity: 100% liquid versus delayed liquidity
PPE & Intangible assets Yes Different nature: tangible versus intangible
Inventory & Intangible assets Yes Different function: buy to sell versus buy to use
Loan: payable within 12m Yes Different timing of settlement: payable within 12m is
and payable after 12m current & payable after 12m is non-current
Provisions & tax payable Yes Different nature: a provision is a liability that involves
uncertainty and tax payable is a ‘definite’ liability
Note: the reasons why the items should be separately presented could be varied as there are sometimes more
than one reason why items should be separately presented.
7.6 Disclosure: either in the statement of financial position or notes (IAS 1.77-80)
7.6.1 Overview
Further disclosure requirements include:
Disclosure of possible extra sub-classifications; and
Disclosure of details regarding share capital and reserves.
These disclosures do not need to be made on the face of the SOFP.

7.6.2 Disclosure of possible extra sub-classifications (IAS 1.77-78 & 1.58)
Line items in the statement of financial position may More SOFP-related

need to be separated into further sub-classifications. disclosure:
Extra sub-classifications may be
These sub-classifications may either be shown as: needed, which could be on the
line items in the SOFP; or face/ in notes. These depend on:
in the notes. See IAS 1.77 specific IFRS requirements;
materiality, liquidity, nature & function of
The possible need for further sub-classifications assets; and
depends on: materiality, timing & nature of liabilities.
whether an IFRS may contain disclosure requirements that requires sub-classifications;
the materiality of the amounts, liquidity, nature and function of assets may suggest that a
sub-classification is relevant;
the materiality of the amounts, timing and nature of liabilities may suggest that a sub-
classification is relevant. See IAS 1.78 and 1.58
Example 13: Presenting further sub-classifications

John has been given a list of line-items that his company wants sub-classified as follows:
- the ‘revenue’ line item: separate into revenue from sales and revenue from services;
- the ‘property, plant and equipment’ line-item: separate into its two parts, being factory
equipment and the office equipment;
- the ‘cash’ line-item: separate into the amount held in cash and the amount held in the 6-
month fixed deposit;
Chapter 3 77
- the ‘trade and other receivables’ line-item: separate into the trade receivable balance and
the rent prepaid balance;
- the ‘provisions’ line-item: separate into the provision for future rehabilitation of land in
20 years time and the provision for leave pay, payable within 1 year of reporting date.
Required: For each of the line-items listed above, explain to the assistant accountant why the
accountant has requested that certain sub-classifications be provided.
Solution 13: Presenting further sub-classifications
Items: Reason:
Revenue line-item The IFRS on revenue (IAS 18) requires disclosure of each significant category of
revenue. Furthermore, revenue from sales and services are different in nature.
PPE line-item The IFRS on PPE (IAS 16) requires separate disclosure of each class of PPE.
Furthermore, office equipment and factory equipment have different in functions.
Cash line-item The cash and the fixed deposit have different liquidities.
Trade & other receivables The trade receivable and rent prepayment are different in nature.
Provisions & tax payable The settlement of the provision for rehabilitation and the settlement of the
provision for leave pay have different timings.
Note: There may be more than one reason why these sub-classifications are required.
7.6.3 Further disclosures for share capital and reserves (IAS 1.79-80)
IAS 1 requires extra detail to be disclosed regarding More SOFP-related disclosure:

two items that are included in the statement of
financial position: Extra disclosure regarding share
capital and reserves is required.
share capital; and
reserves. This SC & reserve disclosure may be given in
the: SOFP, SOCIE or the notes.
If an entity has no share capital (e.g. a partnership), similar disclosure is required for each
category of equity interest instead.
For each class of share capital, the extra detail For each class of reserve within equity, the extra
that must be disclosed includes: see IAS1.79(a) detail that must be disclosed includes: see IAS1.79(b)
the number of shares authorised; its nature; and
the number of shares issued and fully paid for; its purpose
the number of shares issued but not yet fully
paid for;
the par value per share or that they have no par
value;
a reconciliation of the number of outstanding
shares at the beginning and end of the year;
rights, preferences and restrictions attaching to
that class;
shares in the entity held by the entity itself, or
its subsidiaries or its associates; and
shares reserved for issue under options and
sales contracts, including terms and amounts.
The disclosures listed above may be provided in the statement of financial position, statement
of changes in equity or in the notes.
7.7 A typical statement of financial position
An example of what a statement of financial position might look like appears overleaf. The
line items needed for your entity might be fewer or more than those shown in this example: it
depends entirely on what line-items are relevant to your entity (e.g. if an entity does not have
goodwill, then this line-item will not appear on its statement).
78 Chapter 3
Remember that if the ‘liquidity format’ provides more meaningful disclosure for your entity
than the ‘current versus non-current’ classification, then the statement of financial position
will look just the same but simply without the headings ‘current’ and ‘non-current’.
Exam tip! Notice that the issued share capital and reserves on the face of the SOFP
equals the total equity on the face of the SOCIE. Thus, although it is not wrong to list
each type of equity on the face of the SOFP, it is unnecessary. Thus, if a question
requires you to present both a SOFP and a SOCIE, good exam technique would be to:
start with the SOCIE and then,
when preparing your SOFP, simply insert the total equity per your statement of
changes in equity in as the line-item ‘issued shares and reserves’.
Sample presentation: statement of financial position of a simple entity (not a group)
ABC Ltd
20X2 20X1
C’000’s C’000’s
ASSETS X X
Non-current assets X X
Property, plant and equipment X X
Goodwill X X
Other intangible assets X X
Investment properties X X
Available-for-sale investments X X
Current assets X X
Inventories X X
Trade and other receivables X X
Non-current assets (disposal groups) held for disposal X X
Cash and cash equivalents X X
EQUITY AND LIABILITIES X X

Issued share capital and reserves Note 1 X X
Non-current liabilities X X
Long-term borrowings X X
Deferred tax X X
Provisions X X
Current liabilities X X
Trade and other payables X X
Current portion of long-term borrowings X X
Short-term borrowings X X
Current tax payable X X
Current provisions X X
Liabilities of a disposal group held for sale X X
Note 1 This amount would be the total in the statement of changes in equity (SOCIE)
8. Structure and Content: Statement of Comprehensive Income (IAS 1.10 &.81A-.105)
8.1 Total comprehensive income, profit or loss and other comprehensive income
The statement of comprehensive income gives information regarding the entity’s financial
performance. Overall financial performance is reflected by the total comprehensive income.
Total comprehensive income comprises two parts:
profit or loss: income less expenses (excluding items of other comprehensive income); and
other comprehensive income: income and expenses that are not recognised in profit or loss.
Chapter 3 79
Total comprehensive income = Profit or loss + Other comprehensive income

= P/L + OCI I – E (those that are not OCI) I – E (those that are OCI)
Definition of TCI: IAS 1.7 Definition of P/L: IAS 1.7 Definition of OCI: IAS 1.7
the change in equity the total of items of income and expense

during a period income less expenses, (including reclassification
resulting from transactions and excluding the components of other adjustments)
other events, comprehensive income. that are either not required or not
other than those changes resulting permitted to be recognised in profit
from transactions with owners in or loss.
their capacity as owners.
Components of OCI :
There are nine components of OCI, which have been categorised into the four related IFRSs:
IAS 16 Property, plant and equipment: changes in a revaluation surplus;
IAS 19 Employee benefits: remeasurements of defined benefit plans;
IAS 21 The effects of changes in foreign exchange rates: gains and losses arising from translating a foreign
operation’s financial statements;
IFRS 9 Financial instruments:
- gains and losses from investments in equity instruments designated at fair value through OCI;
- gains and losses on financial assets measured at fair value through OCI;
- the effective portion of gains and losses on hedging instruments in a cash flow hedge, and
the gains and losses on hedging instruments that hedge investments in equity instruments measured at fair
value through OCI;
- for certain liabilities designated as at fair value through profit or loss, the amount of the change in fair value
that is attributable to changes in the liability’s credit risk;
- changes in the value of the time value of options (when an option contract is separated into its intrinsic value
and time value and only the changes in this intrinsic value are designated as the hedging instrument);
- changes in the value of the forward elements of forward contracts (when the forward element is separated from
the spot element and only the changes in this spot element are designated as the hedging instrument, and
changes in the value of the foreign currency basis spread of a financial instrument (when excluding it from the
designation of that financial instrument as the hedging instrument). IAS 1.7 (slightly reworded)
8.2 Presentation: one statement or two statements (IAS 1.10 and 1.10A and 1.81A)
8.2.1 Overview
Entities may choose to present their total comprehensive income in:
one single statement, or
two statements.
8.2.2 Single statement layout

An entity may choose to present its income using a single statement. The single statement has
two sections: first the P/L section and then the OCI section, ending with the final total (TCI).
This single statement must present the following 3 totals:
profit or loss (P/L) for the period;
other comprehensive income (OCI) for the period;
total comprehensive income for the period (being: P/L + OCI). Reworded from IAS 1.81A
As for all statements, the title used for this statement is

A single statement for TCI:
fairly flexible: IAS 1 suggests that it be called the
statement of comprehensive income (SOCI), or Could be called SOCI; SOPLAOCI; or any
alternatively, the statement of profit or loss and other other appropriate name (e.g. IS)
comprehensive income (SOPLAOCI) but it allows you Includes two sections:
to use any other appropriate title even if such a title 1st section: P/L &
does not appear in IAS 1 e.g. income statement. 2nd section: OCI
Must include 3 totals:
This textbook uses: P/L
this single-statement approach and OCI
the title of: ‘statement of comprehensive income’. TCI.
80 Chapter 3
Sample presentation: single-statement approach
ABC Ltd
Statement of comprehensive income Note 1
For the year ended 31 December 20X2
20X2 20X1
C C
Income items X X
Expense items (X) (X)
Profit (or loss) for the period X X
Other comprehensive income X X
Other comprehensive income - item 1 X X
Other comprehensive income - item 2 X X
Total comprehensive income X X
8.2.3 Two statement layout
An entity may choose to present its income using two statements, which involves:
statement of profit or loss: this shows the profit or loss and must always be presented as
the first of the two statements; and
statement of comprehensive income: this shows the other comprehensive income and total
comprehensive income and must always start with the total profit or loss.
As with all statements, different titles may be used.
Sample presentation: two- statement approach

ABC Ltd
Statement of profit or loss
20X2 20X1
C C
Income items X X
Expense items (X) (X)
ABC Limited
20X2 20X1
C C
Other comprehensive income for the period X X
Other comprehensive income – item 1 X X
Other comprehensive income – item 2 X X
Total comprehensive income for the period X X
Example 14: Statement of comprehensive income: two layouts compared

The accountant of Orange Limited provides you with the following information:
Trial Balance Extracts at 31 December 20X1 Debit Credit
Revenue 1 000 000
Cost of sales 450 000
Cost of distribution 200 000
Interest expense 100 000
Tax expense 70 000
Other comprehensive income at 31 December 20X1 included one item:
C170 000 on the revaluation of a machine (net of tax) which took place during 20X1.
Required: Prepare the following for Orange Limited’s year ended 31 December 20X1 assuming:
A Orange Limited uses the single-statement layout;
B Orange Limited uses the two-statement layout.
Chapter 3 81
Solution 14A: Statement of comprehensive income: single statement

Orange Limited
20X1 20X0
C C
Revenue 1 000 000 X
Cost of sales (450 000) (X)
Cost of distribution (200 000) (X)
Finance costs (100 000) (X)
Profit before tax 250 000 X
Tax expense (70 000) (X)
Profit for the year 180 000 X
Other comprehensive income for the year 170 000 (X)
Items that may not be reclassified to profit or loss: Note 1
- Revaluation surplus, net of tax: machine 170 000 (X)
Total comprehensive income for the year 350 000 X
Note 1: Please note that this subheading is required disclosure and is explained in sections 8.3.3 and 8.6.
Solution 14B: Statement of comprehensive income: two statements

Orange Limited
Statement of profit or loss
20X1 20X0
C C
Revenue: sales 1 000 000 X
Cost of distribution (200 000) (X)
Finance costs (100 000) (X)
Orange Limited
20X1 20X0
C C
Other comprehensive income for the year 170 000 (X)
Items that may not be reclassified to profit or loss: Note 1
- Revaluation surplus, net of tax: machine 170 000 (X)
Note 1: Please note that this subheading is compulsory disclosure and is explained in sections 8.3.3 and 8.6.
8.3 Line items, totals and sub-headings needed (IAS 1.81-87)
8.3.1 Overview
When presenting the statement/s that show profit or loss (P/L), other comprehensive income
(OCI) and total comprehensive income (TCI), certain minimum line items must be disclosed
on the face thereof.
Additional line items may be necessary if:

required by other IFRSs or if
relevant to understanding the financial performance.
82 Chapter 3
None of these line items may be classified as extraordinary.
Furthermore, the totals for profit or loss (P/L), other comprehensive income (OCI) and
comprehensive income (TCI) must also be presented on the face of the statement.
8.3.2 Minimum line items for: P/L (IAS 1.81A, 1.82, 1.85 and 1.87)
The minimum line items on the face of the statement that discloses profit or loss include:
revenue (excluding interest revenue calculated using the effective interest rate method);
revenue from interest (calculated using the effective interest rate method);
gains and losses from the derecognition of financial assets measured at amortised cost; Note 1
impairment losses (including impairment loss reversals/ gains) determined in accordance
with IFRS 9 Financial instruments; Note 1
finance costs;
share of profits and losses of equity-accounted associates and joint ventures; Note 2
gains and losses on the reclassification of financial assets from measurement at amortised
cost to measurement at fair value through profit or loss; Note 1
any cumulative gain or loss previously recognised in other comprehensive income that is
reclassified to profit or loss on reclassification of a financial asset from measurement at
fair value through other comprehensive income to fair value through profit or loss; Note 1
tax expense;
a single amount for the total relating to discontinued operations; Note 1
profit or loss for the period. Reworded from IAS 1.81A and 1.82
Note 1: These line items are specific to certain IFRSs and will thus be ignored in this chapter. Instead, these will
be covered in the chapters that explain those IFRSs.
Note 2: This line item is specific to certain IFRSs and is thus ignored in this chapter. Associates & Joint Ventures
are covered in a separate book entirely, called Gripping Groups.
8.3.3 Minimum line items for: OCI (IAS 1.81A, 1.82A, 1.85, 1.87, 1.90-96)
The minimum line items on the face of the statement that SOCI: line items, totals &
discloses other comprehensive income include: sub-headings:
each item of other comprehensive income, classified Minimum line items: for
by nature; P/L and
total comprehensive income. See IAS 1.81A and 1.82A OCI
Additional line items:
if IFRS requires or
The other comprehensive income section must be if relevant.
grouped under the following sub-headings: Totals needed for:
Items that may never be reclassified* to profit or P/L,
loss; and OCI &
Items that may be reclassified* subsequently to profit TCI.
No line item to be called extraordinary.
or loss. See IAS 1.82A Line items specific to OCI:
Items on face:
Each item of OCI must be presented in the statement of - classified by nature, and
comprehensive income: - shown before or after tax.
after deducting tax; or Split between 2 sub-headings:
before tax, in which case it will be followed by a - will be reclassified to P/L &
single amount for the tax effect of all the relevant - will never be reclassified to P/L
items per sub-heading (i.e. there would be two single Tax effects on face or notes.
amounts). See IAS 1.91 Reclassification adjustments:
- on face or
- notes.
The tax effect of each item of OCI (including
reclassification adjustments*) may be presented: A reclassification
on the face of the statement; or adjustment is
the transfer of an income or
in the notes. See IAS 1.90 expense from OCI to P/L
i.e. the item was previously recognised
Reclassification adjustments* may be presented either: in OCI but must now be recognised in
on the face of the statement; or P/L instead). Reclassifications are
in the notes. See IAS 1.94 discussed in more detail in section 8.6.
Chapter 3 83
Sample presentation: other comprehensive income section
Apple Limited
20X1 20X0
Profit or loss section: C C
....
Profit for the year X X
Other comprehensive income section: X X
Items that may not be reclassified to profit or loss:
Revaluation surplus, net of tax X X
Items that may be reclassified to profit or loss:
Gain on cash flow hedge, net of tax & reclassification adjustment X X
8.4 Analysis of expenses
8.4.1 Overview (IAS 1.99 and 1.97)

Analysis of expenses:
Expenses used in the calculation of profit or loss must be Presented:
analysed based on either the: On face; or
nature of the expenses (nature method); or In notes
function of the expenses (function method). Two types of analysis:
Function: allocate to functions
The choice between analysing expenses on the ‘nature Nature: no allocation of expenses
method’ or ‘function method’ depends on which method
provides reliable and more relevant information. Exactly the same profit (or loss) will result
no matter which method is used.
This analysis could be included:

as separate line items on the face of the statement of comprehensive income, or
in the notes.
8.4.2 Nature method (IAS 1.102)
When using the nature method, expenses are presented based on their nature and are not
allocated to the various functions within the entity (such as sales, distribution, administration
etc). This method is simpler and thus suits smaller, less sophisticated businesses.
Sample presentation: Expenses analysed by nature (see highlighted section)
ABC Ltd
For the year ended 31 December 20X2 (nature method)
20X2
C
Revenue X
Other income X
Add/ (Less) Changes in inventories of finished goods and work-in-progress (X)
Raw materials and consumables used (X)
Employee benefit costs (X)
Depreciation (X)
Other expenses (X)
Total expenses (X)
Finance costs (X)
...
84 Chapter 3
8.4.3 Function method (IAS 1.103 – 1.105)
Generally, the four main functions (tasks) of a business include the:

sales,
distribution,
administration, and
other operations.
If one uses the function method, one has to allocate the expenses incurred to these different
functions (use or purpose). The function method is therefore more comprehensive than the
nature method and is designed for larger businesses that have the ability to allocate expenses
to their functions on a reasonable basis. It provides information that is more relevant, but
there is a risk that arbitrary allocations may lead to less reliable information.
The ‘function method’ gives more relevant information to Nature or function?

the user than the ‘nature method’: for instance it is Choice depends on which
possible to calculate the gross profit percentage using the gives reliable and more
function method, whereas this calculation isn’t possible if relevant information.
the nature method is used. Function method is normally more
relevant, but if allocations can only
Information relating to the nature of expenses is crucial be done arbitrarily, then the
information to those users attempting to predict future information will not be reliable.
cash flows, therefore, if the function method is used, information regarding the nature of the
expense (e.g. depreciation and staff costs) is also given, but this additional classification
would then have to be provided by way of a separate note. IAS 1.97
An example showing the statement of comprehensive income using the function method
follows. The highlighted section is the part of the statement of comprehensive income that
changes depending on whether the ‘function’ or ‘nature’ method is used.
Sample presentation: Expenses analysed by function (see section in grey)
ABC Ltd
For the year ended 31 December 20X2 (function method)
20X2
C
Revenue X
Other income X
Cost of sales (X)
Distribution costs (X)
Administration costs (X)
Other costs (X)
Finance costs (X)
...
8.5 Material income and expenses (IAS 1. 97-.98)
If an income or expense is material, we must separately

disclose it together with its: Material income/expenses:
nature and
amount. Should each be:
disclosed separately,
This additional separate disclosure could be given either: showing:
as separate line items on the face of the statement of - nature and
- amount,
comprehensive income; or either:
in the notes. - on face of SOCI; or
- in notes.
Chapter 3 85
Examples of material income or expenses include those related to:
write-downs of assets or reversals thereof;

restructuring costs;
disposals of property, plant and equipment and disposals of investments;
discontinued operations;
litigation settlements; and
reversals of any provisions. Summary of IAS 1.98
8.6 Reclassification adjustments (IAS 1.92-1.93 and 1.95-1.96)
8.6.1 Explanation of reclassification adjustments

Reclassification adjustments
are defined as:
A reclassification adjustment refers to a journal entry
processed to recognise an income or expense in profit amounts reclassified to P/L in the
or loss (P/L) where this income or expense had current period
previously been recognised in other comprehensive that were recognised in OCI in the
income (OCI). current or previous periods. IAS 1.7
A reclassification adjustment refers to a
Thus the one side of the journal entry recognises the journal that reverses an item out of OCI
item of income or expense in P/L while the contra entry and reclassifies it into P/L.
removes it from OCI. Reclassifications never occur with:
Revaluation surpluses; or
The relevant IFRSs dictate when reclassifications from Defined benefit plans.
OCI to P/L occur.
Reclassifications may be disallowed in
terms of IFRS 9 when accounting for:
However, the following two types of OCI may never be certain cash flow hedges;
reclassified to P/L: the time value of an option;
changes in a revaluation surplus; the forward element of a forward
remeasurements of defined benefit plans. contract; and
the foreign currency basis spread of a
financial instrument.
Worked example: Reclassification adjustments
Imagine that we made a gain of C200 on an investment of C1 000 and that this gain was
recognised as OCI in 20X1, and then in 20X2 it was reclassified to P/L.
In 20X1, the other comprehensive income will include income of C200 (see jnl 1).
The ledger accounts will look as follows:
Investment (Asset) Gain on investment (OCI)
O/bal 1 000 Jnl 1 200
Jnl 1 200 C/bal 200
C/bal 1 200
Jnl 1 shows the income on the investment initially being recognised as OCI.
In 20X2, the income of C200 is reclassified out of OCI and into profit or loss (see jnl 2).
Investment (Asset) Gain on investment (OCI)
O/bal 1 200 O/bal 200
Jnl 2 200
C/bal 0
Profit on investment (P/L)
Jnl 2 200
Jnl 2 shows the reclassification adjustment, which means that the income is now
recognised in P/L (credit) and taken out of OCI (debit).
86 Chapter 3
8.6.2 Disclosure of reclassification adjustments (IAS 1.94 and 1.90)

The reclassification adjusted must be presented:
together with the related component of OCI
in the period that the income or expense is reclassified from OCI to P/L
may be presented in either:
- the statement of comprehensive income; or
- the notes. See IAS 1.93 and 1.94
Example 15: Statement of comprehensive income: reclassification adjustments

Lemon Limited entered into a forward exchange contract (FEC) when it imported a plant.
This FEC is considered to be a cash flow hedge.
A gain of C100 000 (income) was recognised on this FEC at 31 December 20X1. Since the FEC is
considered to be a cash flow hedge, the gain was recognised in other comprehensive income (OCI) in
terms of the definition of OCI given in IAS 1.7 (the contra entry was debited to the FEC asset).
The gain recognised in OCI is to be reclassified to profit or loss (P/L) over the life of the plant.
The plant had a remaining useful life of 5 years as at 1 January 20X2.
The following was extracted before any journals related to this FEC had been processed:
Trial Balance Extracts at 31 December 20X1 Debit Credit
Revenue 1 000 000
Cost of administration 80 000
Tax expense 70 000
Required:
A Journalise the gains and reclassifications (ignore tax on the gain) in 20X1 and 20X2;
B Present the statement of comprehensive income for the period ended 31 December 20X2 (as a
single statement), with reclassification adjustments provided in the notes. Ignore tax on the gain.
Solution 15A: Journals

31 December 20X1 Debit Credit
FEC asset (A) Given 100 000
Gain on cash flow hedge (OCI) 100 000
Gain on cash flow hedge
31 December 20X2
Gain on cash flow hedge (OCI) 100 000 / 5 years x 1 year 20 000
Gain on cash flow hedge (P/L) 20 000
Reclassification of gain in OCI to P/L over the life of the plant
Solution 15B: Statement of comprehensive income

Orange Limited
20X2 20X1
C C
Revenue 1 000 000 X
Other income: gain on cash flow hedge 100 000 / 5 x 1 year 20 000 X
Administration costs (80 000) (X)
Other comprehensive income for the year 50. (20 000) 100 000
Gain on cash flow hedge, net of tax (N/A) & reclassification adjustment (20 000) 100 000
Items that may not be reclassified to profit or loss (N/A in this question) 0 0
Chapter 3 87
Lemon Limited
20X2 20X1
50. Other comprehensive income: cash flow hedge C C
Gains on cash flow hedge arising during the year 0 100 000
Less reclassification adjustment: gain now in profit and loss (20 000) 0
(20 000) 100 000
Comment:
The total gain on the cash flow hedge is C100 000. This will be recognised in P/L over the life of
the plant: 20 000 in 20X2 and 80 000 evenly over the remaining 4 years (20X3 to 20X6).
The ‘gain on CFH: OCI’ account reflects a balance of C80 000 at the end of 20X2. This closing
balance will appear in both the SOCIE and the SOFP. However, the SOCI shows the movement in
this OCI account each year. Notice that since C20 000 (1/5) of the gain was recognised in P/L in
20X2, this C20 000 must be reversed from OCI in 20X2 otherwise, over the 2 years, the total
income recognised in TCI would be C120 000 and yet the total income to date is only C100 000.
[OCI: (recognise 100 000 – reclassify: 20 000) + P/L (recognise 20 000) = TCI: 100 000]
8.7 Adjustments to a prior year profit or loss (IAS 1.89)
Occasionally a prior year’s income or expense (i.e. P/L)

needs to be changed. This may occur when the entity: Adjusting a prior year P/L
applies a new accounting policy;
corrects a prior period error. May involve a:
prospective adjustment (adjust the
Depending on the circumstances, the change may need current year P/L); or
to be made prospectively or retrospectively: retrospective adjustment (adjust the
opening RE).
A prospective adjustment means adjusting the prior
year’s income or expense (P/L) by processing a journal entry that adjusts the current
year’s income or expense (P/L) instead.
A retrospective adjustment means adjusting a prior year’s income or expense (P/L) by
processing a journal that adjusts the prior year’s income or expense (P/L).
When making a retrospective adjustment, any adjustment to a prior year income or expense
will need to be journalised directly to the retained earnings account – and not to that income
or expense account. This is because the prior year’s income and expense accounts will have
already been closed off to that prior year’s profit or loss account and that prior year’s profit or
loss account will also have been closed off to retained earnings (only the current year’s
income and expense accounts will still be ‘open’).
The statement of comprehensive income will then show the prior year income and expenses
as being restated (assuming that the prior year being adjusted is presented as a comparative).
The statement of changes in equity will include a line item that shows the effect on retained
earnings of the retrospective adjustments to the prior year/s income and expenses.
For more information on these adjustments, please see the chapter on Accounting policies, estimates and errors.
8.8 A sample statement of comprehensive income
The following is an example of a statement of comprehensive income that might apply to a

single entity. It has also been simplified to show a very basic statement where there are no
associates or discontinued operations.
Please remember that the line items in your statement of comprehensive income might be
fewer or more than those shown below. It depends entirely on what line-items are relevant to
the entity (e.g. if the entity does not have a cash flow hedge, then one of the six components
of other comprehensive income would fall away).
88 Chapter 3
Sample presentation: Statement of comprehensive income for a single entity
ABC Ltd
20X2 20X1
C C
Revenue X X
Other income X X
Cost of sales (X) (X)
Distribution costs (X) (X)
Administration costs (X) (X)
Other costs (X) (X)
Finance costs (X) (X)
Profit (or loss) before tax X X
Taxation (X) (X)
Profit (or loss) for the year X X
Other comprehensive income for the year X X
Revaluation surplus, net of tax X X
Gain on cash flow hedge, net of tax & reclassification adjustment X X
Total comprehensive income for the year X X
8.9 A consolidated SOCI: the ‘allocation section’ (IAS 1.81B)
The following information relates to the consolidated

statement of comprehensive income produced for a Consolidated SOCI
group.
If the SOCI relates to a consolidated
If an entity owns part or all of a subsidiary, the entity is group that includes a partly-owned
subsidiary, the SOCI must show how
referred to as a parent and the two entities together are the:
referred to as a group of entities. consolidated P/L and
consolidated TCI
If the parent owns 100% of the subsidiary (called a will be allocated between:
wholly-owned subsidiary), then 100% of the subsidiary’s the parent’s owners and
the non-controlling interests.
income would belong to the parent. Groups are covered in the book ‘Gripping Groups’.
If, however, the parent owns less than 100% of the subsidiary (called a partly-owned
subsidiary), then less than 100% of the subsidiary’s income would belong to the parent - the
rest of it will belong to ‘the other owners’ (non-controlling interests).
Thus, if the group includes a partly-owned subsidiary, the group’s consolidated statement of
comprehensive income must show how much of the consolidated income belongs to the:
owners of the parent; and
non-controlling interests.
This sharing of the consolidated income between the owners of the parent and the non-
controlling interests is referred to as the allocation of income and is presented as a separate
section at the end of the SOCI (*) as follows:
the portion of the profit or loss that is attributable to the *:
- owners of the parent;
- non-controlling interests; and
the portion of total comprehensive income that is attributable to the:
- owners of the parent;
- non-controlling interests.
*: The allocation of profit or loss may be presented in the statement of profit or loss if this has
been provided as a separate statement (i.e. if a two-statement approach had been used).
Chapter 3 89
Sample presentation: Consolidated statement of comprehensive income: the ‘allocation section’
ABC Ltd Group

Consolidated statement of comprehensive income
20X2 20X1
... C C
Total comprehensive income for the year X X
Profit (or loss) for the year attributable to: X X
- owners of the parent X X
- non-controlling interest X X
Total comprehensive income for the year attributable to: X X
- owners of the parent X X
- non-controlling interest X X
9. Structure and Content: Statement of Changes in Equity (IAS 1.106-.110)
9.1 Overview
Components of equity include:

each class of contributed equity (e.g. ordinary shares and preference shares);
retained earnings (which reflects the accumulated profit or loss);
other comprehensive income, of which there are six possible components:
- changes in a revaluation surplus;
- actuarial gains and losses on defined benefit plans;
- gains and losses arising from translating the financial statements of a foreign operation;
- for particular liabilities designated as at fair value through profit or loss, the amount
of the change in fair value that is attributable to changes in the liability’s credit risk;
- the effective portion of gains and losses on hedging instruments in a cash flow hedge;
- gains and losses from investments in equity instruments measured at fair value
through other comprehensive income. See IAS 1.7 & 1.108
A statement of changes in equity is essentially a series of The SOCIE must present:

reconciliations between the opening and closing balances
for each component of equity. changes in equity; thus it needs
reconciliations for each component
Bearing in mind that equity represents the net assets (E = of equity:
A – L), a change in equity simply means an increase or - each class of contributed equity
decrease in the net assets (or a change in position). - retained earnings (P/L)
- each of the 6 items of OCI.
Changes in equity for the period are represented by:
total comprehensive income (P/L + OCI); and Change in E = Change in (A – L)
transactions with owners (including related transaction costs): such as the issue of shares
or dividends declared to shareholders.
9.2 General presentation requirements (IAS 1.106-110)
The statement of changes in equity must present reconciliations between the opening and
closing balances for each component of equity (i.e. each class of contributed equity, retained
earnings and other comprehensive income). See IAS 1.106(d)
When presenting the reconciliations for each component of equity, we must be sure to
separately present the:
Profit or loss for the period
Other comprehensive income period (each component of OCI to be presented separately)
Total comprehensive income for the period. See IAS 1.106 (a) and (d)
90 Chapter 3
If the reconciliation between the opening balance and closing balance of a component of
equity involves transactions with owners in their capacity as owners, these transactions must
be separately presented as being:
contributions by owners (e.g. through the issue of shares); and
distributions to owners (e.g. dividends declared). See IAS 1.106(d)(iii)
9.3 Dividend distributions (IAS 1.107; 1.137; IAS 10; IFRIC 17)
The amount of the dividend distributions that have been The SOCIE: may also
recognised must be presented either: present:
in the statement of changes in equity or the amount of recognised dividend
in the notes. distributions; and
dividends per share (DPS).
The dividends per share may also be disclosed either:
in the statement of changes in equity or The dividend amt and DPS may be shown
in the notes instead.
in the notes.
Not all dividends are recognised!
It is submitted that the amount of the dividend distributions would be best presented in the
statement of changes in equity while the dividends per share would be best presented in the
notes, preferably alongside the earnings per share note.
Dividends that are not recognised are explained in section 11.9.
9.4 Retrospective adjustments (IAS 1.106-110)
If there has been a retrospective change in accounting policy or correction of error, this
retrospective adjustment is presented in the statement of changes in equity as part of the
reconciliation between the opening and closing balances. However, retrospective adjustments
are not considered to be ‘changes in equity’ as defined, but are simply adjustments to the
opening balances of the affected component of equity (e.g. retained earnings). See IAS 1.109
If the reconciliation between the opening balance and Retrospective adj’s are:
closing balance of a component of equity is affected by a presented in the SOCIE,
retrospective adjustment/s, these adjustment/s must be
not ‘changes in equity’!
separately identified and presented as relating to:
a change in accounting policy; or Presentation of RAs must include:
a correction of error. See IAS 1.110 whether they relate to a:
- change in accounting policy; or
If there has been a retrospective adjustment, the effect - correction of error
thereof on the reconciliation of each component of equity the effect on each item of equity
must be disclosed: - for each prior period; and the
for each prior period; and - opening current period balances.
the beginning of the current period. See IAS 1.110
9.5 A sample statement of changes in equity
The following example shows a statement of changes in equity. This statement has been
simplified to show a very basic spread of equity types (i.e. it does not show reserves other
than retained earnings and has only one class of share capital: ordinary shares).
The columns in the statement of changes in equity for your entity might be fewer or more
than those shown in the example. It depends on:
what columns are relevant to the entity, for example:
contributed equity could need columns for ordinary shares and preference shares
other comprehensive income would need to include columns for each of the possible
six types of other comprehensive income relevant to the entity (e.g. if the entity does
not have foreign operations, then a translation reserve would not be necessary); and
the materiality of the reserves.
Chapter 3 91
Sample presentation: Statement of changes in equity
ABC Ltd
Statement of changes in equity
Ordinary Retained Other Total
capital earnings compreh. equity
C C income C
C
Balance: 1 January 20X1 - restated X X X X
Balance: 1 January 20X1: as previously reported X
Change in accounting policy X
Correction of error X
Total comprehensive income X X X
Less dividends declared (X) (X)
Add issue of shares X X
Balance: 31 December 20X1 - restated X X X X
Balance: 31 December 20X2: as previously X
reported
Change in accounting policy X
Correction of error X
Total comprehensive income X X X
Less dividends declared (X) (X)
Add issue of shares X X
Balance: 31 December 20X2 X X X X
9.6 A consolidated statement of changes in equity

If the statement of changes in equity involves a group of entities, extra columns are needed to
show the allocation of total comprehensive income between the:
owners of the parent; and
non-controlling interests.
Sample presentation: Consolidated statement of changes in equity
ABC Ltd
Consolidated statement of changes in equity
Attributable to owners of the parent Non- Total
Ord. Revaluation Retained Total controlling Equity of
capital surplus earnings equity interest the group
C C C C C C
Restated balance: 01/01/X1 X (X) X X X X
Balance: 1 Jan 20X1 - as X
previously reported
Change in accounting policy (X)
Total comprehensive income X X X X X
Less dividends (X) (X) (X) (X)
Add share issue X X X
Restated balance: 31/12/X1 X (X) X X X X
Balance: 31 Dec 20X1 - as X
previously reported
Change in accounting policy (X)
Total comprehensive income (X) X X X X
Transfer to retained earnings (X) X
Less dividends (X) (X) (X) (X)
Add share issue X X X
Balance: 31 Dec 20X2 X (X) X X X X
92 Chapter 3
10. Structure and Content: Statement of Cash Flows (IAS 1.111)
IAS 1 does not cover the statement of cash flows as it is dealt with in its own standard, IAS 7.
11. Structure and Content: Notes to the Financial Statements (IAS 1.112 - .138)
11.1 Overview
Notes are defined as:

containing information in addition to that presented in the:
- SOFP: statement of financial position,
- SOCI: statement of comprehensive income,
- SOCIE: statement of changes in equity, and
- SOCF: statement of cash flows;
narrative descriptions or disaggregations of:
- items recognised in those statements (i.e. supporting information); and about
- items not recognised in those statements (i.e. extra information). IAS 1.7 reworded
IAS 1 clarifies that notes give information about the following:

the basis of preparation; IAS 1.112
the significant accounting policies, including: IAS 1.112
- the measurement basis or bases, and IAS 1.117
- other relevant accounting policies; IAS 1.117
supporting information (i.e. regarding items recognised in the statements) IAS 1.7 which:
- is required by the IFRSs IAS 1.112
- is not required by the IFRSs but is required because it’s relevant IAS 1.112
extra information (i.e. regarding items not recognised in the statements) IAS 1.7 which:
- is required by the IFRSs IAS 1.112
- is not required by the IFRSs but is required because it’s relevant IAS 1.112
IAS 1 also specifically refers to the requirements to provide notes that disclose details about:
judgements made by management regarding:
- the application of accounting policies; see IAS 1.122
- making estimates; see IAS 1.125
capital management; see IAS 1.134
puttable financial instruments classified as equity; see IAS 1.136A
dividends; see IAS 1.137
various other details relating to the entity’s identity and description. see IAS 1.138
11.2 Structure of the notes (IAS 1.112-117)
The order of the notes must be:

presented in a systematic and logical manner, and
cross-referenced when necessary. See IAS 1.113
Cross-referencing is necessary where the notes refer to information contained in the other
statements. In other words, the other four statements making up the financial statements must
be cross-referenced to the notes.
Notes supporting items in the other four components should be listed in the same order that
each line item and each financial statement is presented (on occasion, a note may refer to
more than one line item, in which case one must simply try to be as systematic as possible).
Chapter 3 93
IAS 1 also suggests that the following specific order be used:

Statement of compliance Note 1
Significant accounting policies
Supporting notes (i.e. supporting information contained in the other statements) Note 2
Other notes. Note 2 and Note 3 See IAS 1.114
Note 1. It is submitted that the ‘statement of compliance’ be presented as part of the ‘basis of preparation’ note.
(Please see the discussion relating to basis of preparation, in sections 11.1 and 11.3).
Note 2. Both the supporting notes and other notes would contain information
- Required by IFRSs;
- Required because it is simply considered relevant to the users’ understanding. See IAS 1.112
Note 3. Other notes (i.e. those that do not support information contained in the other statements) could contain:
- Financial information, for example:
unrecognised contractual commitments, contingent liabilities and details of events that happened
after the reporting date but before the financial statements were authorised for issue;
- Non-financial information, for example:
the entity’s objectives and policies relating to its capital management. See IAS 1.114 (d)
11.3 Basis of preparation (IAS 1.112; 1.116 and 1.64)
The basis of preparation is not a defined term and as a result, there are many ways in which
this has been interpreted, two of which are explained below:
Some interpret ‘basis of preparation’ as referring to ‘measurement bases’ (e.g. historical
cost, fair values etc), thus listing it under the ‘significant accounting policies’ (google:
Deloitte’s ‘Model financial statements for the year ended 31 December 2013’);
Others interpret it to mean a number of things, such as whether the financial statements
comply with IFRSs or other national GAAP, whether the financial statements are separate
financial statements prepared for a single entity or are consolidated financial statements
prepared for a group of entities, judgements involved in applying accounting policies and
the sources of uncertainty that arose when making judgements involving estimates etc
(google: ‘KPMG’s guide to annual financial statements – illustrative disclosures’).
This textbook prefers aspects of KPMG’s interpretation above and thus submits that the ‘basis
of preparation’ should be presented separately to the ‘significant accounting policies’ and
should contain the following details, ideally under separate headings:
Reporting entity: identifying whether the financial statements are prepared as separate
financial statements or consolidated financial statements;
Statement of compliance: stating whether the financial statements have been prepared in
compliance with IFRSs, some other national GAAP or other set of principles;
Other issues: such as whether the financial statements are prepared in a way that
presented assets in order of liquidity or under the headings of current and non-current.
Sample presentation: Basis of presentation
ABC Ltd
Notes to the Financial Statements
1. Basis of preparation...
1.1 The reporting entity:
The following financial statements have been prepared as consolidated financial statements
for ABC Limited and its subsidiary.
ABC Limited is a company that is both incorporated and domiciled in South Africa.
The address of its registered office and principal place of business is: 50 Ten Place,
Padfield, Johannesburg.
The group of companies are involved in properties held for the purpose of rental income as
well as the printing and distribution of textbooks.
1.2 Statement of compliance:
These financial statements have been prepared in accordance with IFRS.
94 Chapter 3
11.4 Significant accounting policies (IAS 1.117 – 124)
11.4.1 Overview
A summary of significant accounting policies can be presented as a separate statement, in

which case there would then be 6 statements to the set of financial statements.
The summary of significant policies includes:

The measurement basis or bases used in preparing the financial statements; and
Other accounting policies that are relevant to users (i.e. would help users understand the
financial statements). See IAS 1.117
Judgements that management makes in applying accounting policies could also be included in
the summary of significant accounting policies. See IAS 1.122 (see section 11.5)
Accounting policies are disclosed either because:

an IFRS requires the accounting policy to be disclosed;
it is considered to be relevant to the user’s understanding of the performance and position.
11.4.2 Measurement bases
There are various methods (bases) of measuring items in the financial statements. Users
would be better able to understand the financial statements if they knew how these items were
measured and thus the measurement basis or bases used in preparing the financial statements
should be disclosed. Examples of the various measurement bases used include, for example:
Historical cost
Current cost
Net realisable value
Fair values
Recoverable amounts.
11.4.3 Significant accounting policies are those that are relevant
Only the accounting policies that are significant to an entity need to be disclosed.
When deciding whether or not to disclose an accounting policy, one should consider if it
would assist the user in understanding the performance and position of the entity (i.e. consider
its relevance). See IAS 1.119
Whether or not an accounting policy is relevant to an entity depends largely on the nature of
its operations,(for example, if an entity is not taxed, then including accounting policies
relating to tax and deferred tax would be a silly idea!). It can thus happen that accounting
policies may be considered significant even if the amounts related thereto are immaterial.
Worked example: Significant accounting policy despite immaterial amount

Apple Limited’ core business activities includes investing in property for rental income,
these properties thus being classified and accounted for as investment property.
Due to the receipt from a rich oil merchant of an unprecedented offer to purchase most of Apple’s
properties at highly inflated prices, Apple had very few investment properties at reporting date.
Despite this, users would want to see the entity’s accounting policies relating to its investment
properties in order to help them understand the investment property balance at reporting date.
Conclusion:
The accounting policy for investment properties is significant because it is considered relevant due to
the nature of the business even though the carrying amount of the investment properties is immaterial.
Chapter 3 95
Accounting policies would be relevant where the IFRS allows a choice in accounting policies,
for example, IAS 16 Property, plant and equipment allows entities to measure these assets
using the cost model or revaluation model. The accounting policy note should thus indicate
which model the entity chose to use.
Here are a few more examples of accounting policies:

whether property, plant and equipment is measured at fair value less subsequent
depreciation or at historical cost less depreciation;
whether deferred tax assets are recognised;
when revenue is recognised and how it is measured; and
any accounting policy devised by management in the absence of an IFRS requirement.
Sample presentation: Significant accounting policies
ABC Ltd
2. Significant accounting policies
The following is a list of the significant accounting policies, including measurement bases, that
have been applied by ABC Limited. These accounting policies have all been consistently
applied, except for the changes in accounting policies described in note 50.
2.1 Inventories
Inventories are measured on the lower of cost or net realisable value. The cost of
inventories is based on the weighted average method. Finished goods and work-in-progress
include a share of fixed manufacturing overheads, calculated based on normal production
capacity.
2.2 Property, plant and equipment...
11.5 Judgements made in applying accounting policies (IAS 1.122-124)
Judgements made by management in determining which accounting policies should be

applied must be disclosed if these judgements have had:
the most significant effect on the amounts recognised in the financial statements. IAS 1.122
Judgements made in applying accounting policies may be disclosed either in:

the significant accounting policies note; or
as one of the remaining notes. See IAS 1.122
Sample presentation: Judgements made in applying accounting policies
ABC Ltd
2. Significant accounting policies...
3. Judgements in applying accounting policies
The following are the judgements made by management that have had the most significant
effect of the amounts recognised in the financial statements:
3.1 XYZ Limited is accounted for as a subsidiary
Note 10 refers to XYZ Limited as a subsidiary despite ABC Limited owning only 40%
thereof. Management assessed whether ABC Limited has control over XYZ Limited, thus
making XYZ a subsidiary, by assessing its practical ability to direct the relevant activities
of XYZ Limited. In making its judgement, management took into consideration the
absolute size of its own shareholding (40%) together with the fact that the remaining
shareholding (60%) is dispersed among more than 1 000 remaining shareholders, none of
whom have a shareholding of more than 1% each.
3.2 ...
96 Chapter 3
A further example of judgements in applying an accounting policy: management’s reasoning

behind a difficult case involving whether an item of plant could continue to be accounted for
in terms of IAS 16 Property, plant and equipment, or whether it should be accounted for in
terms of IFRS 5 Non-current assets held for sale and Discontinued operations.
11.6 Judgements involving estimates: sources of estimation uncertainty (IAS1.125–133)

Preparing financial statements involves many estimates. These estimates involve professional
judgements, from estimating depreciation rates to estimating the amount of a provision. These
estimates involve assumptions regarding the future and other sources of uncertainty at
reporting date. If an estimate has been made that involves assumptions regarding the future or
other sources of uncertainty (e.g. the potential cost of rehabilitating land in 20 years time, the
remaining life of an asset, the discount rate to use when calculating a present value), that
involve a high degree of subjective and complex ‘guesswork’, there is, of course, a risk of the
estimate being ‘wrong.’
Disclosure is required when the possibility of this estimate being wrong amounts to:
a significant risk
that a material adjustment to the carrying amount of an asset or liability
may need to be made within the next financial year.
Sample presentation: Sources of estimation uncertainty
ABC Ltd
2. Significant accounting policies...
3. Judgements in applying accounting policies ...
4. Sources of estimation uncertainty
The following are the judgements made by management in the process of making estimates:
4.1 Impairment of plant
Note 15 includes plant, the carrying amount of which was impaired by C100 000 to its
recoverable amount of C800 000. This recoverable amount was estimated based on its
value in use, calculated as the present value of the future cash flows expected from the use
of the plant and present valued using a pre-tax discount rate of 7%.
The future cash flows were estimated based on management’s assumption that the company
secures a certain government contract. However, if the tender submitted for this
government contract is not awarded to ABC Limited, the carrying amount of plant would
be measured at C600 000 (i.e. its recoverable amount) and the impairment expense would
be measured at C300 000.
4.2 ...
Where disclosures are required regarding an estimate that required management to make
judgements involving ‘assumptions about the future and other major sources of estimation
uncertainty’ the disclosures should include, for instance:
the nature and carrying amount of the assets and liabilities affected; IAS 1.31
the nature of the assumption or estimation uncertainty;
the sensitivity of the carrying amounts to the methods, assumptions and estimates used in
their calculation;
the reasons for the sensitivity;
the range of reasonably possible carrying amounts within the next financial year and the
expected resolution of the uncertainty; and
the changes made (if any) to past assumptions if the past uncertainty still exists. IAS1.129
If it is impracticable to provide the above disclosures, we must still disclose:

the source/s of uncertainty;
the nature and carrying amount of the assets and liabilities affected. IAS 1.31
Chapter 3 97
Disclosures are not required, even if there is a significant risk of an item’s carrying amount
changing materially within the next year, if the asset or liability is measured at a fair value
that has been ‘based on a quoted price in an active market for an identical asset or liability’.
IAS 1.128
This is because the change in its carrying amount is caused by the market price
changing and is not caused by incorrect assumptions made by management.
IAS 1 does not indicate where the disclosures involving sources of estimation uncertainty
should be disclosed, but it is submitted that the required disclosures could also be useful if
they were presented in the actual note dealing with the affected estimate.
11.7 Capital management (IAS 1.134-136)
An entity must disclose its objectives, policies and processes for managing its capital. In so
doing, the disclosure must include:
qualitative information, including at least the following information:
- a description of what it considers to be capital;
- the nature of any externally imposed capital requirements
- how externally imposed capital requirements (if any) have been incorporated into the
entity’s management of capital
- how it is meeting its objectives for managing capital;
quantitative information regarding what the entity considers to be capital (because the
term capital is not defined):
- some entities include some financial liabilities when talking about their capital (e.g.
the entity may manage its subordinated debt as part of its capital); while
- some entities exclude certain equity accounts from their idea of capital (e.g. the entity
may not consider its cash flow hedge reserves to be part of capital);
changes to the information provided above from the prior year;
whether it complied with the externally imposed capital requirements (if applicable); and
the results of non-compliance with externally imposed capital requirements (if applicable).
Sample presentation: Capital management
ABC Ltd
1. Basis of preparation
3. Judgements in applying accounting policies
4. Sources of estimation uncertainty
5. Capital management
ABC Limited has a capital base that includes a combination of ordinary shares and non-
redeemable preference shares. The total capital at 31 December 20X2 is C1 000 000.
ABC Limited is not subjected to any externally imposed capital requirements. It does, however,
have an internal policy of maintaining a solid capital base in order to enable continued
development of the business and to ensure general confidence in the business.
The business manages its capital base by monitoring its debt to equity ratio. Its policy is to keep
this ratio from exceeding 3:1. The debt to equity ratio at 31 December 20X2 was 3.3:1 (20X1:
2.9:1). The increase in the debt to equity ratio in 20X2 was due to extra financing needed due to
the refurbishment of one of its uninsured properties following a devastating flood in March.
Management intends to issue 100 000 further ordinary shares in 20X4, which will bring the
debt: equity ratio back in line with the policy of 3: 1.
11.8 Puttable financial instruments classified as equity instruments (IAS 1.136A)

A puttable financial instruments is one that the holder may return to the issuer for an exchange
of cash. Puttable financial instruments that have been issued by the entity are thus normally
classified as liabilities, but some may need to be classified as equity (those that represent the
residual interest in the net assets of the entity). See IAS 32.16A-D
98 Chapter 3
If the entity has issued puttable financial instruments that are classified as equity, the notes
must include:
A summary of the amounts classified as equity
How the entity plans to manage its obligation to provide cash in exchange for a returned
instrument when required to do so by the holder of the instrument;
The future cash outflow expected in relation to this instrument; and
How the expected future cash outflow has been calculated. See IAS 1.136A
11.9 Unrecognised dividends (IAS 1.137 and IFRIC 17.10 and IAS 10.13)
11.9.1 Disclosure of unrecognised dividends
IAS 1 requires that the notes include certain disclosures relating to unrecognised dividends.
For dividends that have not been recognised, we must disclose the following in the notes:
- the amount in total; and
- the amount per share. See IAS 1.137
For any cumulative preference dividends that, for whatever reason, have not been
recognised, we must disclose the following in the notes:
- the amount in total. See IAS 1.137
11.9.2 Why are some dividends not recognised?
A dividend distribution normally follows the following life-cycle:

proposal; then
declaration; then
payment.
Dividends are first proposed in a meeting. If the proposal is accepted, the entity will declare
the dividend. Declaring a dividend means publicly announcing that the dividend will be paid
on a specific date in the future. A dividend only becomes an obligation once it is
appropriately authorised and no longer at the discretion of the entity. IAS 10.13 In some
jurisdictions, a declaration still needs to be approved before an obligation arises (e.g. it may
be declared by the board of directors but this declaration may still need to be approved by the
shareholders). IFRIC 17.10 It is only when an obligation arises to pay the dividend that a journal
is processed:
Debit Credit
Dividends declared (distribution of equity) xxx
Dividends payable (liability) xxx
Dividend declared
Notice that the liability to pay a dividend is not recognised as an expense but rather as a
distribution of equity because a distribution of equity is expressly excluded from the
definition of an expense (read the expense definition again).
Certain dividends would not be recognised since there is not yet an obligation to pay them:
proposed before or after the reporting date but are not yet declared or paid; and
declared before reporting date but within a jurisdiction where further approval is required;
declared after reporting date but before the financial statements are authorised for issue.
11.10 Other disclosure required in the notes (IAS 1.138)
Other information requiring disclosure includes:

the domicile and legal form of the entity;
which country it was incorporated in;
the address of its registered office or principal place of business;
a description of the nature of the entity’s operations and principal activities; and
the name of the parent entity and the ultimate parent of the group (where applicable).
Chapter 3 99
12. Summary
IAS 1: Presentation of financial statements

Objective of IAS 1:
prescribes the basis for presentation of general purpose f/ statements
to ensure comparability both with the entity’s prior periods and with other entities.
sets out overall requirements for the presentation of f/ statements, guidelines for their
structure and minimum requirements for their content
Objective of f/statements
provide info about the:
financial position, performance & cash flows
that is useful to a wide range of users in making economic decisions; and
also shows the results of mgmt’s stewardship of the resources entrusted to it.
5 Components of a set of f/statements
SOFP
SOCIE
SOCI
SOCF
Notes.
8 General features
Fair presentation and compliance with IFRSs
Going concern
Accrual basis
Materiality and aggregation
Offsetting
Reporting frequency
Comparative information
Consistency
Structure and content of the five financial statements
Minimum disclosure requirements (both on the face of each component and in the notes)
SOFP:
o Current (C) vs Non-current (NCL)
o Effect of refinancing of liabilities and breach of covenants liabilities (CL or NCL)
SOCI:
o How to present expenses (function/ nature method)
o How to present P/L
o How to present OCI (and reclassification adjustments)
o How to present TCI (and if it is a consolidated group: how to allocate this between the owners and
the NCI’s)
SOCIE:
o How to present each component of equity: each type of contributed equity (e.g. ordinary
shares), retained earnings, each type of OCI (e.g. revaluation surplus) and TCI
o How to present within these components transactions with owners (contributions from
owners to be shown separately from distributions to owners, which must also be
shown as a dividend per share)
o How to present effects of changes in accounting policy and correction of errors
SOCF:
o How to separate cash flows into: operating, investing and financing activities
Notes:
o Compliance with IFRSs (if applicable)
o Basis of preparation and significant accounting policies
o Measurement bases
o Sources of estimation uncertainty
o How the entity manages its capital
o Items included in the other 4 statements that need supporting detail to be disclosed
o Items not included in the other 4 statements that do require disclosure
100 Chapter 3
The Financial Report =

Financial statements + Other statements and reports
Financial statements (must comply with IFRS)

Statement of financial position:
Gives info about: Financial position
Presents: assets, liabilities, equity
Gives info about: Changes in the financial position
Presents: Movement in equity (issued capital and reserves), showing separately the transactions
with owners
Gives info about: Financial performance
Presents: income and expenses = TCI, where TCI is split between:
o P/L and
o OCI
Statement of cash flows
Gives info about: Cash generating ability
Presents: cash movements analysed into: operating, investing and financing activities
Gives info about: line items that are in the other statements but also but items that have not been
recognised in the other statements but may still be relevant information to the users
Other statements and reports
Index
Directors’ report
Audit report
Any other relevant statements
Other information needed to make it understandable

Name of entity
Name of statement or report
Financial statements for the group or the individual entity
Date/ period of report
Presentation currency
Level of precision
Total comprehensive income =

Profit or loss + Other comprehensive income
P/L comprises income less expenses, being those income and expenses that are not OCI.
OCI comprises income and expenses that are not in P/L:
changes in revaluation surplus
remeasurements of defined benefit plans
gains and losses from translating foreign operations
gains and losses on financial assets measured at fair value through OCI
gains and losses on investments in equity instruments designated at fair value through OCI
effective portion of gains and losses on hedging instruments in a cash flow hedge &
gains and losses on hedging instruments that hedge investments in equity instruments measured at
fair value through OCI
for certain liabilities designated as at fair value through profit or loss, the amount of the change in
fair value that is attributable to changes in the liability’s credit risk
if not part of a designated hedging instrument:
- changes in the value of the time value of options;
- changes in the value of the forward elements of forward contracts, and
- changes in the value of the foreign currency basis spread of a financial instrument. IAS 1.7
Chapter 3 101
Gripping GAAP Revenue from contracts with customers
Chapter 4
Revenue from contracts with customers
Reference: IFRS 15 (including any amendments to 10 December 2014)

Contents: Page
1. Introduction 106
1.1 The big change 106
1.2 What are the significant implications? 106
1.3 Who will be affected by the change? 107
1.4 The reasons behind the development of IFRS 15 107
2. Scope 108
3. Income versus revenue 109
4. IFRS 15 in a nutshell 110
4.1 Overview 110
4.2 The 5-step process to recognition and measurement 110
4.3 Recognition 111
4.4 Measurement 112
4.5 Presentation 112
4.5.1 Overview 112
4.5.2 Rights are presented as assets 113
Example 1: Contract asset versus a receivable 114
4.5.3 Obligations are presented as liabilities 115
Example 2: When to recognise a contract liability 116
4.6 Disclosure 117
5. Identifying the contract (Step 1) 117
5.1 Overview 117
5.2 The contract must meet certain criteria 117
5.3 The contract may be deemed not to exist 118
5.4 When the criteria are not met at inception 119
Example 3: Criteria not met an inception 119
5.5 When the criteria are met at inception but are subsequently not met 120
Example 4: Criteria met an inception but subsequently not met 120
5.6 Combining contracts 121
5.7 Modifying contracts 121
5.7.1 What is a contract modification? 121
5.7.2 Accounting for a modification 121
5.7.3 Modification accounted for as a separate contract 121
5.7.4 Modification accounted for as a termination plus creation of a new contract 122
5.7.5 Modification accounted for as part of the existing contract 122
6. Identifying the performance obligation (Step 2) 122
6.1 Performance obligations are promises 122
6.2 Revenue is recognised separately for each performance obligation 123
6.3 Performance obligations could be explicitly stated or be implicit 123
Example 5: Explicit and implicit promises 123
6.4 The promised transfer must be distinct 124
6.4.1 Overview 124
6.4.2 The goods or services must be capable of being distinct 124
6.4.3 The good or service must be distinct in the context of the contract 125
6.5 Bundling indistinct goods or services 125
Example 6: Distinct goods and services 125
102 Chapter 4
Contents continued: Page

7. Determining the transaction price (Step 3) 126
7.1 Overview 126
Example 7: Transaction price and collectability 127
Example 8: Transaction price: collectability versus implied price concession 127
7.2 Variable consideration 128
7.2.1 Overview 128
7.2.2 When is consideration considered to be variable? 129
Example 9: Variable consideration - discounts 129
7.2.3 Estimating the variable consideration 130
Example 10: Estimating variable consideration: 2 methods: continuous 131
Example 11: Estimating variable consideration: 2 methods: discontinuous 132
7.2.4 Constraining the estimate 133
Example 12: Estimating variable consideration – constraining the estimate 133
Example 13: Estimating variable consideration – determining the constraint 134
Example 14: Estimating variable consideration – effect of a constrained estimate
on the transaction price 135
7.2.5 Refund liabilities 136
Example 15: Receipts exceed constrained estimate of variable consideration 137
7.2.6 Specific transactions involving variable consideration 137
7.2.6.1 Overview 137
7.2.6.2 Contracts involving a volume rebate 138
Example 16: Variable consideration – volume rebate 138
7.2.6.3 Contracts involving a sale with a right of return 138
Example 17: Variable consideration – sale with right of return 139
7.2.7 Reassessment of variable consideration 140
7.2.8 Exception to estimating and constraining variable consideration 140
7.3 Significant financing component 141
7.3.1 Overview 141
Example 18: Significant financing component – arrears versus advance 141
Example 19: Significant financing component – arrears journals 142
Example 20: Significant financing component – advance journals 143
7.3.2 When would we adjust for the effects of financing? 143
Example 21: Significant financing component exists – adjust or not 144
7.3.3 How do we decide whether a financing component is significant or not? 146
7.3.4 What discount rate should we use? 147
Example 22: Significant financing component – discount rate 147
7.3.5 How do we present interest from the significant financing component? 148
7.4 Non-cash consideration 148
7.4.1 Overview 148
7.4.2 Whether to include non-cash items in the transaction price 148
7.4.3 How to measure non-cash consideration 149
Example 23: Non-cash consideration 149
7.5 Consideration payable to the customer 150
7.5.1 Overview 150
Worked example 1: Consideration payable is not for distinct goods or services 151
Worked example 2: Consideration payable is for distinct goods or services 151
Worked example 3: Consideration payable is for distinct goods or services but
exceeds their fair value 152
Worked example 4: Consideration payable – coupons for customer’s customers 152
Worked example 5: Consideration payable – coupons for customer’s customers 152
8. Allocating the transaction price to the performance obligations (Step 4) 153
8.1 Overview 153
Chapter 4 103

8.2 Allocating the transaction price based on stand-alone selling prices 153
Example 24: Allocating the transaction price based on estimated stand-alone selling
prices 153
Example 25: Allocating a transaction price based on estimated stand-alone selling prices 155
Example 26: Allocating a transaction price based on estimated stand-alone selling prices
(where one was estimated based on the residual approach) 156
8.3 Allocating a discount 157
8.3.1 Overview 157
8.3.2 Identifying a discount 157
8.3.3 Allocating a discount proportionately to all performance obligations 157
Worked example 6: Identifying a discount and allocating it to the performance
obligations 157
8.3.4 Allocating a discount to one or some of the performance obligations 158
Example 27: Allocating a discount to only one / some performance obligations 158
Example 28: Allocating a discount – the regular discount ≠ contract discount 160
Example 29: Allocating a discount before applying the residual approach 161
8.4 Allocating variable consideration 162
Example 30: Allocating variable consideration to all/some of the performance
obligations 163
Example 31: Allocating variable consideration 164
8.5 Allocating a change in the transaction price to performance obligations 166
9. Satisfying performance obligations (Step 5) 166
9.1 Overview 166
9.2 How do we assess when a performance obligation has been satisfied? 166
9.3 How do we assess when control has passed? 166
9.4 Classifying performance obligations as satisfied over time or at a point in time 166
9.4.1 Overview 166
9.4.2 Performance obligations satisfied over time 166
9.4.2.1 Criterion 1: Does the customer receive the asset and consume its
benefits as the entity performs? 169
Example 32: Classifying performance obligations: the first criterion 170
9.4.2.2 Criterion 2: Does the customer get control as the asset is being created
or enhanced? 170
Example 33: Classifying performance obligations: the second 172
criterion
9.4.2.3 Criterion 3: Does the entity have no alternative use for the asset and an
enforceable right to payment? 173
9.4.2.3.1 No alternative use 174
9.4.2.3.2 Enforceable right to payment 174
Example 34: Classifying performance obligations: the third criterion 175
9.5 Measuring progress of performance obligations satisfied over time 176
9.5.1 Overview 176
9.5.2 Input methods 176
Example 35: Measure of progress – input methods – straight-lining 176
Example 36: Measure of progress – input methods 177
Example 37: Measure of progress – input methods: total cost changes 178
Example 38: Measure of progress – input methods: input does not contribute
to entity’s progress 179
Example 39: Measure of progress – input methods: input is not proportionate
to the entity’s progress 179
9.5.3 Output methods 180
Example 40: Measure of progress – output method: work surveys 180
9.5.4 If a reasonable measure of progress is not available 181
9.5.5 If a reasonable measure of the outcome is not available 181
Example 41: Outcome not reasonably measured 181
104 Chapter 4

9.6 Repurchase agreements 182
9.6.1 Overview 182
9.6.2 Where a repurchase agreement means the customer does not obtain control 182
9.6.3 Where a repurchase agreement means the customer does not obtain control 182
10. Contract costs 183
10.1 Overview 183
10.2 Costs of obtaining a contract 183
Example 42: Costs of obtaining a contract 184
10.3 Costs to fulfil a contract 184
Example 43: Costs of fulfilling a contract 184
10.4 Capitalised costs are amortised 185
10.5 Capitalised costs are tested for impairments 185
11. Specific revenue transactions 186
11.1 Overview 186
11.2 Sale with a warranty 186
Example 44: Sale with a warranty 187
11.3 Sale with a right of return 187
11.4 Transactions involving principal – agent relationship 187
11.4.1 Overview 187
11.4.2 Where the entity is the principal 187
11.4.3 Where the entity is the agent 188
11.5 Sale on consignment 188
Example 45: Sale with a consignment 189
11.6 Sale on a bill-and-hold basis 189
Example 46: Bill-and-hold sale 189
11.7 Customer options for additional goods and services 190
Worked example 7: Customer receives a material right 190
Worked example 8: Customer does not receive a material right 191
Example 47: Option accounted for as a separate performance obligation 191
Example 48: Option involves similar goods or services 192
Example 49: Option involves customer loyalty programme (entity = principal) 193
12. Presentation 194
12.1 Overview 194
12.2 Sample presentation involving revenue 195
13. Disclosure 195
13.1 Overview 195
13.2 Contracts with customers 195
13.2.1 Disclosure of related revenue and impairment losses to be separate: 196
13.2.2 Disclosure of disaggregated revenue: 196
13.2.3 Disclosure relating to contract balances: 196
13.2.4 Disclosure relating to performance obligations: 197
13.2.5 Disclosure of the remaining unsatisfied performance obligations and how much
of the transaction price has been allocated to these 197
13.2.6 Sample disclosure relating to the line-item ‘revenue from customer contracts’ 197
13.3 Significant judgements 198
13.3.1 Judgements (and changes therein) that significantly affect the timing of revenue 198
13.3.2 Judgements (and changes therein) that significantly affect the amount of 198
revenue
13.4 Contract costs recognised as assets 198
13.4.1 Quantitative information 199
13.4.2 Qualitative information 199
14. Summary 200
Chapter 4 105
1. Introduction
1.1 The big change
IFRS 15 Revenue from contracts with customers was released in May 2014. This new
standard replaces the two previous revenue-related standards and their interpretations:
IAS 18 Revenue;
IAS 11 Construction contracts;
All interpretations relating to revenue, including:
IFRIC 13 Customer loyalty programmes;
IFRIC 15 Agreements for the construction of real estate;
IFRIC 18 Transfer of assets from customers; and
SIC 31 Revenue - barter transactions involving advertising services.
Although IFRS 15 was released in May 2014, it is only effective for financial years beginning
on or after 1 January 2017....although it may be applied earlier than this date if preferred.
This may seem a good way off, but irrespective of whether or not we choose to apply IFRS 15
at an earlier date than is required... or wait until we absolutely have to, we actually need to
understand the implications of IFRS 15 earlier rather than later. Why? Because we are going
to have to apply it retrospectively (accounting for it as a change in accounting policy).
Applying a new standard retrospectively means that we will need to apply it as if it had
always been in existence. This means that entities will need to restate their comparative
figures – and for entities to be able to do this means:
they will have to collect all the relevant prior years’ historic data; and then,
using this data, they will need to recalculate the revenue that would have been recognised
had IFRS 15 always applied (instead of IAS 18 and IAS 11); and then
they will need to be ready to process the necessary journals so that the revenue recognised
in their trial balances to date is changed:
from the ‘revenue recognised and measured in accordance with IAS 18 and IAS 11’
to the ‘revenue recognised and measured in accordance with IFRS 15’.
With such a difficult and time consuming undertaking facing all accountants, it makes sense,
from a practical point of view, for businesses to urgently start preparing their systems to be
able to collect the necessary data in order to be able to restate their prior year figures so as to
comply with IFRS 15. To do this, the accountant needs to understand IFRS 15....now.
1.2 What are the significant implications?
There are many implications arising from the new IFRS 15. These implications include
changes to how we decide when to recognise revenue, how we measure it, how we present
revenue-related transactions and balances in the financial statements and also include far more
onerous disclosure requirements. Whether or not the changes will have a significant effect on
an entity’s revenue will depend largely on what industry it operates within. The following are
thus simply a list of some of the significant changes, from a purely academic point of view.
Previously, revenue from construction contracts was covered in a separate standard,

IAS 11 Construction contracts, and was thus accounted for using different principles to the
principles that applied to revenue from other sources, such as sales.
With the introduction of IFRS 15, this situation has changed with revenue from construction
contracts and revenue from other sources all covered by this same standard. Thus revenue
from construction contracts will be accounted for in the same way as all other revenue (e.g.
revenue from sales).
106 Chapter 4
Another significant change is that revenue was recognised when the ‘risks and rewards’
transferred to the customer. This has fallen away and been replaced by the concept of
‘control’. In other words, revenue is recognised when ‘control’ has passed to the customer.
The previous standards on revenue provided little guidance as to when to recognise the
revenue and how to measure it when a contract involved more than one task. IFRS 15, on the
other hand, deals with this situation. IFRS 15 refers to these tasks as performance obligations,
and requires us to first ‘unpack’ a contract into the separate performance obligations that are
considered to be ‘distinct’, and then allocate the transaction price to each of these
performance obligations that are considered to be ‘distinct’. This new clarification may have a
significant impact on certain industries such as:
the construction industry, where a contract for the construction of a building may involve
multiple obligations, such as the supply of various materials as well as the completion of
a number of tasks (e.g. building walls, adding a roof, installing plumbing etc); and
the telecommunications industry, where for example, a cell phone contract may involve
the supply of the phone and also the supply of airtime. .
Another issue is that IFRS 15 now clarifies how we should account for the time value of
money. IFRS 15 clarifies that when accounting for the time value of money, we may need to
recognise interest, not only on the entity’s receivables but also on amounts it has received in
advance. In other words, whereas a receivable may lead to the recognition of interest income,
amounts received in advance may lead to the recognition of interest expense. However, the
time value of money may be ignored if, at contract inception we expect the period between
the receipt of payments and transfer of goods to be one year or less.
IFRS 15 does not only help us to account for revenue – it also helps us to account for related
costs. The effect of the IFRS 15 is that the decision to capitalise contracts costs will be
reached more often than under the previous standards of IAS 18 and IAS 11.
1.3 Who will be affected by the change?
The switch from IAS 18 and IAS 11 (together with their interpretations) to IFRS 15 will
affect some industries more than others.
If an entity simply sells individual items, the revenue recognised under the new IFRS 15 will
probably not differ much, or at all. However, due to the changes in how revenue is recognised
(i.e. which will affect the timing of the revenue recognition) and how revenue is measured
(i.e. which will affect how much should be recognised), entities that, for example, combine
sales and services into what is often called a ‘bundled contract’ (e.g. those that operate in
industries such as construction, real estate or telecommunications), may have significant
differences in how they account for their revenue. However, even if the recognition and
measurement changes will not affect our particular industry much, we are certainly all going
to be affected by the increased disclosure requirements.
1.4 The reasons behind the development of IFRS 15
The International Accounting Standards Board (IASB) and the US Financial Accounting
Standards Board (US FASB) accounted for revenue differently and, since revenue is possibly
the single-most important line-item in a set of financial statements from the perspective of
many users, this was a big problem. Thus, the topic of revenue has been one of the main
hurdles to achieving convergence between the IASB and the FASB and the ultimate goal of
having a single set of international accounting standards.
To add to the differences between how the IASB and FASB accounted for revenue, there
were also problems in both the IASB’s revenue-related standards (IAS 18 and IAS 11) and
the FASB’s revenue-related standards (ASC 605).
Chapter 4 107
These problems are summarised as follows:

The IASB’s revenue-related standards were considered highly principles-based – which is
normally something that is prized by the IASB, but they were considered so principles-
based that they were accused of being vague. This vagueness often forced businesses to
apply their judgment (for better or worse) to their own particular set of circumstances.
To be fair to those who had to apply their professional judgement to the recognition and
measurement of revenue, there are so many different and complex contracts ‘out there’,
that there were many equally understandable and defendable judgements that could have
applied, and thus there were an astounding array of answers as to what an entity’s revenue
line-item could or should have been. This means that businesses that applied IFRSs were
often forced to use a smorgasbord of self-styled principles and policies that made it
impossible to compare their results with another entity’s results.
The FASB’s revenue-related standards, on the other hand, involved reams of rules.
Whilst having these rules made compliance relatively straight-forward for most industries
and for certain specific transactions, there were still certain situations where entities had
drafted contracts for which there was no suitable rule. So businesses that applied the
FASB’s standards had the same problem of being forced to create one’s own policy, thus
making it impossible to compare their results with another entity’s results.
A further problem was that there were many who argued that certain of the rules that did
exist were too complex and that some rules contradicted other rules.
As a result of the problems with both the IASB’s and FASB’s previous revenue standards,
and in the interests of convergence, IFRS 15 was developed as a joint initiative between the
IASB and the FASB. The release of IFRS 15 is certainly a significant milestone towards
achieving that, still elusive, global GAAP.
2. Scope
As its name suggests, IFRS 15 only deals with contracts

and where these contracts involve customers. Both these A contract is defined as:
terms are defined in IFRS 15:
An agreement between two or
A contract is an agreement that results in the parties to more parties
the agreement having rights and obligations that are that creates enforceable rights
enforceable. Now, this contract need not actually be in and obligations. IFRS 15 Appendix A
writing – it can be verbal or simply implied by the way
in which the entity normally conducts its business. What is of importance is that it is
enforceable by law.
A customer is defined
A customer is simply a party (e.g. a person) who has as:
come to an agreement with the entity, promising to give a party that has contracted with
some form of consideration (e.g. cash) in exchange for an entity
goods or services (e.g. widgets) that the entity promises to obtain goods or services
to provide as part of its ordinary activities. Thus, a that are an output of the entity’s
party that agrees to pay the entity for goods or services ordinary activities
that are not part of the entity’s ordinary activities, in exchange for consideration.
would not be a customer. Thus this contract would not IFRS 15 Appendix A
be accounted for under IFRS 15.

Another issue is that IFRS 15 is not the only standard dealing with revenue. Although
IFRS 15 will no doubt apply to most contracts with customers, some contracts are not covered
by IFRS 15.
The contracts that are excluded from IFRS 15 are contracts to which other standards apply. In
other words, we first decide whether other standards would apply to the contract: if other
standards apply, then IFRS 15 will not apply; but if no other standards apply, then IFRS 15
will apply.
108 Chapter 4
For example, lease contracts, insurance contracts and

financial instruments are scoped out of IFRS 15 if the IFRS 15 does not apply
standards normally relevant to these types of contracts are to:
found to apply (e.g. IAS 17 Leases; IFRS 4 Insurance contracts that do not involve
contracts and IFRS 9 Financial instruments). customers as defined
contracts that are covered by
A further scope exclusion is a contract that represents the other standards
exchange of non-monetary items between entities that are - lease contracts under IAS 17
involved in the same type of business and where the - insurance contracts under IFRS 4
contract was entered into in order to assist each other to - financial instruments and ‘other
secure sales to existing or possible future customers. contractual rights or obligations’
under IFRS 9, IFRS 10, IFRS 11,
IAS 27 or IAS 28
For example, IFRS 15 will not apply to a contract that is
exchanges of non-monetary items
entered into between entity A and entity B if A and B are between entities in the same line
both milk distribution companies, perhaps each operating of business to facilitate sales to
in different areas, if the contract is simply an agreement customers or potential customers.
See IFRS 15.5-6
to provide each other with milk in the event that one
entity has a surplus and the other entity a shortage.
3. Income versus revenue
The Conceptual Framework defines ‘income’ but IFRS 15 refers to ‘revenue’ – or more
specifically, ‘revenue from contracts with customers’. The term ‘income’ includes ‘revenue’
but it also includes other forms of income, some of which are commonly referred to as gains.
As mentioned already, IFRS 15 is not the only standard that may lead to revenue. In fact,
although it will invariably be the standard to apply in most cases, it is only applied as the ‘last
resort’. In other words, it only applies to revenue arising from contracts with customers if
certain other specified standards do not apply (e.g. IAS 17 Leases).
Income
(Conceptual Framework)
Revenue from contracts with customers Other revenue and

Income that is not revenue (e.g. gains)
(covered by IFRS 15) (not covered in IFRS 15)
It is important for us to realise that there is a difference between revenue from contracts with
customers (i.e. the revenue that falls under IFRS 15) and revenue from other sources (i.e. the
revenue that does not fall under IFRS 15) because revenue from contracts with customers
must be disclosed separately from other revenue sources. See IFRS 15.113(a)
Income is defined as Revenue is defined as
increases in economic benefits income

during the accounting period arising in the course of
in the form of an entity’s ordinary activities. IFRS 15.Appendix A
a) inflows, or
b) enhancements of assets, or
c) decreases of liabilities
that result in increases in equity,
other than those relating to contributions
CF 4.25
from equity participants.
As you can see, income can arise from any kind of activity but revenue is an income earned
exclusively through ordinary activities. This means, for example, that where an entity’s
normal business does not normally involve selling its items of property, plant and equipment,
a profit on sale of an item of property, plant and equipment would be income but it would not
qualify as revenue.
Chapter 4 109
On the other hand, if an entity’s main business regularly involves selling items of property,
plant and equipment, income from these sales would be recognised as revenue. Similarly,
banks charge interest on loans, this being one of its core business activities, and thus the
interest earned by a bank would be presented as revenue whereas the interest earned by a
manufacturing entity that occasionally charges interest on overdue accounts would simply be
presented as income (it may not meet the definition of revenue). See IFRS 15.BC247
4. IFRS 15 in a nutshell
4.1 Overview
Under the previous standard, IAS 18 Revenue, the general principles were that we would:
recognise revenue if it met the fairly complex definition of revenue and met the
recognition criteria provided in the Conceptual Framework; and
measure revenue at the fair value of the consideration.
This previous standard, IAS 18, was structured in a way that then expanded on these general
recognition and measurement principles, explaining how these principles would apply to the
five different main forms of revenue: sales, services, interest, royalties and dividends. In other
words, each of these different types of revenue had their own specific recognition and
measurement issues to consider.
The new IFRS 15 no longer has different principles for different forms of revenue. Instead, it
provides us with a five-step approach to recognising and measuring all types of revenue that
are covered by the standard.
4.2 The 5-step process to recognition and measurement
The 5-step process is the process followed when recognising and measuring revenue. These
steps are inter-related. This means that the process of considering step 3, for example, may
require us to simultaneously consider step 5, or vice versa.
Step 1 Step 2 Step 3 Step 4 Step 5

Identify the Identify the Determine the Allocate the Recognise
contract/s with performance transaction transaction revenue when/
a customer obligations in price price to the as the entity
the contract performance satisfies a
obligations in performance
the contract obligation
Recognition Recognition Measurement Measurement Recognition
IFRS 15 provides guidance to help us determine if and when each of these five steps dealing
with recognition and measurement have been completed.
We will look at each of these five steps in more detail under sections 5 to 9. But first, let us
take a ‘bird’s eye view’ of the recognition, measurement and presentation/ disclosure
requirements contained in IFRS 15.
Revenue is recognised
4.3 Recognition (IFRS 15.9 - .45) when:
we have identified the contract

When deciding if and when to recognise revenue (i.e. if and (step 1);
when to process a journal for revenue), we consider we have identified the
IFRS 15’s step 1, step 2 and step 5. This essentially means performance obligations (step 2);
that revenue should be recognised when we have a legally and
enforceable contract, we can identify our obligations in this the performance obligations are
contract and can also identify as and when we have satisfied (step 5).
See IFRS 15.9; 15.22 & 15.31
satisfied these obligations.
110 Chapter 4
The three steps involved in deciding if and when to recognise revenue are as follows:
We must be able to identify a contract with a customer:

(IFRS 15 describes this as step 1):
The contract need not be in writing or even be verbal – it can simply be implied. What is
of importance is that it is enforceable by law.
We must be able to identify the performance obligations in this contract:

Contracts may include a commitment to provide a variety of goods or a variety of services
or a combination thereof.
Revenue will need to be recognised separately for each good, service, bundle of goods
and/or services and each series of goods or services that is considered to be ‘distinct’.
The goods and services (whether provided individually or in bundles), or a series thereof,
that are considered distinct are called performance obligations.
For a good or service, or bundle of goods or services, to be considered distinct, it must be:
capable of being distinct – which means the good For a good or service
or service must be able to benefit the customer, to be distinct, it must
whether this can be achieved on its own or by be:
combining it with other resources that are capable of being be distinct:
available to the customer (either because they are - can benefit the customer; &
owned by the customer or are simply readily distinct in context of the contract:
available on the market); and - it is separately identifiable from
other G/S in the contract.
distinct in the context of the contract – which See IFRS 15.27
means that the promise to transfer the good or

service must be able to be separately identifiable from the other promises within the
contract (e.g. a contract that promises a fridge motor and a fridge body where the
fridge motor can only be used with that specific fridge body and the fridge body
cannot be used without the fridge motor are considered to be promises that are so
highly inter-related that they would not be separately identifiable).
The concept of ‘distinct’ is explained in more detail in section 6.4.
We must be able to identify when the performance obligations are satisfied:

This step is very important because the related revenue
Note this change!
must be recognised as and when the entity completes its
performance obligations.
The previous IAS 18 required that
The entity is considered to have satisfied its obligations the risks & rewards transferred
when it has transferred the goods and/ or services to the to the customer before revenue
customer in a way that gives the customer control over could be recognised.
the goods and/ or services. This could happen at a point This new IFRS 15 requires that
in time (instantly) or over a period of time (gradually). control passes to the customer
before revenue is recognised.
Please note that, although this step is described in The transfer of risks and rewards is
IFRS 15 as step 5, it is essentially the third and final now just one of the factors that may
step in deciding when to recognise revenue. suggest that control has passed.
This is one of the critical changes
included in the new IFRS 15.
If after considering these steps we decide that revenue must
be recognised, it means we will need to process a journal entry. In order to process a journal
entry, we will obviously need to know the amount of the journal. This is referred to as
measurement (see section 4.4).
Chapter 4 111
4.4 Measurement (IFRS 15.46 - .90)

Revenue is measured:
When deciding on the measurement of revenue (i.e. how
much the revenue journal should be), we consider based on the transaction price;
IFRS 15’s step 3 and step 4. which must then be
allocated to each performance
Essentially, revenue is measured by first deciding the obligation based on the relative
transaction price, being the total amount we expect to be stand-alone selling prices of the
underlying goods or services.
entitled to, and then allocating this to each of our See IFRS 15.73 - .90
performance obligations.
The two steps to apply when measuring revenue are the following:
Determine the transaction price:

The transaction price is the amount of consideration that the entity expects to be entitled
to for the transfer of the goods and / or services to the customer.
The transaction price must exclude any amounts that the entity will be collecting on
behalf of a third party (e.g. the transaction price would not include VAT since this would
be an amount collected on behalf of, and thus owed to, the tax authorities).
Allocate the transaction price to each performance obligation:

If the contract involves only one single performance obligation, the contract’s entire
transaction price will obviously apply to that single obligation.
However, if a contract involves more than one performance obligation, the transaction
price will need to be allocated to each separate obligation. The reason we take the trouble
to allocate the transaction price to each of the performance obligations is because revenue
is recognised separately for each separate obligation as and when that performance
obligation is satisfied (i.e. completed).
The allocation of the transaction price to each performance obligation is done in

proportion to the stand-alone transaction prices of the ‘distinct’ goods or services that
makes up each obligation.
The portion of the transaction price that is allocated to a performance obligation is only
recognised as revenue once that obligation has been satisfied (i.e. completed). With this in
mind, we need to understand that some performance obligations are satisfied:
at a point in time (i.e. in an instant); and others are satisfied
over time (i.e. gradually).
If the performance obligation will be completed in an instant (i.e. at a point in time) the
related revenue will be recognised in an instant. If it will be completed gradually (i.e. over
time), the revenue from this obligation will also be recognised gradually.
When recognising revenue over time, the amount of revenue to be recognised will need to
be measured based on the progress towards complete satisfaction. This progress is
measured using either an input method or an output method.
4.5 Presentation (IAS 1.81 and IFRS 15.105 - .109)
4.5.1 Overview
Revenue must be presented as a line-item in the statement of comprehensive income (as part
of profit or loss). See IAS 1.81
112 Chapter 4
In addition to the presentation in the statement of comprehensive income, revenue also affects
the presentation of our financial position (SOFP). In this regard, a customer contract may lead
to the presentation in our statement of financial position (SOFP) of the following line-items:
a contract asset or contract liability; and/or
a receivable (receivables are to be presented separately from contract assets).
Assets = our rights Liabilities = our obligations
A contract asset is defined as: A contract liability is defined as:
an entity’s right to consideration an entity’s obligation to transfer goods or
in exchange for goods or services that the services to a customer
entity has transferred to a customer for which:
when that right is conditioned on something - the entity has received consideration
other than the passage of time from the customer; or
(e.g. the entity’s future performance). - the amount of consideration is due.
IFRS 15 App A IFRS 15 App A (slightly reworded)
A receivable is defined as:

an entity’s right to consideration
that is unconditional. IFRS 15.108 (extract)
A right to consideration is unconditional if:

all we have to do is wait for time to pass
before payment thereof falls due.
See IFRS 15.108 (reworded)
Now, in order to understand the use of these line-items, we need to understand that when we
enter into a contract with a customer, we accept certain rights and certain obligations:
the right to receive the promised consideration; and
the obligation to transfer promised goods or services to the customer (i.e. the obligation to
satisfy certain specified performance obligations – in other words, to complete them).
The relationship between these rights and obligations will determine whether we have:
a contract asset: if our remaining rights are greater than our remaining obligations; or
a contract liability: if our remaining rights are less than our remaining obligations.
See IFRS 15.BC18
When we calculate the amount to reflect as a contract asset, we must be sure to subtract the
amounts to be reflected as a receivable. In other words, our contract asset must not include
our unconditional rights.
Rights are assets:
4.5.2 Rights are presented as assets (IFRS 15.107-.108) A contract asset is a:
conditional right
As mentioned above, an entity’s right to consideration is
recognised as an asset. However, as we can see, there are A receivable is an:
two types of assets: a contract asset and a receivable. unconditional right.
* The need to simply wait for time
When recognising revenue (a credit entry) that is received to pass is not considered to be a
in cash, the asset we would recognise is cash in bank (a condition. See IFRS 15.107-.108
debit entry).
However, if the revenue is not received in cash, we would need to decide whether to debit the
contract asset or the receivable asset.
Deciding which asset to debit depends on whether the right is conditional or not. If the
entity’s right to consideration:
is conditional upon something happening, other than the passing of time* (e.g. conditional
upon the future performance of the entity), then we debit the contract asset;
is unconditional (i.e. there are no conditions other than the possible requirement to simply
wait for the passing of time*), then we debit the receivable.
* Note: a condition that requires us to simply wait for the passage of time is not considered to
be a condition for purposes of IFRS 15.
Chapter 4 113
In other words, a receivable represents a right that is unconditional (i.e. at most, all we have
to do is wait for time to pass) whereas a contract asset represents a right that is conditional.
Example 1: Contract asset versus a receivable Adaptation of IFRS 15.IE38 & 39

Home Fires signed a contract with Deluxe Renovations (the customer) on 1 March 20X2,
the terms of which included the following:
Home Fires would supply and install a designer fireplace on 1 April 20X2 after which
it would be required to supply and install a fire-door.
Deluxe Renovations (the customer) promised consideration of C20 000, payable one
month after both the fireplace and the door have been supplied and installed.
The contract is cancellable in the event of non-performance.
The stand-alone selling prices for the supplied and fitted products are as follows:
fireplace: C15 000; and
fire-door: C5 000.
Home Fires supplies and installs the fireplace on 1 April 20X2 and supplies and installs the door on
5 May 20X2. The customer obtains control of each product on the date of its installation.
The customer pays the promised consideration on 25 July 20X2.
Required:
Prepare all journals for the information given, using the general journal of Home Fires.
Solution 1 : Contract asset versus a receivable

Comment:
This example shows when the recognition of revenue:
- requires a debit to a contract asset (i.e. when the right to the consideration is conditional) and
- requires a debit to a receivable (i.e. when the right to the consideration is unconditional)
This example also shows the transfer of a contract asset to a receivable when a conditional right to
consideration becomes an unconditional right.
This contract involves the supply and fitment of a fireplace and the supply and fitment of a door,
which are clearly distinct from one another.
Thus we conclude that the contract has two performance obligations (POs): to supply and install both
a fireplace and a door.
Journal on 1 April 20X2:
When the fireplace is installed (1 April 20X2), the entity (Home Fires) has performed one of its POs
and thus the consideration relating to this PO must be recognised as revenue.
However, this consideration is not yet unconditionally receivable: because Home Fires must supply
and fit both a fireplace and a door and the contract is cancellable if this does not happen, this amount
will only become unconditionally receivable when the second PO is satisfied.
Thus, we may not yet debit the receivable and must therefore debit the contract asset instead.
Journals on 5 May 20X2:
When the door is installed (5 May 20X2), the entity has performed its second PO and thus the
consideration relating to this PO must be recognised as revenue.
At this point, the consideration from both POs becomes unconditionally receivable (only the passage
of time remains to the due date of 5 June 20X2, calculated as one month from the satisfaction of the
last PO) and thus all consideration receivable must be debited to the receivable account.
Journal on 25 July 20X2: The receipt of cash is recorded. Please note that the date on which the
customer was meant to have paid was 5 June 20X2, in terms of the contract (being 1 month after both
POs were satisfied). However, this date is of no relevance to our journals.
114 Chapter 4
1 April 20X2 Debit Credit

Contract asset (A) Given 15 000
Revenue from customer contract (I) 15 000
Recognising revenue on supply & installation of fireplace (satisfaction of
PO #1), recognised as a contract asset since the right to the
consideration is not yet unconditional (we still need to satisfy PO#2)
5 May 20X2
Accounts receivable (A) Given 5 000
Recognising revenue on supply & installation of fire-door (satisfaction of
PO #2), recognised as a receivable since the right to this consideration is
unconditional (we have satisfied both POs)
Contract asset (A) 15 000
Transferring the contract asset to the receivable asset since the right to
the consideration for PO#1 is now unconditional (both POs are satisfied)
25 July 20X2
Bank Given 20 000
Accounts receivable (A) 20 000
Receipt of payment from customer (also referred to as consideration)
4.5.3 Obligations are presented as liabilities (IFRS 15.106)
If we have not yet satisfied our performance obligations, we obviously cannot recognise
revenue (see step 5). However, although we may not yet recognise revenue, we may need to
recognise a contract liability instead (i.e. credit contract liability), if we (the entity) either:
have already received the consideration from the customer (i.e. we have debited bank but
cannot yet credit revenue since the performance obligation has not yet been satisfied); or
have an unconditional right to this consideration (i.e. we have debited accounts receivable
but cannot yet credit revenue since the performance obligation has not yet been satisfied).
This contract liability is recognised when the entity either receives the consideration or
obtains the unconditional right to this consideration, whichever happens first.
Thus, a contract liability reflects our obligation to either return any amounts received to our
customer, or to satisfy our performance obligations (i.e. do what we promised to do).
Normally, an unconditional right to consideration arises only when we have satisfied our
performance obligations (see previous example where we were only able to recognise a
receivable once both performance obligations were satisfied). However, an unconditional
right to consideration can arise before we have satisfied our performance obligations (i.e.
before we are able to recognise revenue). This happens if, for example, the contract is non-
cancellable. If we sign a non-cancellable contract, the date on which our customer is required
to make payment is the date on which we obtain an unconditional right to the consideration,
even if we have not performed our obligations.
The following example shows us that, if we have not yet satisfied our performance
obligations, we will need to recognise a contract liability (i.e. we credit the contract liability
instead of revenue), if we have either had to recognise a receipt of consideration (debit the
bank account) or had to recognise an unconditional right to consideration (debit the
receivables account), whichever happened first.
The due date for payment in a contract is normally irrelevant when accounting for revenue
from contracts with customers. However, the date is very important if the contract is non-
cancellable, because it becomes the date on which the entity obtains an unconditional right to
receive the consideration.
Chapter 4 115
Example 2: When to recognise a contract liability

Home Fires signed a contract with Deluxe Renovations on 1 March 20X2, the terms of
which included the following:
Home Fires agreed to supply and install a designer fireplace before 30 May 20X2.
Deluxe Renovations agreed to pay C15 000 in advance, on 1 April 20X2.
Home Fires installed the fireplace on 10 May 20X2, on which date the customer obtained control.
The customer paid the promised consideration on 30 April 20X2 (i.e. in advance of the installation but
after the due date).
Required: Prepare all journals relating to the information presented above in the general journal of
Home Fires assuming that:
a) the contract is non-cancellable.
Adaptation of IFRS 15.IE38 & 39
b) the contract is cancellable in the event of non-performance.
Solution 2: When to recognise a contract liability

Comment in general:
In both (a) and (b) of the example, the due date for receipt of the consideration (1 April) occurs before
the cash is received (30 April). However:
In part (a), the contract is non-cancellable and thus the due date (1 April) is the date on which the
entity obtains an unconditional right to consideration. Since the unconditional right arises before
the cash is received (30 April), we need to debit the receivables account before we get to debit
bank. At this point, on 1 April, because we have not satisfied our performance obligations, we
cannot credit revenue and thus we will need to recognise the contract liability.
Debit accounts receivable and Credit contract liability.
In part (b), the contract is cancellable and thus the due date does not lead to the entity having an
unconditional right to consideration before the performance obligations are satisfied (i.e. the due
date is irrelevant to our journals). Thus the contract liability is simply recognised when the cash is
received (because the performance obligations have not been satisfied by this date).
Debit bank and Credit contract liability.
Solution 2A: Contract liability – recognised when recognising the receivable

Comment on Part A:
Since the contract is non-cancellable, Home Fires obtains an unconditional right to consideration on
1 April 20X2, being the due date for payment stipulated in the contract (this date occurs before the
cash was received). An unconditional right to consideration must be recognised as a receivable.
Since the installation had not yet occurred on this date (1 April), the debit to the receivable account
will require a contra entry of a credit to the contract liability account (i.e. showing that the entity still
needs to perform i.e. its obligation to perform) and not a credit to the revenue account.
On the date that the fireplace is installed (10 May), the contract liability is reversed and recognised as
revenue instead (because the PO has been satisfied).
Contract liability (L) 15 000
Recognising the unconditional right to receive consideration (the
receivable) and the obligation to install the fireplace (contract liability)
30 April 20X2
Bank (A) Given 15 000
Recognising the receipt of cash as a decrease to the related receivable
(the unconditional right to receive consideration no longer exists)
10 May 20X2
Contract liability (L) Given 15 000
Reversing the contract liability and recognising it as revenue instead
since the PO is now satisfied.
116 Chapter 4
Solution 2B: Contract liability – recognised when recognising the receipt

Comment:
Notice that this solution does not process a journal entry on 1 April. This is because, since the
contract is cancellable, the due date for payment stipulated in the contract (1 April) does not give
Home Fires an unconditional right to consideration. Thus we do not recognise a receivable.
In other words, the due date is irrelevant.
We wait for the receipt of the consideration before processing our first journal. The receipt occurs on
30 April. Since the installation had not yet occurred on this date, the debit to the bank account will
require a contra entry of a credit to the contract liability account (i.e. reflecting the fact that the entity
still needs to perform) and not a credit to the revenue account.
On the date that the fireplace is installed (10 May), the contract liability is reversed and recognised as
revenue instead (because the PO has been satisfied).
Recognising the receipt of cash and the obligation to install the fireplace
(contract liability)
10 May 20X2
Contract liability (L) Given 15 000
Reversing the contract liability and recognising it as revenue instead
since the PO is now satisfied.
4.6 Disclosure (IFRS 15.110 - .129)

IFRS 15 includes copious disclosure requirements. The disclosure requirements are
summarised in section 13. The basic requirement is that there must be enough disclosure that
a user of the financial statements can assess the ‘nature, amount, timing and uncertainty’ of
both the revenue and the cash flows that stem from the entity’s customer contracts. See IFRS 15.110
IFRS 15 contains significant changes in disclosure requirements from IAS 18:

One of the significant changes is that the previous IAS 18 used to require that revenue be
disclosed based on the categories of sales, services, interest, royalties or dividends.
Now revenue may be disclosed based on a variety of categories (e.g. revenue from different
geographical areas, revenue from different products, revenue from long-term contracts versus short-
term contracts, revenue from shop sales versus from online sales - as well as sales, services etc).
5. Identifying the contract (step 1)
5.1 Overview (IFRS 15.10)
IFRS 15 only applies if it involves a contract with a customer. However, this contract need
not be in writing nor does it even need to be verbal. Instead, it could simply be implied by
virtue of the entity’s common business practice. What is important is that the rights and
obligations contained in the contract are enforceable by law. See IFRS 15.10
5.2 The contract must meet certain criteria (IFRS 15.9)
A contract is said to exist if it meets all of the following five criteria:

a) If it is approved by all parties who are also committed to fulfilling their obligations;
b) If each party’s rights to the goods and/or services are identifiable;
c) If the payment terms are identifiable;
d) If the contract has commercial substance; and
e) It is probable that the entity will collect the consideration to which it expects to be
entitled. See IFRS 15.9
A contract will not exist if any one of the above five criteria are not met.
Chapter 4 117
These criteria make it clear that the contract must specify the rights and obligations. What is
important is that these rights and obligations are legally Please note:
enforceable. As already mentioned, to be legally Even if all criteria are
enforceable does not require that the contract be in writing. met, the contract may
still be deemed not to
Depending on where you are in the world (i.e. which exist (see section 5.3).
geographical area you are doing business in), contracts can
be considered legally binding if they are verbal or could even be considered legally binding
based purely on the entity’s ‘customary business practices’. It is not only which geographical
area in which you are doing business that may affect whether or not an agreement is legally
binding....it is feasible for contracts within the same entity to take different forms depending
on which customer it is dealing with. For example, an entity may insist on written contracts
with certain customers but may be happy to accept a handshake when contracting with other
long-standing customers. Thus, when deciding whether an entity has entered into a legally
enforceable contract, we must consider that entity’s ‘practices and processes’. See IFRS 15.10
Goods and services promised in a contract are generally easily identifiable. However, some
contracts have no fixed duration: they could be terminated at any time or can be renewed
continuously (e.g. a contract to provide electricity to a customer on a monthly basis) or even
automatically on certain dates (e.g. a cell phone contract to provide air-time to a customer for
two year periods and which automatically renews at the end of the two years). In such cases,
we simply account for the rights and obligations that are presently enforceable (e.g. the
obligation to provide electricity for a month or the promise to provide air-time for two years).
The payment terms refer to both the amount of consideration and the timing of the payments.
A contract will have commercial substance if it is expected that the contract will change the
risk, timing or amount of the entity’s future cash flows. In other words, we would calculate
the present value of the future cash flows from the contract. A present value calculation takes
into account the cash flows (amount), the effects of the when payments will occur (timing)
and uses a discount rate that reflects the related risks (risk). See IFRS 15.9(d)
When considering whether it is probable that the entity will collect the consideration, we only
consider the customer’s ability to pay and intention to pay when payment falls due. In other
words, a customer may currently not have the ability to pay but may be expected to have the
ability to pay when payment falls due.
It is also important to note that the consideration we are referring to is the consideration that
we expect to be entitled to – this may not necessarily be the price quoted in the contract. For
example, a contract could quote a price of C100 000 but if we offer a volume discount of
C10 000 to the customer on condition that he buys further goods within the month, and if we
expect that he will buy further goods within the month, then we only need to consider whether
the customer has the ability and intention to pay C90 000.
5.3 The contract may be deemed not to exist (IFRS 15.12)
A contract will not exist if any one of the above five criteria Contracts are deemed
are not met (see section 5.2). However, even if all criteria not to exist if:
are met, the contract will be deemed not to exist if: all parties are equally entitled to
each and every party to the contract terminate a contract that is wholly
has a ‘unilateral enforceable right to terminate’ unperformed, without compensating
a ‘wholly unperformed contract’, the others.
without providing any compensation to the other A wholly unperformed contract is
party/ies. one where the entity:
has not yet done anything
A wholly unperformed contract is a contract where the has not yet been paid; and
entity has not yet transferred any of the promised goods or is not yet owed anything. See IFRS 15.12
services, has not yet received any consideration and is not
yet entitled to any consideration.
118 Chapter 4
5.4 When the criteria are not met at inception (IFRS 15.14-.16)
It can happen that a contract does not meet these five criteria at inception. If this happens, the
entity must continually re-examine the contract in the light of changing circumstances in
order to establish whether these criteria are subsequently met. See IFRS 15.14
While these criteria are not met, any consideration received by the entity may obviously not
be recognised as revenue because, technically, we do not have a contract. Thus, any amounts
received must be recognised as a liability. The reasoning behind recognising amounts
received as a liability is that it represents the entity’s obligation to either:
provide the goods or services that it has promised to provide; or
refund the amounts received. See IFRS 15.15-16 If criteria are not
met, receipts must be
The liability is simply measured at the amount of the recognised as a liability.
consideration received. See IFRS 15.16 The liability is
transferred to revenue when
the:
These receipts that are recognised as a liability will either
be recognised as revenue (i.e. debit liability and credit 5 criteria are eventually met;
revenue) or will be refunded (i.e. debit liability and credit entity has no further
obligations and the receipts
bank). However, the entity may not recognise the contract are non-refundable; or the
liability as revenue until: contract is terminated and the
all five criteria (in para 9) are subsequently met; or receipts are non-refundable
it has no further obligations in terms of the contract ‘and all, or substantially all,’ of the
promised consideration has been received and is non-refundable; or
the contract is terminated and the consideration received is non-refundable. See IFRS 15.15-16
Example 3: Criteria not met an inception

On 5 November, a customer requested Publications Limited to print a large quantity of
magazines. The customer is not yet able to identify exactly how many magazines will need
to be printed but insists that they will have to be printed during December.
Publications agreed to these terms but, since December is an exceedingly busy month for the printers, it
requires the customer to pay a C5 000 deposit to secure this printing time.
This deposit will be set-off against the contract price but is non-refundable in the event that the contract
is cancelled. The deposit was paid on 12 November. The contract was cancelled on 28 November.
Required: Explain how this contract should be accounted for.
Solution 3: Criteria not met an inception

A contract was entered into on 5 November. However, since the customer is unable to confirm how
many magazines will need to be printed, the rights and obligations cannot yet be identified. Thus at
least one of the 5 criteria to support the existence of a contract is not met. All 5 criteria must be met and
thus we conclude that a contract for purposes of IFRS 15 does not exist.
During the period that all criteria for a contract to exist are not met, any receipts must be recognised as
a liability. Thus the deposit on 12 November must be recognised as a liability. This liability is then
recognised as revenue on 28 November since the contract is terminated and the deposit was non-
refundable. Thus the receipt and forfeiture of the deposit are journalised as follows:
12 November Debit Credit
Refund liability (L) 5 000
Recording the receipt of a non-refundable deposit
28 November
Refund liability (L) Given 5 000
Revenue (I) 5 000
Recognising the non-refundable deposit as revenue
Chapter 4 119
5.5 When the criteria are met at inception but are subsequently not met (IFRS 15.13)
Conversely, a contract that does meet the criteria at inception may subsequently be found to
no longer meet these criteria. For example, a customer may subsequently experience cash
flow problems with the result that the entity may need to reconsider whether it is still probable
that the promised consideration will be received.
Unlike the situation when the contract does not meet the criteria at inception, if a contract
does meet the criteria at inception, we are not required to continually reassess whether the
criteria continue to be met. We only need to reassess the situation when there is a ‘significant
change in facts and circumstances’ (e.g. if we become aware that one of our customers is
experiencing significant cash flow problems).
If a reassessment of the facts and circumstances leads us to believe, for example, that it is no
longer probable that that we will receive payment from the customer, it means that the criteria
for the existence of a contract are no longer met. In other words, in terms of IFRS 15, we have
no contract.
Since revenue from contracts with customers may only be recognised if a contract exists, we
must immediately stop recognising revenue from this contract. Furthermore, any related
receivables account that may have arisen from this contract will need to be checked for
impairment losses in terms of IFRS 9 Financial instruments. These impairment losses will
need to be presented separately. The issue of impairments is discussed in more detail when we
discuss step 3: determining the transaction price (section 7).
Example 4: Criteria met an inception but subsequently not met

On 2 January, an entity entered into a contract with a customer. All criteria for the existence
of a contract were met on this date. The entity began to perform its obligations and duly
invoiced the customer each month for C1 000, which was deemed appropriate in terms of the contract.
On 5 May, the entity received a letter from the customer’s lawyer to say that the customer was
disputing the terms of the contract. The entity continued performing its obligations in May.
Required: Explain how the above situation should be accounted for.
Solution 4: Criteria met an inception but subsequently not met

On 2 January, all criteria for the existence of a contract were met. Thus revenue from the contract at
C1 000 per month would have been recognised until ‘significant changes in facts and circumstances’
suggested otherwise: Debit Receivable and Credit Revenue. See the first journal below.
On 5 May, a lawyer’s letter was received indicating that there was a ‘significant change in facts and
circumstances’ and which suggested that the criteria for the existence of a contract were no longer met
(the terms of the contract were under dispute). The entity continued to perform its obligations during
May, but since the contract criteria are no longer met, the revenue may not be recognised. Instead, the
entity must recognise this as a liability: Debit Receivable and Credit Liability (it is submitted that this
liability should not be called a contract liability since the definition thereof is not met and we
technically do not have a contract, but could be called a refund liability instead). See the second journal
below.
The receivable balance must also be tested for impairments in terms of IFRS 9 Financial instruments.
Total of the jnls from January to end April Debit Credit
Receivable (A) C1 000 x 5 5 000
Revenue (I) 5 000
Recording the receipt of a non-refundable deposit
May
Receivable (A) C1 000 x 1 1 000
Refund liability (L) 1 000
Recognising the non-refundable deposit as revenue
120 Chapter 4
5.6 Combining contracts (IFRS 15.17)
We would account for two or more contracts as if they were a single contract:
a) if they were entered into at the same time – or nearly the same time; and
b) if they involved the same customer – or the customer’s related parties; and
c) if:
- they were ‘negotiated as a package with a single commercial objective’; or
- the amount to be paid in terms of one of the contracts ‘depends on the price or
performance of’ one of the other contract/s; or
- all or some of the goods or services that are promised in these contracts are, together,
considered to form ‘a single performance obligation’ (see section 6). IFRS 15.17 reworded
5.7 Modifying contracts (IFRS 15.18-.21)
5.7.1 What is a contract modification?(IFRS 15.18-.19)
A modification to a contract is when either the scope of A modification exists

work or the price (or both) that is contained in a contract is if:
subsequently changed. Modifications are also known by
other terms, such as a variations or amendments. all parties agree
to a change in the:
Just as was the case when identifying the original contract, - scope; and/ or
a modification to a contract need not be in writing or even - price. See IFRS 15.18
be verbal – it can simply be implied. What is of importance is that it is approved by all parties
in a way that makes the changes legally enforceable.
5.7.2 Accounting for a modification (IFRS 15.19-.21)

Modifications are
We would account for a change to the contract only if it has accounted for only if
they are enforceable.
been approved by all parties to the contract. However, this See IFRS 15.18
does not mean that everything has to be agreed upon – it
can happen that all parties have agreed to a change in the scope of work, but have not yet
agreed to the revised price. In this case, we would need to estimate the new price. Estimating
a new price involves ‘estimating variable consideration’ and taking into account the
‘constraining estimates of variable consideration’ (see section 7 on ‘determining the
transaction price’).
Before we account for a change, we must consider all terms and conditions to be sure that the
change is enforceable. Modifications that are not considered enforceable are ignored.
Depending on the circumstances, if the extra goods or Modifications may be

services are considered to be distinct from the original accounted for as:
goods or services, the modification is either accounted for:
as an additional separate contract; or 1 an extra separate contract
as a termination of the old contract and the creation of 2 a termination of the old and
a new contract. IFRS 15.20 & .21 (a) creation of a new contract
3 part of the existing contract.
See IFRS 15.20 & 21
If the extra goods or services are not distinct, the
modification will be accounted for:
as part of the existing contract. IFRS 15.21 (b)
5.7.3 Modification accounted for as a separate contract (IFRS 15.20)
The modification is accounted for as a separate contract if the following criteria are met:
the scope increases due to extra goods or services that are distinct; and
the price increases by an amount that reflects the ‘stand-alone selling prices’ of these
extra goods or services. See IFRS 15.20
Chapter 4 121
The price does not need to increase by an exact amount representing the stand-alone selling
prices but must simply be representative thereof. These stand-alone selling prices may, for
example, be adjusted downwards to account for the fact that the entity won’t need to incur
certain additional costs that would otherwise need to be incurred to secure another customer
(e.g. selling costs could be avoided or extra transport costs may be avoided etc).
5.7.4 Modification accounted for as a termination plus creation of a new contract
If the modification does not meet the criteria to be accounted for as a separate contract (see
section 5.7.3), then it would be accounted for as if it were a termination of the old contract
and a creation of a completely new revised contract if, on date of modification:
the remaining goods or services still to be transferred are distinct from
the goods or services already transferred. See IFRS 15.21 (a)
The amount of the consideration to be allocated to this deemed new contract is the total of:
the portion of the original transaction price that has not yet been recognised as revenue;
plus: the extra consideration promised as a result of the modification. See IFRS 15.21 (a)
5.7.5 Modification accounted for as part of the existing contract (IFRS 15.21(b))
If the modification does not meet the criteria to be accounted for as a separate contract (see
section 5.7.3), then it would be accounted for as an adjusting to the existing contract, if on
date of modification:
the remaining goods or services still to be transferred are not distinct from
the goods or services already transferred. See IFRS 15.21 (a)
Accounting for the modification as if it were an adjustment to the original contract means:
Adding the extra consideration from the modification to the original transaction price;
Adding the extra obligation/s from the modification to the original performance
obligations that remain currently unsatisfied.
Since our total obligation has changed and the total transaction price has changed, we would
need to reassess our estimated progress towards completion of the performance obligation and
then make an adjustment to the revenue recognised to date.
This adjustment to revenue recognised to date must be accounted for as a change in estimate,
using the cumulative catch-up method (see chapter 26).
6. Identifying the performance obligations (step 2)
6.1 Performance obligations are promises (IFRS 15.22-.23 & .25)
A performance obligation is simply a promise made by an entity to a customer, and where the
promise is made within a contract, to transfer certain goods or services to that customer.
A contract that an entity enters into with a customer may include one or more performance
obligations (promises).
A performance obligation is defined as:

a promise contained in a contract,
to transfer to a customer either:
- a distinct good or service or bundle of goods or services; or
- to transfer a series of distinct goods or services that are:
- substantially the same; and
- have the same pattern of transfer to the customer. IFRS 15.22 reworded
122 Chapter 4
This definition of a performance obligation refers only to goods or services that are distinct
(what makes something distinct is explained in section 6.4). Goods or services that are
indistinct will need to be bundled together until we find ourselves with a distinct bundle,
which will thus represent a performance obligation (this is explained in section 6.5).
Where the promise involves providing a series of goods or services (e.g. a contract that
promises to mow the lawn every week for 2 years), the series will be considered distinct if the
goods or services in the series are largely the same and have the same pattern of transfer. This
is defined below.
Goods or services within a series have the same pattern of transfer if:
the obligation to transfer each good or service in the series:
- will be satisfied over time; and
the progress towards completion of the transfer of each good or service in the series will be:
- assessed using the same measurement method. IFRS 15.23 reworded
The definition of a performance obligation refers to the promise to transfer goods or services
to a customer. This means that not all activities necessary to complete a contract would be
considered to be part of a performance obligation. In other words, activities that are necessary
in terms of the contract but yet do not result in the actual transfer of goods or services to the
customer, would not be part of the performance obligation (e.g. initial administrative tasks
necessary for the completion of the contract). See IFRS 15.25
6.2 Revenue is recognised separately for each performance obligation (IFRS 15.31)
It is important to be able to identify each and every performance obligation (promise)

contained in a customer contract because, when we recognise revenue from a contract, we are
required to recognise the revenue from each performance obligation (promise) separately.
6.3 Performance obligations could be explicitly stated or be implicit (IFRS 15.24)
Interestingly, the various promises could be explicitly stated in the contract or could be
implicit. An implicit promise is one that emanates from the:
‘entity’s customary business practice, published policies or specific statements
if, at the time of entering into the contract,
those promises result in the customer having a valid expectation
that the entity will transfer a good or service to the customer’. IFRS 15.24 reworded
It is important to notice that IFRS 15 only considers implicit promise that resulted in a valid
expectation arising at contract inception. Any implied promises that arose thereafter would
not be accounted for as performance obligations under the same contract. Further implied
promises may need the consideration of IAS 37 Provisions, contingent liabilities and
contingent assets.
Example 5: Explicit and implicit promises

A car dealership signed a contract with a customer agreeing to the sale of a car for
C100 000. The dealership has been in business for 5 years.
Consider the following scenarios and explain how each contract should be accounted for:
A: The contract specifically mentions that, should the contract be concluded, a specific top of the
range cell phone will be ‘thrown in for free’. These cell phones are currently valued at C10 000.
B: During the past 5 years, all customers concluding sale agreements have been given specific top of
the range cell phone for free. Similar cell phones are currently valued at C10 000.
C: After signing the contract with the customer, and in order to try to encourage the customer to
purchase a second vehicle for her son, the dealership phoned the customer to announce that it
would be giving her a top of the range cell phone for free. The cell phone is valued at C10 000.
Chapter 4 123
Solution 5: Explicit and implicit promises

A: Since the contract explicitly promises both a car and a cell phone, the transaction price of
C100 000 will have to be allocated between these two performance obligations.
B: The contract only explicitly promises the car. However, the past practice of providing a top of the
range cell phone to all customers who purchase a car from the dealership gives the customer a valid
expectation at contract inception. Thus the cell phone is an implied promise.
The transaction price of C100 000 must be allocated between these two performance obligations
(explicit and implicit).
C: The contract does not mention a cell phone (i.e. no explicit promise) and past practice does not
give the customer an expectation of a phone (i.e. no implicit promise).
Thus the transaction price is allocated entirely to the only promise (the explicit promise): the car.
The subsequent promise of a phone must be accounted for in terms of IAS 37 Provisions,
contingent liabilities and assets.
6.4 The promised transfer must be distinct (IFRS 15.26-.30)
6.4.1 Overview
The definition of a performance obligation refers to the transfer of goods or services (or a
bundle thereof) that is distinct. The transfer is distinct if it is both capable of being distinct
and is distinct in the context of the contract.
Distinct: A transfer of a good or service is distinct if the following 2 criteria are met:
a) The good or service capable of being distinct
This means it must be able to generate economic benefits for the customer either:
- on its own; or
- together with other resources that are readily available to the customer; and
b) the good or service is distinct in the context of the contract
This means that the promise to transfer the good or service is:
- separately identifiable from other promises in the contract. IFRS 15.27 reworded very slightly
6.4.2 The goods or services must be capable of being distinct (IFRS 15.28)
For a good or service to be capable of being distinct, the customer must be able to benefit
from it. In other words, the goods or services transferred must be capable of generating
economic benefits for the customer. Goods or services are considered capable of generating
economic benefits for the customer in any number of ways, for example, by the customer
being able to use or consume the goods or services or being able to sell them for a price
greater than scrap value.
We consider the goods or services capable of generating economic benefits for the customer
even if these benefits will only be possible in conjunction with other readily available
resources (i.e. with other readily available goods or services). It is worth emphasising that the
customer need not already own these other necessary resources – they need only to be
resources that are readily available.
These other resources (i.e. other goods or services) would be considered readily available if
they are sold separately by the entity (or any other entity).
We could also deem that the promised good or service to be capable of generating economic
benefits for the customer under certain circumstances. An example of such circumstances is if
the entity regularly sells such goods or services separately.
124 Chapter 4
6.4.3 The good or service must be distinct in the context of the contract (IFRS 15.29)
For a good or service to be distinct in the context of the contract means that the promise to
transfer it must be separately identifiable from other promises made in the contract. There are
no criteria that need to be met before concluding that a promise is separately identifiable, but
we must apply professional judgement when considering all facts and circumstances.
As a guideline, IFRS 15 mentions certain factors to be considered, (these factors are provided
by way of example only), in deciding whether or not a specific promise to transfer goods or
services is separately identifiable from other promises in the contract.
The following are the examples given of goods or services promised in terms of a contract
which would not be considered separately identifiable and would thus not be distinct in the
context of a contract. Goods or services that are:
used as an input to create an output within the same contract: if the entity is using the
goods or services as an input to create some other promised item for the customer within
the same contract, then that good or service being used is considered to be part of this
other promised item (i.e. it is merely an input to create an output);
used as an input to modify an output within the same contract: if the entity is using the
goods or services to significantly customise another good or service promised within the
same contract, then that good or service is considered to be part of the customised good or
service (i.e. it is merely an input to modify an output);
highly dependent on another good or service promised within the same contract: for
example, if it is not possible for the customer to buy the one without the other, then these
goods or services are so interdependent that they cannot be considered separately
identifiable from one another. See IFRS 15.29
6.5 Bundling indistinct goods or services (IFRS 15.30)
If our contract promises a good or service that is not considered to be distinct from other
goods or services promised in the contract, we will need to combine it with the other
indistinct goods or services that have been promised until we find ourselves with a bundle of
goods or services that is considered distinct.
Obviously, this process of bundling indistinct goods or services until we find ourselves with a
distinct bundle (i.e. a performance obligation) may result in all the promises contained in the
contract being considered to be a single performance obligation.
Example 6: Distinct goods and services
Rad Building has signed a contract to construct an additional bathroom for a customer and
promises to provide all building materials, sanitary ware, electrical supplies and labour.
Required:
a) Explain whether the goods and services contained in the contract are capable of being distinct.
b) Explain whether the goods and services promised are distinct in the context of the contract.
c) Explain whether the contract contains one or more performance obligation.
d) Explain whether the goods and services contained in the contract would be considered distinct (and
thus whether the contract contains more than one performance obligation) if the contract also
includes a promise to repair the gutters of the customer’s house.
Solution 6: Distinct goods and services

a) Each of the individual goods (the building materials, the sanitary ware and electrical supplies) and
services (the labour involved in constructing the building, installing the sanitary ware and electrical
supplies) are capable of being distinct. This is because the customer is able to benefit from each of
them separately. This can be proved in a number of ways:
- each good and service is of a type that is sold and provided to customers on a separate basis
(e.g. we can buy a bath separately from the building materials etc);
- the customer can generate economic benefits from each of the goods or services: it could sell
them onwards, or it could use them etc.
Chapter 4 125
b) Each of the goods and services are not considered distinct in the context of the contract. This is
because the promises to transfer them are not separately identifiable from one another. This is
evidenced by the fact that a significant aspect to this contract is the promise to combine the goods
and services in a way that produces a bathroom (i.e. to use them as an input to create an output).
c) Although the individual goods and services promised in the contract are capable of being distinct,
they are not considered to be distinct in the context of the contract. Since both these criteria were
not met, the individual goods and services promised in the contract are not individually distinct.
However, by grouping them together they form one distinct bundle: the bathroom. The contract
thus has one performance obligation: to construct the bathroom.
d) The construction of the bathroom and the repair to the gutters of the pre-existing house are highly
independent promises: the customer could have contracted with the entity to provide the one
without the other. Since they are highly independent, these two promises are separately
identifiable. The contract thus has two performance obligations: the promise to construct a
bathroom and the promise to repair the gutters.
7. Determining the transaction price (step 3)
7.1 Overview
The transaction price is
Let’s start by saying that the transaction price is not defined as:
necessarily the total price quoted in a contract. In other the amount of consideration
words, the contract price does not necessarily equal the to which an entity expects to be
transaction price. entitled
in exchange for transferring
Instead, the transaction price is the amount of consideration goods/ services to a customer,
to which the entity expects to be entitled for satisfying the excluding amounts collected on
behalf of third parties.
performance obligations contained in the contract. IFRS 15.App A (reworded slightly)
Given that the transaction price is the total amount we expect to recognise as revenue from the
completed contract, it would include only the amount that we expect to earn from the
contract. Thus, the transaction price is defined as excluding
any amounts included in the contract price that we expect to The transaction price
is the amount we
receive on behalf of third parties (e.g. if the total price for expect to be entitled
the contract includes VAT, this VAT portion would be to – not the amount we
excluded when we calculate the transaction price). expect to collect!
When determining this transaction price, we look only at Factors that must be
the existing contract. In other words, we ignore, for considered in the
example, any renewals of the contract or modifications to determination of the
transaction price:
the contract that may possibly be expected.
variable consideration (we need to
It is also important to realise that the collectability of the estimate it and constrain it)
promised consideration is not considered when determining significant financing components
the transaction price. Instead, we consider it when non-cash consideration
determining whether we have a contract: if we believe, at consideration payable to the
contract inception, that the collectability of the promised customer.
consideration is improbable, then we would not have a P.S. Collectability is not a factor!
If, at contract inception, we believe
contract as defined (in other words, collectability is that the promised consideration is
considered as part of step 1). not probable, then we do not have a
contract at all. If we think
However, if collectability was probable at contract collectability is probable, but it
inception but, at contract inception, there was an becomes uncertain after inception,
then we may need to recognise an
expectation that some of it may not be collectable or the impairment loss.
collectability of some or all of it became uncertain after See IFRS 15.48
contract inception, we would need to consider recognising
an impairment loss – it will have no impact on the transaction price (see example 7).
126 Chapter 4
However, we do need to carefully assess whether the fact that we entered into a contract
knowing that a part of it may not be collectable, is not evidence of an implied price
concession, which is taken into account when determining the transaction price (see
example 8). Impairment losses are recognised in terms of IFRS 9 (see chapter 22).
Example 7: Transaction price and collectability
We sign a contract with a customer on 1 January 20X1. The contract price is C100 000. At
the time of signing the contract, we believed would be entitled to the C100 000 and that it
was probable that we would collect the C100 000. However, experience suggests that 10% of our
receivables are not recovered. We satisfy our performance obligation on 20 January 20X1.
Required: Show the journals required relating to the information provided above.
Solution 7: Transaction price and collectability

Comment: Notice that the transaction price reflects the amount to which we expect to be entitled – not
the amount we expect to collect.
On condition that the collectability concerns do not mean that the consideration is not probable of being
collected (in which case we would not have a contract and would thus not be able to process a journal
at all), we recognise the receivable and the revenue at the full transaction price and we recognise a
separate impairment loss expense and corresponding allowance for credit losses account (similar to the
doubtful debts expense and doubtful debts allowance that we recognised under the previous IAS 18) .
20 January 20X1 Debit Credit
Receivable (A) Given 100 000
Revenue (I) Balancing 100 000
Impairment - credit losses (E) C100 000 x 10% 10 000
Receivable: allowance for credit losses (-A) C100 000 x 10% 10 000
Recognising the revenue when customer obtains control, and recognising
a separate allowance for credit losses on initial recognition
Example 8: Transaction price: collectability versus implied price concession

An entity signs a contract on 1 January 20X1with a new customer in a new geographical
region. The contract price is C100 000.
At the time of signing the contract, the entity is aware that the customer has significant cash flow
problems and may probably only be able to pay C60 000. However, the entity believes that the
customer’s financial situation will improve in time and also that transacting with this new customer
may result in further potential customers in this region.
The entity satisfies its performance obligation on 20 January 20X1.
Required: Discuss how this information should be considered.
Solution 8: Transaction price: collectability versus implied price concession

This situation has a bearing on both ‘step 1: determining whether we have a contract’ and ‘step 3:
determining the transaction price’.
The IASB has indicated that if part of the contract price is considered to be recoverable, that may be
sufficient to conclude that we have a contract.
If this is the case, our next step would be to decide whether, by entering into such a contract, the entity
is not implicitly accepting that it will provide a price concession (implied price concession) or whether
the receivable should be immediately impaired to reflect the customer’s credit risk.
If it is concluded that it is a price concession, then the entity would determine the transaction price at
C60 000 (thus revenue of C60 000 will be recognised when the performance obligation is satisfied).
Receivable (A) Given 60 000
Recognising the revenue: transaction price adjusted because it was an
implied price concession
Chapter 4 127
If it is concluded that it is an issue of collectability, then the transaction price is the full C100 000 (thus
revenue of C100 000 will be recognised when the performance obligation is satisfied) and an
impairment loss of C40 000 must be immediately recognised. See the journal below.
Receivable (A) 100 000
Revenue (I) 100 000
Impairment - credit losses (E) 100 000 – 60 000 40 000
Receivable: allowance for credit losses (-A) 40 000
Recognising the revenue and loss allowance: transaction price is not
adjusted because it was an issue of collectability (but the consideration
was still considered to be probable of being collected and thus it did not
fail the contract criteria)
When determining the transaction price, we also need to consider a number of other factors:
a) Whether the contract includes a variable consideration:
b) Whether the contract includes a significant financing component
c) Whether the contract includes non-cash consideration
d) Whether the contract includes consideration payable to the customer.
Each of these issues will now be discussed in more detail in sections 7.2 to 7.5.
7.2 Variable consideration (IFRS 15.50-.59)

7.2.1 Overview
A contract may include
consideration that is
The consideration in the contract could be a fixed amount fixed/ variable / both.
or could be variable or could be a combination thereof.
Since the transaction price must reflect the amount of consideration to which the entity
expects to be entitled, all consideration would be considered for inclusion in the transaction
price whether or not it was fixed or variable.
When dealing with fixed consideration, we simply have to Variable consideration
estimate how much of it the entity expects to be entitled. is included in the
transaction price
However, in the case of variable consideration, we first measured by:
need to estimate the amount of the variable consideration
estimating the amount to which
and then estimate how much of this the entity expects to be the entity believes it will be
entitled to. entitled; and
constraining (limiting) the
Thus, given that we first have to estimate what the variable estimate to an amount that has a
consideration will actually end up being before estimating high probability of not causing a
how much of it we will be entitled to, there is an increased significant reversal of revenue in
risk that we could overstate our revenue. As a result, we are the future.
required to constrain (limit) the estimate of variable consideration.
Thus, if the contract includes variable consideration, we will need to decide how much of this
variable consideration to include in the transaction price by:
estimating the amount to which we think we will be entitled; and then
constraining (i.e. limiting) this estimate to the amount that has a high probability of not
resulting in a significant reversal of revenue in the future.
This decision-making process may be done as a two-step approach (i.e. first calculate the
estimate and then constrain the estimate) or, if our internal processes enable it, it could be
done as one step (i.e. calculate the estimate in a way that automatically applies the
constraints). See IFRS 15.BC215
The amount to which we must constrain our estimate of variable revenue is the amount for
which there is a high probability of no significant reversal of revenue in the future.
128 Chapter 4
7.2.2 When is consideration considered to be variable? Consideration may be

considered variable due
Variations in the consideration can come in many forms. to:
Examples include: discounts, rebates, refunds, performance contractual terms; or
bonuses (or even penalties), price concessions and other the customer’s valid expectation
incentives. See IFRS 15.51 of a price concession; or
other facts & circumstances
Consideration will be considered to be variable if any one suggesting the entity’s intention to
of the following criteria are met: give a price concession.
the contractual terms explicitly state how the
See IFRS 15.52
consideration may vary; or

other facts and circumstances imply that there will be a price concession (often called a
discount, rebate or credit), through either:
- the ‘entity’s customary business practice, published policies or specific statements’
giving a customer a valid expectation that the entity will give a price concession; or
- other facts and circumstances suggesting that, at contract inception, the entity
intended to provide a price concession. See IFRS 15.52
Specific mention should probably be made of implied price concessions. If, at the inception of
the contract, there were facts and circumstances that made the entity aware that there was a
certain credit risk involved (i.e. affecting the collectability of the revenue), the fact that the
entity concluded the contract anyway, may either suggest an implied price concession or that
the entity simply chose to accept the risk that the customer may default. If it suggests an
implied price concession, it means that what would have been subsequently expensed as a bad
or doubtful debt under the previous IAS 18 Revenue, is now accounted for immediately as a
reduction in the amount of revenue initially recognised. IFRS 15 provides very little guidance
on how to determine whether situations such as these should be accounted for as an implied
price concession or as an acceptable credit risk. See previous example 8.
Example 9: Variable consideration - discounts

Anastasia Limited sold inventory to a customer for C100 000, on credit. This customer
qualified for a trade discount of 10% off this price. The customer obtained control of the
inventory on 1 February 20X2. A further discount of 5% is offered off the contract price to those
customers who pay within 30 days. Based on experience, Anastasia expects most of its customers to
pay within this time frame. This customer paid within 20 days (on 20 February 20X2).
Required: Journalise the above information.
Solution 9: Variable consideration - discounts

The contract price is C100 000, but we first consider all discounts in determining the transaction price.
Trade discount: The trade discount is not variable as we know the customer qualifies for this
discount. Thus we know that we will not be entitled to C10 000 of the contract price (C100 000 x
10%) – thus our TP is reduced by the trade discount.
Settlement discount: It is not certain that the customer will qualify for the settlement discount and
thus the further discount of C5 000 is variable consideration.
The existence of the potential settlement discount effectively means that our contract price includes:
variable consideration: C5 000 (C100 000 x 5%) and
fixed consideration: C85 000 (Contract price C100 000 – Trade discount: C10 000 – variable
consideration: C5 000).
Since the entity expects the settlement discount to be granted, the transaction price is based on the
reduced contract price.
1 February 20X2 Debit Credit
Receivable (A) 100 000 – Trade discount: 10 000 90 000
Receivable: settlement discount allowance (-A) C100 000 x 5% 5 000
Recognising the revenue when customer obtains control, net of discount
Chapter 4 129

Bank (A) 100 000 – trade discount 10 000 – settlement discount 5 000 85 000
Receivable: settlement discount allowance (-A) 5 000
Receivable (A) 90 000
Recognising the receipt from the customer
Note: If the customer did not pay on time, the allowance account would then be transferred to revenue.
Comment: This example did not involve constraining the estimate. This is because we reduced the
transaction price by the full settlement discount offered. In other words, the variable consideration was
excluded entirely from the transaction price (TP). Had we included some of the variable consideration
in the TP, we would have then had to consider constraining the estimated variable consideration
included in the TP.
Notice that, although the variable discount offered is immediately accounted for as a
reduction in the revenue account, and the receivables account should also reflect the reduced
amount expected to be received from the customer, the expected variable discount must not
be credited directly to the receivables account.
The receivables account would only be reduced by the discount when the customer
actually pays timeously and the discount is actually granted.
Settlement discounts are thus initially credited to a measurement account, which we will
call a settlement discount allowance account, a ‘negative asset’ account.
In so doing, the statement of account sent to the customer will show the full balance
owing, but the statement of financial position will reflect a net receivables balance
(receivables account – settlement discount allowance account).
If the customer does not pay in time to qualify for the discount, the settlement discount
allowance account is reversed and recognised as revenue (i.e. as an adjustment to the
transaction price): debit settlement discount allowance and credit revenue
7.2.3 Estimating the variable consideration (IFRS 15.53 - .54)
There are two methods that are available for estimating the variable consideration:
the ‘expected value’ method; and
the single ‘most likely amount’ method.
Which method to use is not a free choice but must be decided based on which method will is
expected to be the best predictor of the consideration to which the entity will be entitled.
IFRS 15 states that:
The ‘expected value method’ is probably ideal for situations where there are many
similar contracts on which to base the estimates of the possible outcomes; whereas
The ‘most likely amount’ method would probably be best suited to a contract wherein
there are only two possible outcomes. See IFRS 15.53
The two measurement methods for variable consideration
The expected value method entails: The most-likely amount method entails:
identifying the various possible identifying the various possible amounts
amounts of consideration; of consideration; and
multiplying each of these by its selecting the single amount that is that
relative probability of occurring; and contract’s most likely outcome.
adding together each ‘probability-
See IFRS 15.53 (a) See IFRS 15.53 (b)
weighted amount’.
When using the ‘expected value’ method, although we are required to consider all ‘historical,
current and forecast’ information that we are reasonably able to get our hands on, we are not
required to include in the calculation each and every amount of consideration that is possible.
Instead, we need only include a ‘reasonable number’ of possible consideration amounts.
130 Chapter 4
For example,
If we estimate that there may be anything up to 100 or so different amounts possible, we do
not need to calculate and assess the probability of each and every one of these possibilities
when calculating our expected value, but may base our expected value calculation on just a
selection of possible amounts that we feel will give us a reasonable estimate of the outcome
(i.e. ‘a reasonable estimate of the distribution of possible outcomes’ IFRS 15.BC201). So if, for
example, 80 of the 100 outcomes are considered to be highly unlikely, we could base our
expected value calculation on only the remaining 20 outcomes that we feel are more likely to
occur – or we could base our calculation on only those outcomes we feel are most likely to
occur. The decision as to what is considered a ‘reasonable number’ of possible outcomes will
need our professional judgement.
Once we decide which method to use, we must apply it consistently throughout the period of
the contract. However, different methods may be used within a contract if there are different
types of variable consideration to which different methods are appropriate. See IFRS 15.BC202
At the end of each reporting period, we must reassess the estimates of variable consideration
and if necessary, account for a change in the estimated transaction price. See IFRS 15.59
Example 10: Estimating variable consideration – the two methods of estimation

Estimating when the distribution is continuous
Fundraising For All (FFA) provides its clients with various initiatives to help raise funds to
support that client’s cause, for example, hosting music festivals to corporate fundraising events, school
book fairs etc. It entered into a contract with Desperate Dan, who was trying to raise funding for the
rescue and housing of donkeys that had been maltreated.
In this contract, FFA agreed to arrange and market a series of children’s plays to be held over the
months of September to December. The plays would take place in tents erected in and around the
province and all money collected would go towards funding Desperate Dan’s ‘Donkeys in Distress’. In
exchange for this, FFA would be paid a sum of C100 000 and would receive a performance bonus of
anything between C0 and C300 000 depending on the number of plays presented during the period.
FFA considered all previous similar contracts, the current economic trends and how these trends are
impacting other existing fundraising events and its projections for all similar projects when preparing
the following schedule of expected performance bonuses from this contract:
Performance bonus: Probability:

C %
10 000 15%
80 000 20%
180 000 25%
240 000 40%
100%
Required:
a) Explain which method should be used to estimate the variable consideration.
b) Calculate the estimated variable consideration using your chosen method, but do not attempt to
constrain the estimate.
c) Assuming that the process of constraining of the estimate was not a limiting factor in any way (i.e.
the estimated variable consideration is an amount that is highly probable of not resulting in a
significant reversal of revenue in the future), calculate the estimated transaction price.
Solution 10: Estimating variable consideration – continuous distribution

a) Since the range of possible outcomes is constituted by a continuous range of anything between
C0 and C300 000 (i.e. not constituted by individual amounts, one of which is the most likely), the
‘most likely amount’ method is not able to be used. Thus, the ‘expected value’ method is the
most appropriate.
Chapter 4 131
b) The estimated variable consideration is measured at its expected value of C158 500.
The measurement of its expected value is as follows:
Performance bonus: Probability: Expected value
C % C
10 000 15% 1 500
80 000 20% 16 000
180 000 25% 45 000
240 000 40% 96 000
100% 158 500
c) Assuming the constraint was not a limiting factor, the estimated transaction price would be
C258 500 (fixed consideration: C100 000 + variable consideration: C158 500).
Example 11: Estimating variable consideration – the two methods of estimation

Estimating when the distribution is discontinuous (i.e. the
distribution includes a limited number of ‘discrete amounts’)
This example is based on the same contract information presented in the previous example. However,
in this example, the performance bonuses are not simply anything between C0 to C300 000, but instead
are discrete amounts as follows:
Performance bonus: If number of plays presented is
C between:
0 0 – 24
100 000 25 – 48
200 000 49 – 60
300 000 61 – or more
FFA prepared the following schedule of expected performance bonuses:
C %
0 30%
100 000 30%
200 000 35%
300 000 5%
100%
Required:
a) Calculate the estimated variable consideration using the ‘expected value’ method – but before
considering the effects of constraining the estimate.
b) Calculate the estimated variable consideration using the ‘most likely amount’ method – but before
considering the effects of constraining the estimate.
c) Explain why we cannot yet calculate the estimated transaction price.
Solution 11: Estimating variable consideration – discontinuous distribution
a) Using the ‘expected value’ method, the estimated variable consideration is C115 000. However,
this estimate is before considering the required ‘constraining of the estimate’.
The measurement of the expected value is as follows:
Performance bonus: Probability: Expected value
C % C
0 30% 0
100 000 30% 30 000
200 000 35% 70 000
300 000 5% 15 000
100% 115 000
b) Using the ‘most likely amount’ method, the estimated variable consideration is C200 000. This is
because C200 000 reflected the highest probability of occurring (35%). However, this estimate of
C200 000 is before considering the required ‘constraining of the estimate’.
c) We cannot yet calculate the transaction price because, although we have the fixed consideration
and have an estimated variable consideration, this estimated variable consideration is not yet
final since we have not yet applied the principle of constraining the estimate.
132 Chapter 4
7.2.4 Constraining the estimate The process of

constraining the
When calculating the estimated variable consideration to estimated variable
include in the transaction price, we will obviously be faced consideration:
with uncertainties. Uncertainties always present us with the The transaction price may only
risk that we may misinterpret them and a misinterpretation include the estimated variable
may result in revenue being overstated. consideration to the extent that:
‘it is highly probable
Revenue is an incredibly important line item to the users of that a significant reversal
financial statements and a significant overstatement thereof in the amount of cumulative
would be considered in a very serious light. revenue recognised
will not occur
Thus, in order to prevent a significant overstatement of our when the uncertainty associated
revenue, we apply the principle of including only that with the variable consideration
portion of the estimated variable consideration that we is subsequently resolved’.
IFRS 15.56
believe has a ‘high probability’ of not resulting in a
See IFRS 15.56
‘significant reversal’ in the future of the ‘cumulative revenue recognised’ to date.
Applying this principle is referred to as the process of constraining (limiting) the estimate.
Example 12: Estimating variable consideration – constraining the estimate

An entity has entered into a contract that has a fixed consideration of C400 000 and a
variable consideration that has been estimated at C300 000 based on its expected value.
The amount of variable consideration that would be highly probable of not resulting in a significant
reversal of the cumulative revenue recognised to the date that the uncertainty is resolved, is C250 000.
Required: Explain the calculation of the final estimated transaction price.
Solution 12: Estimating variable consideration – constraining the estimate

The contract includes both fixed and variable consideration, both of which must be considered for
inclusion in the transaction price.
The variable consideration was first estimated at C300 000 based on the ‘expected value’ method.
However, in order to prevent overstatement of revenue, we must constrain this estimate to an amount
that is not expected to result in a significant reversal of cumulative revenue recognised to the date that
the uncertainty is expected to eventually be resolved. This amount is estimated to be C250 000.
Thus, the total transaction price that we plan to recognise as revenue is C650 000 (fixed consideration:
C400 000 + constrained estimated variable consideration: C250 000).
If we look carefully at the wording of paragraph 56 (see previous pop-up), the calculation of
the constraint (i.e. the amount to which the estimated variable consideration must be limited)
involves assessing both:
the probability of a revenue reversal (i.e. is it highly
Highly probable =
probable?); and likely to occur
the amount of the possible revenue reversal (i.e. is it See IFRS 15.BC211
significant?). See IFRS 15.57

There are no criteria to determine whether a potential The significance of a
reversal is considered highly probable to occur or whether potential reversal of
the amount of a particular reversal would be considered revenue is determined
significant. Thus, professional judgment will be required by:
for both these aspects. considering the reversal in
relation to the total
consideration recognised to the
A reversal is considered to be probable of occurring if it is date of this reversal.
more likely than not to occur (this is based on the definition See IFRS 15.56
of highly probable in IFRS 5).

Thus, the term highly probable suggests a higher likelihood than simply more likely than not.
In other words, highly probable is taken to mean likely to occur.
Chapter 4 133
The significance of the amount of a potential reversal of revenue on the date that the
uncertainty clears up must be considered in relation to the entire contract revenue recognised
(i.e. including both the fixed and variable consideration recognised). What is considered to be
significant to one entity will not necessarily be significant to another entity. Thus professional
judgement will be needed in deciding what is significant.
Although there are no criteria to determine whether a potential reversal is highly probable to
occur, there may be indicators that there is an increased risk that a reversal is highly probable
of occurring or that it may be significant.
Examples of such indicators (given in IFRS 15) include:

the amount of the variable consideration will be highly affected by external factors (i.e.
factors that the entity cannot influence, such as the weather, economic state of the
country, market price of shares, actions of third parties, technological advancements by
competitors etc);
Deciding whether a
the amount of the variable consideration will only be significant reversal is
decided after a long time; highly probable, entails
considering:
the entity is unable to reasonably predict the variable
consideration because it has limited experience with the entity’s ability to estimate
(e.g. due to lack of experience on
similar contracts; similar contracts or the complexity
the entity is unable to reasonably predict the variable of the contract); and
consideration because, although it has had experience whether factors beyond the
with other similar contracts, the various outcomes have entity’s control may affect the
been so varied that they have not provided a pattern on variable consideration.
which predictions may be made (i.e. the experience does not provided predictive value);
the contract has a large number of outcomes and these outcomes represent a broad range
of possible consideration amounts. See IFRS 15.57
Example 13: Estimating variable consideration – determining the constraint

An entity has signed a contract in which the promised consideration includes fixed
consideration of C100 000 and variable consideration, estimated based on the expected
value method, of C90 000.
The entity has estimated that the amount of the variable consideration that is highly probable of not
resulting in any future reversal of revenue is C80 000 but the accountant is unsure whether this means
that going ahead and recognising the variable consideration of C90 000 would mean that the potential
reversal of C10 000 would be considered significant in terms of IFRS 15.
The accountant has determined that, when the entity finally knows the amount of variable consideration
that it will receive, the entity will have already recognised revenue to the extent of 10% of the fixed
consideration and 100% of the estimated variable consideration.
The entity considers amounts equal to or greater than 7% of revenue to be significant.
Required: Explain whether the estimated variable consideration should be constrained and calculate
the estimated transaction price.
Solution 13: Estimating variable consideration – determining the constraint

The transaction price will be C180 000 (fixed consideration: C100 000 + variable consideration: C80 000).
If we decide to include in the transaction price the estimated variable consideration of C90 000 and
then, later on, when the uncertainties are resolved, we realise that the variable consideration is only
C80 000, then C10 000 will need to be reversed. Whether this reversal is significant needs to be
assessed in relation to the total revenue that will have been recognised to date, calculated as follows:
C
Fixed consideration C100 000 x 10% 10 000
Variable consideration C90 000 x 100% 90 000
Cumulative revenue recognised to date 100 000
134 Chapter 4
A reversal of C10 000 would thus be 10% of the cumulative revenue recognised to date (C10 000 /
C100 000). Since this is greater than the 7% threshold applied by this entity, this potential reversal of
C10 000 should be considered significant.
Thus we conclude that C90 000 may lead to a significant reversal of cumulative revenue when the
uncertainty is expected to resolve itself. Thus, we conclude that C80 00 is the amount that is highly
probable of not leading to a significant reversal of cumulative revenue recognised to the date when the
uncertainty is expected to resolve itself.
Thus the estimated variable consideration of C90 000 should be constrained to C80 000.
The application of the constraint on estimated variable consideration will differ from situation
to situation. For the sake of completeness, we now look again at a prior example (example 11)
in which we estimated the variable consideration but stopped short of constraining the
estimate. You will see in this example that the method of estimating variable consideration
that involves a range of outcomes that is discontinuous (i.e. the range is constituted by a
specific number of distinct amounts rather than a continuous range of possibilities) will also
have an impact on how the estimate is constrained.
Example 14: Estimating variable consideration – effect of a constrained

estimate on the transaction price
This example is based on the same contract information presented in example 11 except that
we now consider the effects of constraining the estimate. The information is repeated here for your
convenience.
A fixed sum of C100 000 is payable plus a performance bonus, dependent on how many plays are
presented. The performance bonuses are discrete amounts as follows:
Performance bonus: If number of plays presented is
C between:
0 0 – 24
100 000 25 – 48
200 000 49 – 60
300 000 61 – or more
FFA prepared the following schedule of expected performance bonuses:
C %
0 30%
100 000 30%
200 000 35%
300 000 5%
100%
Required:
a) Calculate the estimated variable consideration using the ‘expected value’ method and apply the
principle of constraining the estimate and then calculate the final estimated transaction price.
b) Calculate the estimated variable consideration using the ‘most likely amount’ method and apply the
principle of constraining the estimate and then calculate the final estimated transaction price.
Solution 14: Estimating variable consideration – effect of a constrained estimate on the

transaction price
a) Using the ‘expected value’ method, the estimated variable consideration is C115 000 (see
calculation in part (a) of example 11). However, this estimate is before considering the required
‘constraining of the estimate’.
When constraining the estimate, we must limit the estimated variable consideration to an amount
that is highly probable of not resulting in a significant reversal of revenue in future.
When calculating the expected value of a discontinuous range (i.e. a range made up of distinct
amounts), we will often end up calculating an amount that is technically not possible.
Chapter 4 135
This is exactly what has occurred in this example: our expected value is C115 000 and yet we
know that this is not one of the possible bonuses. Thus, in this situation, the principle of
constraining the estimate requires us to limit the variable consideration to an amount that is one of
the distinct amounts possible. Thus, we would constrain the estimate of C115 000 to C100 000.
The reason we cannot leave it at C115 000, is because to receive C115 000 will require us, in
reality, to achieve a bonus of C200 000 or more and, looking at the probabilities, we only have a
40% chance of achieving this i.e. we will need to present 49 or more plays (5% + 35%). In other
words, we have a high probability (100% - 40% = 60%) of not achieving a bonus of at least
C200 000. Since it is currently highly probable (i.e. likely) that we will not achieve a bonus of
C200 000, the extra C15 000 will be highly probable of needing to be reversed out of revenue in
future.
Thus the estimate of C115 000 (based on the ‘expected value’) must be constrained to C100 000
since it is highly probable (30% + 30% = 60%) the latter will be received and thus it is highly
probable that there will not be a significant reversal of revenue.
The total estimated consideration will thus be C200 000 (fixed consideration: C100 000 + variable
Note: this solution assumes that the potential reversal of C15 000 is considered to be significant in
relation to the total potential consideration recognised of C215 000 (fixed consideration: C100 000
+ variable consideration: C115 000).
b) Using the ‘most likely amount’ method, the estimated variable consideration is C200 000. This is
because C200 000 is the outcome that has the highest probability of occurring (35%). However,
this estimate of C200 000 is before considering the required ‘constraining of the estimate’.
When constraining the estimate, we must limit the estimated variable consideration to an amount
that is highly probable of not resulting in a significant reversal of revenue in future.
To include variable consideration of C200 000 in the transaction price, we must believe that it is
highly probable that this amount will not result in a significant reversal in the future. However,
when we look at the probabilities, we can see that, given that this would require us to present 49 or
more plays, there is actually only a 40% chance (5% + 35%) of achieving a bonus of C200 000.
This means that there is a high probability (60%) of a significant reversal of revenue in the future.
In contrast, there is a 70% chance (5% + 35% + 30%) of achieving the next best bonus of
C100 000. Thus, recognising as revenue the estimate of C200 000, while being aware that,
currently, the highly probable bonus is C100 000, means that we would be facing a highly probable
reversal of C100 000 (C200 000 – C100 000)
Thus the estimate of C200 000 (based on the ‘most likely amount’) must be constrained to
C100 000 since it is highly probable the latter will be received and thus it is highly probable that
there will not be a significant reversal of revenue.
The total estimated consideration will thus be C200 000 (fixed consideration: C100 000 + variable
Note: this solution assumes that the potential reversal of C100 000 is considered to be significant in
relation to the total potential consideration recognised of C300 000 (fixed consideration: C100 000
+ variable consideration: C200 000).
7.2.5 Refund liabilities (IFRS 15.55)

A refund liability is
As you have no doubt gathered, the uncertainties affecting measured as:
variable consideration mean that we tend to err on the side the amount received (or
of caution: we carefully estimate the variable consideration receivable)
and then we constrain this estimate. less: the amount the entity
expects to be entitled to (i.e.
the amount included in the
Thus, the variable consideration that gets included in the transaction price).
transaction price (i.e. the constrained estimate) is often See IFRS 15.55
lower than the amounts of consideration actually received.
136 Chapter 4
Until such time as the uncertainty resolves itself (i.e. and the variable consideration becomes
fixed), if our customer happens to pay us more than the variable consideration that we have
included in the transaction price (i.e. more than we are currently prepared to recognise as
revenue), this excess must be recognised as a refund liability.
This refund liability represents our obligation to refund this excess amount received if our
estimates are proved correct.
We do not have to have received any consideration before we recognise a refund liability. It is
possible, for instance, to be owed an amount before we are prepared to recognise it as
revenue. For example, a contract could require a customer to pay the entity part of the
consideration as a deposit (say C10 000), part of which may be refunded depending on future
events. Assuming the deposit owed by the customer (variable consideration), is constrained to
nil (i.e. on the expectation that the full C10 000 will be refunded), the entity would recognise
a receivable of C10 000 and a refund liability of C10 000.
Refund liabilities can also arise in relation to the sale of goods that are sold with the ‘right of
return’. How to account for goods that are sold with the ‘right of return’ are explained in
detail in section 7.2.6.3.
Please note, however, that refund liabilities only reflect obligations to refund the customer –
they do not include obligations under warranties. Warranties are explained in section 11.
Example 15: Receipts exceeds constrained estimate of variable consideration

An entity has signed a contract with customer X in which the promised consideration is
entirely represented by variable consideration estimated at C90 000 (based on its expected
value) and which was constrained to C80 000.
By the end of the reporting period, the entity had recognised C64 000 (80%) of this variable
consideration based on the performance obligations completed to date. The customer made its first
payment a few days before reporting date. The amount received from this customer was C70 000.
Required:
Prepare the journal entry to reflect the information provided.
Solution 15: Receipts exceeds constrained estimate of variable consideration

Debit Credit
Revenue from customer contracts (I) 64 000
Recording the revenue from the contract with customer X – this is based
on 80 % of the constrained estimate of C80 000
Accounts receivable (A) The balance in this account 64 000
Refund liability (L) Balancing: 70 000 – 64 000 6 000
Recording the receipt from the customer
7.2.6 Specific transactions involving variable consideration (IFRS 15.58)
7.2.6.1 Overview
There are many different types of transactions that involve the issue of variable consideration.
However, it may be helpful if we look at a few specific and fairly common transactions:
contracts involving a volume rebate;
contracts involving a sale with a right to return; and
contracts involving royalties earned from licensed intellectual property that are calculated
based on either sales or usage.
Chapter 4 137
7.2.6.2 Contracts involving a volume rebate (IFRS 15.51 & .55 & B20 – B27)
When a contract includes the offer of a reduced price (e.g. a volume rebate) based on, for
example, a threshold sales volume, we need to take this into consideration when determining
the transaction price. This is variable consideration because we do not know whether the
threshold will be reached. We thus estimate the transaction price based on the amount we
expect to be entitled to and ensure that this estimate is constrained in a way that will not result
in a highly probable significant reversal of revenue in the future. Any portion of the contract
price that is not included in the transaction price and will thus not be recognised as revenue
will thus be recognised as a refund liability. This refund liability will need to be reassessed at
each reporting date and any adjustments will be accounted for in revenue.
Example 16: Variable consideration – volume rebate

An entity sold 500 tennis racquets to a customer for C100 each on 1 June 20X8. The entity
offers a volume rebate of 10% off the contracted price if a customer purchases more than
2 000 racquets before 31 December of a year. This rebate is offered retrospectively. At the time of the
sale, it was expected that this customer would qualify for the rebate. However, by 31 December, the
customer had not purchased any further racquets due to being forced to close a number of shops.
Required: Prepare the journal entry to reflect the information provided.
Solution 16: Variable consideration – volume rebate

1 June 20X8 Debit Credit
Accounts receivable (A) 500 x C100 5 000
Refund liability (L) 500 x C100 x 10% 500
Revenue from customer contracts (I) (500 – 100) x C10 4 500
Recognise revenue (amount we expect to be entitled to) and refund
liability (amount we expect to refund by way of a rebate)
31 December 20X8
Refund liability (L) (100 – 80) x C10 500
Revenue from customer contracts (I) 500
Adjustment to refund liability and revenue when uncertainty is resolved
7.2.6.3 Contracts involving a sale with a right of return (IFRS 15.51 & .55 & B20 – B27)
A sale with a right of return involves variable consideration A sale with the right
because we can’t be certain how much of the consideration of return involves
variable consideration:
we will get to keep and how much we may have to refund
in the event that goods are returned. consideration for the products we
expect will be returned is not
included in the TP (i.e. it must be
This refund could come in many different forms: it could be recognised as a refund liability –
a full or partial refund, or a credit that the customer can use not revenue);
to reduce his account balance or to buy something in the consideration for the products
future or could be another entirely different product in that we expect won’t be returned
exchange. is included in the TP (i.e. it will be
recognised as revenue) – we must
However, it is important to note that, when accounting for a estimate this variable
consideration & constrain it with
right to return, we only consider returns of goods that have reference to the expected
commercial substance. In other words, a sale of goods to a returns.
customer who may exchange the goods for a different size
or colour is not a right of return that needs to be accounted for because such an exchange will
have no effect on our net assets or profit (i.e. no adjustment is made for these exchanges).
If we sell an item to a customer and, at the same time, we offer the customer a right to return
it, we must exclude the consideration for these items from the transaction price if the entity
expects them to be returned.
138 Chapter 4
This should make sense because, if you recall, the transaction price reflects the amount of
consideration to which the entity expects to be entitled. Thus, if an entity expects certain
goods to be returned, it cannot expect to be entitled to the consideration for these goods. The
consideration for these goods is thus excluded from the transaction price (and thus not
recognised as revenue). The consideration for these goods is thus recognised as a
refund liability instead.
The remaining promised consideration (i.e. the consideration to which the entity expects to be
entitled – or, in other words, the consideration for the goods or services that the entity does
not expect to be returned), is variable consideration since we cannot be certain as to what will
or will not be returned. Thus, for the purpose of including in the transaction price (and
ultimately in revenue), we estimate how much of the consideration is variable and then
constrain this estimate, based on the products that we expect will be returned. This
constrained variable consideration (i.e. reflecting the sale of goods that we do not expect will
be returned) is included in the transaction price and will thus be recognised as revenue.
In addition to splitting the contract price between that which will be included in the
transaction price (revenue) and that which will be excluded from the transaction price (refund
liability), we must also recognise an asset reflecting the right to recover the goods that the
customers must physically return in exchange for the refund. This right to recover the goods is
measured at the same carrying amount that was expensed when it was sold (in other words, in
the case of inventory, this would typically be the cost of the goods) but adjusted for any costs
expected to have to be incurred in recovering these goods. These costs would include any
decreases in the value of the goods, reflecting the fact that the returned goods are no longer
new and may not have their original packaging (the return of defective goods is not accounted
for as a right of return – these are accounted for as warranties – see section 11).
At each reporting period, we would then have to reassess our estimation of:
the refund liability – any adjustment will be recognised in revenue; and
the refund asset (right to recover the goods) – any adjustment will be recognised in cost of
sales expense.
Summary: The accounts to be recognised when accounting for a right of return

Recognise the following
accounts:
Goods not expected to be returned Revenue

Contract price
Goods expected to be returned Refund liability
Refund asset (the right to

recover the goods)
Example 17: Variable consideration – sale with right of return

An entity sold 500 green t-shirts to a long-standing customer for C10 each (each t-shirt cost
C7). The customer will be giving these t-shirts to people attending a particular
environmental event. The customer may return any t-shirts in excess of requirements if they are
returned in good condition before 15 January 20X1.
Using expected values, the entity estimates that the customer will return 100 t-shirts (it did not
constrain this estimate since it believes that it is highly probable that this estimate will not lead to a
significant reversal of revenue in the future).
The customer took delivery of the 500 t-shirts on 5 January 20X1.
On 12 January 20X1, the customer returned 80 t-shirts and paid for the 420 t-shirts used.
Required: Prepare the journal entry to reflect the information provided.
Chapter 4 139
Solution 17: Variable consideration – sale with right of return

Accounts receivable (A) 500 x C10 5 000
Refund liability (L) 100 x C10 1 000
Revenue from customer contracts (I) (500 – 100) x C10 4 000
Recognise revenue (amount we expect to be entitled to) and refund
liability (amount we expect to refund)
Cost of sales (E) (500 – 100) x C7 2 800
Right of return asset (A) 100 x C7 700
Inventory (A) 500 x C7 3 500
Recognising the cost of the sale and the right of return asset (cost of the
inventories we expect to recover when the customer returns his t-shirts)
12 January 20X1
Refund liability (L) (100 – 80) x C10 1 000
Revenue from customer contracts (I) 200
Accounts receivable (A) 800
Bank (A) 420 x C10 4 200
Adjusting the refund liability by adjusting revenue for the goods that
were not returned, reduce the receivable by the remaining refund liability
being the goods that were returned & recognising the cash received
Cost of sales (E) 20 x C7 140
Inventory (A) 80 x C7 560
Right of return asset (A) 700
Reverse right of return asset: uncertainty is resolved: partly expensed (20
shirts not returned) and partly returned to inventory (80 shirts returned)
Please remember that the ability to return defective products is not accounted for as a ‘right of
return’ but rather as a warranty. Accounting for warranties is explained in section 11.
7.2.7 Reassessment of variable consideration (IFRS 15.59 and .87-.89)
The transaction price, which is estimated at contract inception, must be re-estimated at every
reporting date to reflect the circumstances at this date and the change in circumstances during
the reporting period.
Any change in the transaction price must be allocated to performance obligations on the same
basis that the original transaction price was allocated at contract inception. If one or more of
these performance obligations have already been satisfied, the related revenue from this
performance obligation will have already been recognised. Thus if the transaction price
increases (or decreases), the portion of the increase (or decrease) that relates to this satisfied
performance obligation will be recognised as an increase (or decrease) in revenue.
7.2.8 Exception to estimating and constraining variable consideration (IFRS 15.58)
An entity may sign a contract with a customer wherein the entity will earn royalties from
allowing the customer to use certain licensed intellectual property. The promised
consideration may be calculated in many ways but if it is calculated based on how many items
under licence the customer sells or uses, the promised consideration is clearly variable
consideration (because we won’t know how many items the customer will sell or use).
However, although it is variable consideration, we would not apply the usual principle of
estimating the variable consideration and then constraining this estimate. Instead, royalty
consideration from licensed intellectual property that are calculated based on sales or usage
will only be recognised as revenue when the customer sells or uses the items under licence.
Thus, at this point, there would be no variability to account for.
140 Chapter 4
7.3 Significant financing component (IFRS 15.60-.65)

7.3.1 Overview A financing component
exists if there is a
If the contract includes a significant financing component, difference between:
we will need to exclude the effects thereof from the the timing of the payment &
transaction price. the timing of the performance.
See IFRS 15.60
In other words, the transaction price should reflect the cash

selling price when (or as) the customer obtained control thereof. Another way of putting this
is that the transaction price must be adjusted for the time value of money - we need to remove
the effects of the financing from the promised consideration in order to calculate the
contract’s true transaction price.
The related interest is then recognised separately using an appropriate discount rate over the
period of the financing using the effective interest rate method in terms of IFRS 9 Financial
instruments. See IFRS 15.IE140
The reason why we need to separate the effects of financing is because the economic
characteristics of a transaction that involves providing goods or services and a transaction that
involves financing are vastly different. See IFRS 15.BC246
The fact that financing is being provided need not be explicitly stated in the contract – it can
simply be implied by the payment terms. This means that, whether or not the contract states
that it includes an element of financing, a financing component is deemed to exist if the
timing of the payment differs from the timing of the transfer of the good/ service. See IFRS 15.60
We also need to realise that it could be either the entity or the customer providing financing:
If the customer pays in advance (i.e. before he receives control over the goods or
services), then the customer is providing the finance and the entity is receiving the benefit
of the financing. Thus, the entity may need to recognise a finance expense.
If the customer pays in arrears (i.e. after he receives control over the goods or services),
then the entity is providing the finance and the customer is receiving the benefit of the
financing. Thus, the entity may need to recognise finance income. See IFRS 15.62
For practical purposes (referred to as a practical expedient), IFRS 15 allows us to ignore the
time value of money if, at inception of the contract, the period between the customer
obtaining control and the receipt of the consideration is expected to be 12 months or less.
Example 18: Significant financing component – arrears versus advance

An entity signed a contract with a customer to transfer goods to the customer in exchange
for promised consideration of C100 000.
The timing of the transfer and the timing of the payment differ.
A consideration of this difference and all other facts and circumstances led the accountant to conclude,
correctly, that the contract includes a significant financing component.
The difference between the promised consideration and the cash selling price on the expected date of
transfer is C10 000.
Required:
Identify the party that obtains the benefit of the financing and then calculate the transaction price and
the effect of the financing that the entity will have to account for:
A) the customer pays in arrears (i.e. after the transfer of goods);
B) the customer pays in advance (i.e. before the transfer of goods).
Chapter 4 141
Solution 18: Significant financing component – arrears versus advance

a) The customer obtains the benefit of the financing.
The entity will have to account for the following:
Transaction price = cash selling price = C90 000 (contract revenue)
Calculation: Promised consideration 100 000 – Difference (Financing income) 10 000
Finance income = C10 000 (amount given) (a separate income i.e. separate to the contract revenue)
b) The entity obtains the benefit of the financing.
The entity will have to account for the following:
Transaction price = cash selling price = C110 000 (revenue from the contract)
Calculation: Promised consideration: 100 000 + Difference (Financing expense): 10 000
Finance expense = C10 000 (amount given) (separate expense i.e. not set-off against contract revenue)
Example 19: Significant financing component – arrears journals

Pink Limited signed a contract with a customer on 1 January 20X1 to transfer goods to the
customer (transfer takes place on 1 January 20X1) in exchange for promised consideration
of C121 000, payable on 31 December 20X2. After careful consideration of the facts, it was decided:
that the payment terms constitute a significant financing component in terms of IFRS 15.
the implicit interest rate of 10% is an appropriate discount rate in terms of IFRS 15.
Required: Prepare all related journals for Pink Limited, using its General Journal.
Solution 19: Significant financing component – arrears journals

Comment:
The payment occurs 2 years after transfer takes place (i.e. the customer pays in arrears) and thus
the entity is providing financing to the customer over this 2 year period and will need to recognise
interest income.
The transaction price for the contract to transfer goods must be measured at the cash sales price on
date of transfer. We are not given this, but we can work this out by calculating the present valuing
of the payment to the date that the goods are transferred to the customer (i.e. when the customer
obtains control).
The interest rate implied by the payment terms was given as 10% but could have been calculated
using your calculator. In this situation, the implicit interest rate was considered to be an
appropriate discount rate to use in the calculation of the present value of C121 000. Using a
financial calculator, we calculate the cash selling price of C100 000. We recognise this as revenue
on the date that the goods are transferred (i.e. as our PO is satisfied).
The interest is recognised on this receivable over the 2 years that financing is provided, using the
effective interest rate method.
Revenue from contracts with customers (I) 100 000
Recognising the revenue from the contract on transfer of the goods
31 December 20X1
Accounts receivable (A) 100 000 x 10% x 12/12 10 000
Revenue from interest (I) 10 000
Recognising the interest income on the significant financing component
31 December 20X2
Accounts receivable (A) (100 000 + 10 000) x 10% x 11 000
Revenue from interest (I) 12/12 11 000
Recognising the interest income on the significant financing component
Bank (A) 100 000 + 10 000 + 11 000 121 000
Recognising the receipt of the promised consideration from the customer
142 Chapter 4
Example 20: Significant financing component – advance journals

Blue Limited signed a contract with a customer on 1 January 20X1 to transfer goods to the
customer (transfer takes place on 31 December 20X2) in exchange for consideration of
C100 000, payable on 1 January 20X1, or C121 000 on 31 December 20X2. The customer chooses to
make a payment of C100 000 on 1 January 20X1.
The payment terms are considered to constitute a significant financing component in terms of IFRS 15.
The implicit interest rate of 10% is considered to be an appropriate discount rate in terms of IFRS 15.
Required: Prepare all related journals for Blue Limited, using its General Journal.
Solution 20: Significant financing component – advance journals

Comment:
The customer chooses to pay 2 years before transfer takes place (i.e. the customer pays in advance)
and thus the customer is providing financing to the entity over this 2 year period and thus the entity
will need to recognise an interest expense.
date of transfer. Although the customer pays C100 000, the future value on date of transfer of the
goods is given as C121 000. The future amount (C121 000) is more than the amount actually
received (C100 000) because the amount actually received is effectively a net amount of the
amount the customer owes us for the goods (C121 000) less the amount we owe the customer for
the interest (C21 000).
The interest rate implied by the payment terms was given as 10% but could have been calculated
using your calculator (FV C121 000; PV C100 000; Period 2 years). In this situation, the implicit
interest rate was considered an appropriate discount rate to use in the calculation of the interest.
The interest is recognised on this liability over the 2 years that financing is provided, using the
effective interest rate method.
Cash (A) Given 100 000
Recognising the cash received in advance from the customer as a liability
31 December 20X1
Interest expense 100 000 x 10% x 12/12 10 000
Recognising the interest expense on the significant financing component
Journals continued ... Debit Credit
31 December 20X2
Interest expense (100 000 + 10 000) x 10% x 11 000
Contract liability (L) 12/12 11 000
Contract liability (L) 100 000 + 10 000 + 11 000 121 000
Revenue from contracts with customers 121 000
7.3.2 When would we adjust for the effects of financing? The transaction price
excludes the effect of
Although a financing component may exist, the only time financing if:
we would adjust the transaction price for the existence of
the timing difference is > 1yr &
the financing component is if:
the benefit is significant to the
the difference between the timing of the payment and contract. See IFRS 15.61 & .63
the timing of the transfer of goods or services is more
than one year; and
the financing benefit provided (to the entity or its customer) is considered significant to
the contract. See IFRS 15.61 & .63
Chapter 4 143
Example 21: Significant financing component exists – adjust or not

Both Blipper and its customer Ben signed a contract on 1 April 20X2 in which the
contractual terms include the following:
the entity will transfer the promised goods to the customer at inception of the contract;
the customer will pay the promised consideration of C484 on 31 March 20X4; and
no interest will be charged.
The cash selling price for these goods on date of transfer (i.e. 1 April 20X2) is C400. The customer
made the required payment on the date stipulated in the contract.
The benefit from any financing is considered to be significant. The appropriate discount rate is
considered to be 10%.
Required:
A. Prepare all related journal entries to reflect the information provided above.
B. Show how your answer would change if the terms of the contract required the customer to pay the
promised consideration on 31 December 20X2 (i.e. not 31 March 20X4).
C. Explain how your answer would change if the benefit of the financing component was considered
to be insignificant.
Solution 21A: Transaction price adjusted for significant financing

Comment:
The timing of the transfer of the goods differs from the timing of the payment and thus there is a
financing component to this contract.
The difference in the timings is more than one year (it is 2 years) and the benefit from the
financing is significant (we are told to assume this). Since both criteria are met, we must adjust the
transaction price for the existence of the financing.
Thus, although the promised consideration is C484, we must separate out the financing component
from the transfer of goods and services and measure the related transaction price at the notional
cash selling price of C400 and account for this in terms of the five-step approach in IFRS 15.
The financing component of C84 (promised consideration: C484 – transaction price: C400) is
measured over the period of the financing using the effective interest rate method in IFRS 9.
In this case, the entity provides the finance and thus earns interest. The interest earned is credited
to ‘interest income’. When presenting the SOCI, the effects of the financing component must be
presented separately from the revenue from contracts with customers. If earning this interest was
considered part of the entity’s ordinary activities, then the interest would be recognised as interest
revenue (instead of interest income), but it would still be presented separately from the revenue
from customer contracts.
5-step approach to recognising revenue from the contract with the customer:
- Identify the contract: A contract exists between Blipper and Ben, creating enforceable rights
and obligations.
- Identify the performance obligations: This contract has one performance obligation – the
transfer of goods.
- Determine the transaction price: The transaction price is the amount that the entity expects to
be entitled to, measured net of the significant financing component: C400 (explained above).
- Allocate the transaction price to the performance obligation/s: Since there is only one
performance obligation (the transfer of goods), the entire transaction price is allocated to this
one performance obligation.
- Recognise revenue from the contract when the performance obligation (PO) is satisfied: The
PO is satisfied when the customer gets control of the goods (1 April 20X2). Thus revenue from
the contract with the customer must be recognised on this date.

Revenue from contracts with customers (I) 400
Recording the revenue from the contract with customer Ben
144 Chapter 4

Accounts receivable (A) 400 x 10% x 9/12 30
Revenue from interest (I) 30
Recording the revenue from interest on the contract with the customer
31 December 20X3
Accounts receivable (A) (400 x 10% x 3/12) + (400 x 43
Revenue from interest (I) 1.1 x 10% x 9/12) 43
31 March 20X4
Accounts receivable (A) 400 x 1.1 x 10% x 3/12 11
Revenue from interest (I) 11
Bank (A) 400 + 30 + 43 + 11 484
Recording the receipt of the promised consideration from the customer
Solution 21B: Transaction price not adjusted for significant financing

Comment:
The timing of the transfer of the goods and the payment differs and thus there is a financing
component to this contract.
The difference in the timings is less than one year (it is 9 months) and thus, although the benefit
from the financing is significant (we are told to assume this), we do not remove the effects of the
financing when calculating the transaction price.
The transaction price is thus measured at the promised consideration of C484.

31 December 20X2
Bank (A) 484
Solution 21C: Transaction price not adjusted for financing

Comment:
The timing of the transfer of the goods and the payment differs and thus there is a financing
component to this contract.
The difference in the timings is more than one year (it is 2 years) but the benefit from the financing
is insignificant (we are told to assume this) and thus we do not adjust the transaction price.
The transaction price is thus measured at the promised consideration of C484.

31 March 20X4
Bank (A) 484
Chapter 4 145
7.3.3 How do we decide whether a financing component is significant or not?

When assessing if a financing component is significant, we
assess it in relation to the contract – not to the individual The significance of a
financing component is
performance obligation/s which may be financed. determined:
Whether or not the benefit of a financing component is relative to the contract as a
significant to the contract requires us to consider all ‘facts whole; &
and circumstances’ including: involves assessing all facts &
any difference between the promised consideration and circumstances.
See IFRS 15.61
the cash selling price; and
the ‘combined effect’ of the following:
- the expected time period between the transfer of the good/ service and the receipt of
the consideration; and
- the prevailing market interest rates. See IFRS 15.61 (reworded slightly)
Normally, if there is a significant difference between the amount of the promised
consideration and the cash selling price and the period between the date of payment and the
date of transfer of the goods or services is more than one year, a significant financing
component is said to exist and we must remove the effects of the financing when calculating
the transaction price. However, a significant financing component will be deemed not to exist
in the following situations. In each of these situations, the essential reason for deeming that a
significant financing component does not exist is because the primary purpose of the payment
terms in these situations is not to provide financing. In other words, the payment terms are for
a reason other than financing:
a) A significant financing component would not be considered to exist if the transfer of
goods or services is delayed at the customer’s request (i.e. the customer has paid in
advance but has requested/ chosen to delay the transfer of goods).
Examples of this situation include sales on a bill and hold basis, prepaid electricity and the
sale of customer loyalty points where the purpose of the payment terms (i.e. where the
customer has paid but is able to delay the receipt of the promised goods or services) may
be assumed to not be related to a financing arrangement.
b) A significant financing component would not be considered to exist if a ‘substantial
amount’ of the promised consideration is variable and this variability (of the amount of
the payments or timing thereof) is dependent on future events over which neither the
customer nor the entity has control.
Examples of this situation include royalty contracts where, for example, the contractual
terms may allow a delay in the payment of the promised consideration, the purpose of
which is merely to provide the parties with the necessary comfort where significant
uncertainty exists as to the value of the royalty.
c) A significant financing component would not be considered to exist if ‘the difference
between the promised consideration and the cash selling price’ is to satisfy a purpose
other than financing.
Examples of this situation include a customer paying in arrears in order to ensure
successful completion of a project or a customer paying in advance in order to secure
See IFRS 15.62 & .BC233
goods that are in limited supply.
Allocation of a significant financing component to more than one PO appears unclear
As already mentioned, when we consider whether or not the benefit of a financing component is
significant, we consider it in context of the entire contract – not on the basis of a specific
performance obligation that may be financed.
However, it appears unclear, in the case of a contract that has more than one performance obligation, how a
financing benefit that is considered to be significant in the context of the contract would be allocated to the
specific performance obligations....Would they, for example, be allocated to only those performance obligations
that are being financed, or would they be allocated to all the performance obligations in the contract.
The wording in this regard appears vague and thus it is expected that further guidance from the IASB may be
needed. See IFRS 15.61 & .BC234
146 Chapter 4
7.3.4 What discount rate should we use? (IFRS 15.64)
The discount rate that we should use is the rate that the
entity and the customer would have agreed upon if they had The discount rate to
use is:
entered into a separate financing agreement on inception of
the contract. This discount rate is based on the relevant the rate the entity & customer
circumstances on the date of inception of the contracts and would have agreed upon
must not be updated for any changes in circumstances. if they had entered into a
separate financing agreement
on date of contract inception.
This discount rate takes into account the credit risk of the See IFRS 15.64
borrower at contract inception and other related factors

such as any security provided by the borrower. In other words, we would not use a market-
related interest rate, a risk-free interest rate or the interest rate in the contract (whether it is
explicitly stated or whether it is the implicit rate) unless it reflects the interest rate that the
entity and the customer would have agreed upon had they entered into a separate financing
agreement at contract inception.
Example 22: Significant financing component – discount rate

The following example is a continuation of the previous example XXX (i.e. the previous
example involving Blue Limited).
The difference is that the interest rate implicit in the contract is now not considered to be an appropriate
discount rate for purposes of IFRS 15.
Blue Limited signed a contract with a customer on 1 January 20X1 to transfer goods to the customer
(transfer takes place on 31 December 20X2) in exchange for consideration of C100 000, payable on
1 January 20X1, or C121 000 on 31 December 20X2. The customer chooses to make a payment of
C100 000 on 1 January 20X1.
The payment terms are considered to constitute a significant financing component in terms of IFRS 15.
The implicit interest rate in the contract is 10% but the rate that the customer and entity would have
agreed to had they entered into a separate financing agreement on date of contract inception is 8%.
Required:
Prepare all related journals for Blue Limited, using its General Journal.
Solution 22: Significant financing component – discount rate

Comment:
The customer chooses to pay 2 years before transfer takes place (i.e. the customer pays in advance)
and thus the customer is providing financing to the entity over this 2 year period and thus the entity
will need to recognise an interest expense.
date of transfer. Although the future value on date of transfer of the goods is given as C121 000,
this is based on the implicit interest rate of 10% when an appropriate discount rate for this contract
is said to be 8%. Thus the contract liability is accreted (increased) by interest of only 8%, with the
result that the revenue recognised on date of transfer will only be C116 640 (i.e. its notional cash
selling price).
Cash (A) Given 100 000
Recognising the cash received in advance from the customer as a liability
31 December 20X1
Interest expense 100 000 x 8% x 12/12 8 000
Chapter 4 147

Interest expense (100 000 + 8 000) x 8% x 12/12 8 640
Contract liability (L) 100 000 + 8 000 + 8 640 116 640
7.3.5 How do we present interest from the significant financing component? (IFRS 15.65)
When accounting for the interest relating to a significant Interest contained in a
financing component that is found to exist in a contract contract is presented
with a customer, we would either recognise that we have separately from
earned interest (income) or incurred interest (expense), revenue from contracts
with customers.
depending on whether we provided the financing to the See IFRS 15.65
customer or received the financing from the customer.
Interest income is presented as interest revenue only if it was earned as part of the entity’s
ordinary activities. However, this interest income, whether presented as part of revenue or
not, is not considered part of the revenue from the contract with the customer and thus it
must be presented separately from the line-item ‘revenue from contracts with customers’.
Interest expense is presented separately from the line-item ‘revenue from contracts with
customers’ (i.e. a related ‘interest expense’ may not be offset against the ‘revenue from
contracts with customers’). See IFRS 15.65 & .BC247
7.4 Non-cash consideration (IFRS 15.66-.69)
7.4.1 Overview
Non-cash consideration
If the contract price includes non-cash consideration, this
will need to be included in the transaction price – unless the is included in the TP if the entity
gets control of the non-cash items,
entity does not obtain control over the non-cash items. This
is measured at its FV.
non-cash consideration should be measured at its fair value See IFRS 15.61
assuming this is able to be reasonably estimated. If a
reasonable estimate is not possible, it is measured based on the stand-alone prices of the
goods or services to be transferred to the customer (i.e. it is measured on the basis of the
goods or services given up).
7.4.2 Whether to include non-cash items in the transaction price
A contract price may include non-cash consideration. Non-cash consideration arises in a

contract when this contract requires the customer to pay the promised consideration, either
partly or entirely, using something other than cash – with a non-cash item/s. For example, the
customer could be required to pay the consideration by providing the entity with services or
with some other non-cash item (e.g. a vehicle).
If the entity obtains control over these non-cash items, they are considered to be non-cash
consideration and must be included in the transaction price. If the entity does not obtain
control over these non-cash items (e.g. goods or services etc), these non-cash items are not
considered to be non-cash consideration and are thus not included in the transaction price.
For example, if the customer provides the entity with a machine to be used by the entity in
completing its obligations but over which the entity does not obtain control, then the
transaction price must not include the value of the machine because the machine is not
considered to be ‘non-cash consideration’. Conversely, if the customer provides the entity
with a machine to be used by the entity in completing its obligations, for example, and the
entity obtains control over this asset, then the machine is considered to be ‘non-cash
consideration’ and thus the transaction price must include the value of the machine.
148 Chapter 4
7.4.3 How to measure non-cash consideration

When including non-cash consideration in the transaction price, we measure it at its fair
value. However, if a reasonable estimate of the fair value is not possible, we measure it
indirectly based on the stand-alone selling prices of the goods or services transferred (i.e. the
goods or services given up).
When trying to estimate the fair value of the non-cash consideration, we may find that the fair
value is variable. There are two reasons why the fair value could vary:
it could vary due to the form of the consideration (e.g. if the non-cash consideration is a
share that the customer will give to the entity, the price of which changes daily on the
stock exchange, it may be difficult to estimate what this fair value will be); or
it could vary due to reasons other than form (e.g. uncertainties regarding the future and
thus what or how much non-cash consideration will be received, if any).
If the variability of the fair value is due to reasons other than the form of the non-cash
consideration (e.g. it is due to uncertainty regarding whether or not it will be received), then
we must measure the non-cash consideration as variable consideration. Thus, we will need to
ensure that the estimate of its fair value is constrained (i.e. limited) to an amount that has a
high probability of not resulting in a significant revenue reversal in the future. See IFRS 15.BC253
Once the non-cash consideration is recognised as having been received, it is accounted for in
terms of the IFRS that is relevant to that item. For example, if we receive an asset that we
intend to use in our business, we would account for that asset in terms of IAS 16 Property,
plant and equipment, whereas if we receive an asset that we intend to sell as part of our
normal activities, then we would account for it in terms of IAS 2 Inventory.
Once the fair value of the non-cash consideration has been recognised, changes to that fair
value are not recognised within revenue. See IFRS 15.IE158
Example 23: Non-cash consideration
Yellow Limited signed a contract with a customer, Mauve Limited, on 1 January 20X1.
Required: Briefly explain what Yellow’s transaction price would be in the following instances:
a) The contract requires Yellow to provide services to Maeve over a period of 3 months and requires
Maeve, to pay C100 000 in cash and to provide a machine that Yellow will use in the performance
of the services. Yellow will return the machine at the end of the contract. The fair value of the
machine is C50 000.
b) The contract requires Yellow to transfer goods to the customer on 1 January 20X1 and requires
Maeve to pay C100 000 in cash and to issue Yellow with 1 000 shares in Mauve on 30 June 20X1,
the date on which Maeve will be issuing these shares. The fair value of these shares could be
anything between C40 and C60 per share on date of issue, but is expected to be C50 per share. The
cash selling price of the goods being transferred is C160 000.
Solution 23: Non-cash consideration

a) The contract refers to the promise of both cash (C100 000) and a machine (C50 000). However,
Yellow must return the machine and thus it does not obtain control of the machine. Thus, the
machine is not considered to be non-cash consideration. Consequently, the value of the machine is
not included in the transaction price.
The transaction price is thus C100 000 (i.e. the cash consideration only).
b) Yellow will obtain control over the shares and thus the contract is said to include both cash
consideration (C100 000) and non-cash consideration (shares).
We are not sure what the fair value of the shares will be. However, the variability of the fair value
is due entirely to the form of the non-cash consideration and thus it is not considered to be ‘variable
consideration’ for purposes of IFRS 15. In other words, when measuring the fair value of the
shares, we do not apply the requirements for measuring variable consideration (we do not need to
estimate it using one of the two methods and then constrain this estimate).
Chapter 4 149
If the estimate of C50 per share is a reliable estimate, then the transaction price will be C150 000
(cash consideration: C100 000 + non-cash consideration: C50 x 1000 shares).
Recognising revenue from the customer contract when the
performance obligation is satisfied (transaction price includes
non-cash consideration measured at its FV)
If the estimate of C50 per share is not a reliable estimate, then non-cash consideration will be
measured indirectly based on the stand-alone prices of the goods transferred.
The stand-alone price of the goods transferred is given as C160 000.
The transaction price is thus C160 000 (the stand-alone selling price of the goods transferred).
The non-cash consideration is measured indirectly using this stand-alone price (i.e. we balance back
to the non-cash consideration):
Since part of the consideration is cash of C100 000, the non-cash consideration is measured at C60
000 (total consideration: C160 000 – cash: C100 000).
Recognising revenue from customer contract when
performance obligation satisfied (transaction price includes
non-cash consideration measured indirectly based on the
stand-alone price of the goods transferred)
Note: if the actual fair value per share is, for example, C70 on the date that we receive the shares, the
increase of C10 in the share’s fair value (C70 – C60) is recognised as a gain in terms of
IFRS 9 Financial instruments and not as an increase to revenue.
7.5 Consideration payable to the customer (IFRS 15.70-.72)
7.5.1 Overview The transaction price

is reduced by the
consideration payable
Sometimes a contract includes not only consideration to the customer (or the customer’s
payable by the customer to the entity, but also consideration customers), unless it is for the
payable by the entity to the customer. If this happens, the transfer of distinct goods or
transaction price must be reduced by: services for which FVs can be
the consideration (1) reliably estimated.
See IFRS 15.70
that the entity expects to pay the customer (2)
unless the payment by the entity is for the transfer of distinct goods or services from the
customer (and the fair value of these goods or services is able to be reasonably estimated
and the cash payable does not exceed this fair value).
Note 1: Consideration could come in the form of:
a cash amount that the entity pays, or expects to pay, the customer (or the customer’s
customers); or
credits, coupons, vouchers or other items that may be used to reduce the amount owed to
the entity. See IFRS 15.70
Note 2: If a contract requires the entity to pay consideration to ‘parties that purchase the entity’s
goods or services from the customer’ (e.g. our customer’s customers), we would account
for this payment as if it was consideration payable to the customer.
A reduction to the transaction price obviously means a reduction to the amount recognised as
revenue. However, the reduction to the revenue would not necessarily be recognised at the
time the revenue is recognised.
150 Chapter 4
Instead, the reduction to the revenue is recognised on the

later of the following two dates: Consideration payable
to a customer
the date on which the revenue is recognised; and includes:
the date on which the entity pays or promises to pay the
cash; and
consideration. See IFRS 15.72
other items that may be used to
reduce the amount owed to the
These principles are best explained by way of example. entity (e.g. coupons) and
includes consideration payable to
If the consideration payable is not for the acquisition of customers and also the
distinct goods or services, we must adjust the transaction customer’s customers.
See IFRS 15.70
price (i.e. we reduce the TP).
Worked example 1: Consideration payable is not for distinct goods or services

(do reduce the TP)
If we expect a customer to pay us C100 000 in return for goods and we expect to pay the
customer C20 000, but we are not effectively purchasing something for C20 000, we would net the two
amounts off and account for the transaction price at the reduced C80 000. Assume that we first paid the
customer and then transferred 40% of the goods:
Debit Credit
Contract asset: prepayment (A) Given 20 000
Bank 20 000
Recognising payment to customer
Receivable (A) 100 000 x 40% 40 000
Revenue from customer contracts (I) (100 000 – 20 000) x 40% 32 000
Contract asset: prepayment (A) 20 000 x 40% 8 000
Recognising 40% of the receivable and 40% of the revenue
based on the reduced transaction price
This can happen where, for example, our customer requires the construction of a store-room (cost
C20 000) in order to house the goods he is buying from us. Since we do not obtain control of the store-
room, we are not effectively acquiring control of a distinct good or service.
If the consideration payable is for the transfer of distinct goods or services, this must simply
be recognised as a separate transaction and would not affect the transaction price.
Worked example 2: Consideration payable is for distinct goods or services

(do not reduce the TP)
If we expect the customer to pay us C100 000 and we expect to pay the customer C20 000,
but we are effectively purchasing inventory for C20 000, we would not net the two amounts off. We
would account for the C100 000 as the transaction price for revenue (IFRS 15) – we would not reduce
it by the consideration payable. The C20 000 payable would be accounted for as the cost of purchasing
inventory (IAS 2). Assume that we first paid the customer and then transferred 40% of the goods:
Debit Credit
Inventory (A) Given 20 000
Bank 20 000
Receivable (A) 100 000 x 40% 40 000
Revenue from customer contracts (I) 100 000 x 40% 40 000
based on the unadjusted transaction price
If the consideration payable is for a distinct good or service but the fair value thereof is not
able to be reasonably estimated, then the entire consideration payable to the customer is
accounted for as a reduction in the transaction price. Similarly, if the consideration payable is
for a distinct good or service but the consideration payable exceeds the fair value thereof, then
the excess will be accounted for as a reduction of the transaction price.
Chapter 4 151
Worked example 3: Consideration payable is for distinct goods or services but

exceeds their fair value (do reduce the TP – by the excess)
If we expect the customer to pay us C100 000 and we expect to pay the customer C20 000,
but we are effectively purchasing inventory with a fair value of C15 000, the consideration payable
exceeds the fair value of the distinct good purchased.
The transaction price must be reduced by this excess of C5 000.
Assume that we first paid the customer and then transferred 40% of the goods:
Debit Credit
Inventory (A) FV 15 000
Contract asset: prepayment (A) 20 000 – 15 000 5 000
Bank Given 20 000
Accounts receivable (A) 100 000 x 40% 40 000
Contract asset: prepayment (A) 5 000 x 40% 2 000
Revenue from customer contracts (I) (100 000 – 5 000) x 40% 38 000
based on the adjusted transaction price
The consideration payable does not need to be in the form of cash – it could for example be in
the form of coupons. Similarly, the consideration need not be payable to the customer – it
could be payable to the customer’s customers.
Worked example 4: Consideration payable – coupons for customer’s customers

A manufacturer of shampoo (the entity) enters into a contract with a retailer (the customer)
in which the manufacturer agrees to sell 100 000 bottles of shampoo to the retailer in
exchange for consideration of C1 000 000 and the manufacturer further agrees to provide coupons – not
for use by the retailer, but for use by the retailer’s customers (the shoppers).
A coupon is then attached to each bottle offering the customer a refund of C1 on presentation of the
coupon and this refund of C1 per bottle may be offset by the retailer in determining the amount payable
to the manufacturer.
In this case, the consideration payable is in the form of coupons that the customer’s customers can
utilise when purchasing shampoo from the customer (i.e. the retailer). However, the retailer may then
utilise the coupons to reduce the amount owing to the manufacturer. Thus, when the manufacturer
determines the transaction price, it must deduct the potential consideration payable. Thus the
transaction would be determined at C900 000.
Calculation: Consideration payable by the customer: (100 000 bottles x C10 each) – Consideration payable by the
entity: (100 000 bottles x C1 each).
Worked example 5: Consideration payable – coupons for customer’s customers

This example follows on from the previous worked example (worked example 4), where the
manufacturer of the shampoo (the entity) agreed to provide coupons offering a discount of
C1 per bottle which are for use by the retailer’s customers (the shoppers).
If the coupon is available for use immediately (i.e. the shopper can get the C1 discount immediately),
then the manufacturer (i.e. the entity) would recognise the reduction in the revenue on the date that it
recognised the revenue (i.e. on the date that the manufacturer transferred the shampoo bottles to the
retailer).
If the coupon is available for use by the retailer’s customers at some date in the future (e.g. against the
purchase of another product that is not yet available upon the shelves), then the manufacturer (i.e. the
entity) would recognise the reduction in the revenue on the date that it sold these new products to the
See the pop-up on the apparent contradiction!
retailer.
152 Chapter 4
Contradiction relating to the recognition of a reduction in the transaction price

The delayed timing of the recognition of the potential reduction in revenue (e.g. the
potential discounts that may arise due to the potential use of coupons) required in the
section on ‘consideration payable to customers’ appears to contradict the section on ‘variable
consideration’. Variable consideration includes aspects such as discounts and other implied price
concessions and yet the section relating to variable consideration requires that we estimate the
variable consideration using either the expected value method or the most likely outcome method
and then constrain the estimate and that this variable consideration needs to be taken into
account in determining the transaction price at inception of the contract – not at a later date.
8. Allocating the transaction price to the performance obligations (step 4)
8.1 Overview
A contract frequently involves more than one performance The objective when
obligation (PO) and yet the transaction price (TP) is allocating the transaction
price (TP) is:
determined for the contract as a whole.
for an entity to allocate the TP
to each PO (or distinct
The transaction price represents the revenue that will be good/service)
earned from the whole contract and thus, since revenue is in an amount that depicts
recognised when (or as) the performance obligation is the amount of consideration
satisfied, we will need to allocate the transaction price to which the entity expects to
(revenue) to each of these performance obligations. be entitled
in exchange for transferring
The transaction price is allocated to each of the the promised goods or services
performance obligations based on their relative stand-alone to the customer.
IFRS 15.73
selling prices.
Exceptions to this approach may arise if the transaction price includes:

a discount; or
variable consideration.
We will first discuss the allocation of a transaction price Stand-alone selling prices
where no discount is involved, then discuss the allocation are defined as
of a transaction price that does involve discount and then ‘the price at which
finally will discuss the allocation of a transaction price that an entity would sell
involves variable consideration. a promised good or service
separately to a customer’.
8.2 Allocating the transaction price based on stand- IFRS 15.77
alone selling prices (IFRS 15.76-.80) The stand-alone selling price is

determined at:
To be able to allocate a transaction price to the various contract inception. See IFRS 15.76
performance obligations, we will need the relative stand-
alone selling prices for each of the distinct goods and services that make up these obligations.
Example 24: Allocating a transaction price based on stand-alone selling prices

Bright Blue Limited signed a contract with a customer, Deep Purple Limited, to supply and
install a highly customised manufacturing plant and to provide maintenance over this plant
for a two-year period. The total contract price is C200 000.
The installation is not considered to be a service that is distinct from the supply of the plant and thus
the entity concludes that the contract contains two performance obligations, for which the stand-alone
selling prices are as follows:
Supply and installation of plant C180 000
Maintenance over 2 years C40 000
Required: Briefly explain, together with calculations, how the transaction price is to be allocated.
Chapter 4 153
A stand-alone selling price is the price at which the distinct good or service would be sold if it
was sold separately on the date of inception of the contract. See IFRS 15.76-.77
Solution 24: Allocating a transaction price based on stand-alone selling prices

The transaction price must be allocated to each performance obligation in the contract based on the
stand-alone selling prices.
Two performance obligations have been identified in the contract and the stand-alone selling prices for
each (whether observed or estimated) were given in the question. The transaction price is thus allocated
as follows:
Stand-alone Allocation of
selling prices transaction price
Supply and installation of plant C180 000 TP: C200 000 x 180 000 / 220 000 C163 636
Maintenance over 2 years C40 000 TP: C200 000 x 40 000 / 220 000 C36 364
C220 000 C200 000
TP: Transaction price
Thus, Bright Blue would recognise revenue of:

C163 636 when the plant is installed (satisfied at a point in time); Note 1 and
C36 364 over the two-year period that the maintenance is provided (satisfied over time). Note 1
Note 1: How to decide whether a PO is satisfied at a point in time or over time is explained in section 9.
The best evidence of the stand-alone selling price is an observable price. An observable price
is the price at which the good or service is sold separately to a ‘similar customer’ under
‘similar circumstances’. However, an entity may not necessarily have access to an observable
price because, for example, the entity may have never sold this good or service before or may
not have sold the good or service on a separate basis before. If a separately observable price is
not available, then the entity must estimate it.
The standard does not stipulate how we should estimate a Stand-alone selling prices
stand-alone selling price, but it does suggest three possible can be:
approaches that may be helpful – a combination of which
directly observable (ideal); or
could be used if necessary (the entity may also use any See IFRS 15.77-8
estimated.
other approach that it may prefer):
adjusted market assessment approach: this approach effectively assesses the market and
estimates what the customer might be prepared to pay in this market (e.g. the entity could
consider what others in the market are selling the good or service for and could then make
appropriate adjustments for its own entity-specific costs and required margins);
expected cost plus margin approach: this approach involves the entity first estimating the
costs it expects to incur in the process of satisfying the PO and then adding its required
margin to get to a suitable selling price;
residual approach: this approach is suitable when the entity knows the stand-alone selling
prices for some of its goods or services, (i.e. it does not know all of the stand-alone selling
prices), in which case the unknown stand-alone selling price/s is determined as a
balancing act as follows:
Transaction price – The sum of the observable stand-alone selling prices. See IFRS 15.79
Although the residual approach is suggested as one of the ways in which we could estimate
the stand-alone selling prices, it may only be used if one of the following criteria is met:
a) the entity sells the same goods or services to different customers but for such a broad
range of amounts that the price is considered to be highly variable; or
b) the entity has not previously sold that good or service on a stand-alone basis and has not
yet set a price for it and thus the price is uncertain. See IFRS 15.79 reworded.
154 Chapter 4
Although the standard does not stipulate how we should estimate stand-alone selling prices,
it does state that, irrespective of what method is used, the method used:
must result in an allocation that meets the allocation objective (IFRS 15.77 – see pop-up
under the overview) – in other words, the portion of the transaction price that is allocated
to a performance obligation must depict the price to which the entity expects to be entitled
for transferring the related underlying goods or services;
must consider all the information that is reasonably available to the entity (e.g. factors
relating to the customer, the entity and the market);
must maximise the use of observable inputs; and
must be applied consistently to other similar circumstances. See IFRS 15.78
Example 25: Allocating a transaction price

based on estimated stand-alone selling prices
Green Limited signed a contract with a customer, Yellow Limited, to supply 3 products: X,
Y, and Z, each of which is considered to be a separate performance obligation. The total consideration
promised in the contract is C200 000.
Green regularly sells product X – the stand-alone selling price for X is C100 000.
Products Y and Z have never been sold before but Green estimates that the cost of producing Y will be
C100 000 and costs of producing Z will be C50 000. A suitable profit margin is 10% on cost.
Required: Briefly explain, together with calculations, how Green should allocate the transaction price.
Solution 25: Allocating the transaction price

Product X is the only product that has a stand-alone selling price based on a directly observable price.
The stand-alone selling price for products Y and Z must be estimated.
Since Purple has estimated the cost of production for products X and Y and is able to suggest a suitable
margin, it is suggested that the ‘expected cost plus margin approach’ be used to estimate these stand-
alone selling prices.
The stand-alone selling prices are as follows:
Stand-alone
selling prices
Product X C100 000 Directly observable price: given
Product Y C110 000 Estimated cost + margin approach:
Estimated costs: C100 000 + required margin: C100 000 x 10%
Product Z C55 000 Estimated cost + margin approach:
C265 000
The transaction price of C200 000 (which, incidentally clear includes an inherent discount of C65 000)
must now be allocated to the POs based on their relative stand-alone selling prices (2 of which were
estimated):
Product X C100 000 TP: C200 000 x 100 000 / 265 000 C75 000
Product Y C110 000 TP: C200 000 x 110 000 / 265 000 C83 000
Product Z C55 000 TP: C200 000 x 55 000 / 265 000 C42 000
C265 000 C200 000
Chapter 4 155
Example 26: Allocating a transaction price

based on estimated stand-alone selling prices (where one was
estimated based on the residual approach)
Purple Limited signed a contract with a customer, Red Limited, to supply 3 products: A, B, and C, each
of which is considered to be a separate performance obligation. The total consideration promised in the
contract is C200 000.
Purple regularly sells product A and B. Product A sells for C100 000 but product B sells for anything
between C20 000 and C70 000, depending on a variety of factors.
Product C has never been sold before, but Purple estimates that the cost of production will be C50 000
and a suitable profit margin is 10% on cost.
Required: Briefly explain, together with calculations, how Purple should allocate the transaction price.
Solution 26: Allocating the transaction price

Product A is the only product that has a stand-alone selling price based on a directly observable price.
The stand-alone selling price for products B and C must be estimated.
Since Purple has estimated the cost of production for product C and is able to suggest a suitable
margin, it is suggested that the ‘expected cost plus margin approach’ be used to estimate C’s stand-
alone selling price.
Since insufficient detail is provided as to how to estimate the stand-alone selling price for product B, it
is suggested that the ‘residual approach’ may be appropriate for this product (we are assuming that the
criteria that must be met before using the residual approach, are indeed met).
The stand-alone selling prices are as follows:
Stand-alone
selling prices
Product A C100 000 Directly observable price: given
Product B C45 000 Residual approach:
TP: C200 000 – C100 000 (A) – C55 000 (C)
Product C C55 000 Estimated cost + margin approach:
C200 000
The sum of the stand-alone selling prices (C200 000) equals the transaction price (C200 000) and thus
no further calculations are necessary.
Before we accept the resultant allocation of the transaction price, we need to check that, where we have
estimated the stand-alone selling prices for a PO (i.e. in the case of B and C), the transaction price
allocated to that particular PO meets the allocation objective. The allocation objective is that the price
allocated to the PO reflects the amount to which the entity expects to be entitled for the transfer of the
underlying goods or services.
In the case of product B, we are told that the normal price is anything between C20 000 and
C70 000 and thus the allocation of C45 000, being within this range, is acceptable.
We are not given a range for product C and thus we assume that the allocation of C55 000 is an
amount to which the entity would expect to be entitled.
Note: If we had been told that the normal price range for product B was anything between, for example,
C50 000 and C70 000 we would not have been able to accept the allocation of C45 000 since it is
outside of the expected range. In this case, we would have had to return to the drawing board and come
up with another method of estimating the stand-alone price for product B (e.g. looking at competitor
prices and making appropriate adjustments for the entity’s own cost structure and expected margins
etc) or using a different method to estimate the stand-alone price for product C that, when using the
residual approach to estimate product B, gives us an allocation that falls within the expected range.
156 Chapter 4
Comment: Notice that, whereas we normally allocate the transaction price (TP) to each performance
obligation (PO) by multiplying the TP by the relevant % (i.e. based on the relative stand-alone selling
prices per PO), we did not do this in this example. This is because one of the POs was determined
based on the residual approach.
It is probably also wise to remind you at this point that we are allocating the transaction price
based on the stand-alone prices that exist at contract inception. Obviously, these stand-alone
prices, whether determined based on observable prices or based on estimates, may change
after contract inception (e.g. through inflation, annual increases, changes in the market,
improved estimation etc). However, any changes in the stand-alone selling prices after date of
contract inception will not result in the re-allocation of the transaction price. See IFRS 15.88
8.3 Allocating a discount (IFRS 15.81-.83)
8.3.1 Overview
If the transaction price includes a discount (i.e. if the transaction price is net of a discount),
the process of allocating this discounted transaction price to the performance obligations in
the contract based on the relative stand-alone selling prices will mean that we will have
automatically allocated the discount proportionally to each of the performance obligations.
However, we need to be careful here, because there are instances where a discount does not
apply to all the performance obligations in the contract.
8.3.2 Identifying a discount
The fact that a discount has been given to a customer is not

A discount exists if the
always stipulated in the contract. Conversely, a contract promised consideration <
could state that the contract price is calculated after sum of the stand-alone
See IFRS 15.81
deducting discounts on certain goods or services when in prices.
fact the goods or services are not truly discounted and the
statement to this effect is essentially a marketing ploy.
To identify whether the promised transfer of goods or services are truly discounted, we
simply calculate the sum of the stand-alone selling prices of these goods or services and
compare this with the consideration promised in the contract: if the promised consideration is
less than the sum of the stand-alone selling prices, we conclude that the consideration is
discounted. For example, if we look at example 24, we see that the sum of the stand-alone
prices is C220 000 when the total transaction price in the contract was C200 000. This means
that the transaction price was discounted by C20 000.
8.3.3 Allocating a discount proportionately to all performance obligations
If we find that a discount exists, it will be automatically A discount is normally

allocated proportionately across all performance obligations allocated proportionately
when we allocate the transaction price to the performance to all POs in the contract.
obligations using the underlying stand-alone selling prices. This happens automatically when
For example, if we look at example 24, we see that there allocating the TP to the POs based
was no specific treatment of the C20 000 discount inherent on their relative stand-alone selling
See IFRS 15.81
prices.
in the contract – it was simply allocated when allocating the
discounted transaction price.
Worked example 6: Identifying a discount; and

Allocating it to the performance obligations
Using the information given in example 24 (i.e. dealing with Bright Blue and Deep Purple),
we can see that the total of the two stand-alone selling prices is C220 000 (C180 000 + C40 000).
Since the promised consideration is C200 000, it means that the customer has been given a discount of
C20 000 (C220 000 – C200 000).
Chapter 4 157
When allocating the transaction price to the two performance obligations, we automatically allocated
this discount proportionally to both performance obligations because the allocation was based on the
stand-alone prices.
However, although no information was provided in this example to suggest otherwise, it is possible that
this discount applied only to one of the performance obligations in which case the allocation of the
transaction price in example 24 would not have been correct.
See example 27 (dealing with Snack and Meal) for how to allocate a transaction price when a discount
does not apply to all performance obligations in the contract.
8.3.4 Allocating a discount to one or some of the performance obligations

A discount is allocated to
Discounts are allocated proportionately to all the only one/ some of the POs
performance obligations unless there is observable evidence in the contract if there is
to suggest that the discount applies to only one (or some) of sufficient observable
the performance obligations in the contract (i.e. it does not evidence (that meets all 3 criteria in
apply to all the performance obligations in the contract). para 82) that it relates to only
one/some of the POs.
See IFRS 15.81 -82
If this observable evidence exists, we should not allocate
the discount proportionately to all performance obligations in the contract but should allocate
the discount to only this (or these) specific performance obligation(s) to which the discount
relates. However, before we may take the observable evidence into consideration, all three
criteria listed in IFRS 15.82 must be met (see pop-up below).
The following three criteria must be met before a discount may be allocated to
specific POs:
a) the entity regularly sells each distinct good or service (or each bundle of distinct goods or services)
in the contract on a stand-alone basis;
b) the entity also regularly sells, on a stand-alone basis, a bundle (or bundles) of some of those
distinct goods or services at a discount to the individual stand-alone selling prices of the goods or
services in each bundle; and
c) the discount attributable to each bundle of goods or services described in paragraph 82(b) is
substantially the same as the discount in the contract and
an analysis of the goods or services in each bundle provides observable evidence of the performance
obligation (or performance obligations) to which the entire discount in the contract belongs.
IFRS 15.82
If any of these three criteria are not met, the evidence suggesting that the discount should be
allocated to one or some of the performance obligations (i.e. not all of the performance
obligations) will not be considered to be sufficiently observable.
In other words, the evidence will not give us enough confidence that the discount relates only
to one or some of the obligations. If this happens, this evidence must be ignored and thus,
despite the evidence, the discount in the contract will be allocated proportionately to all
performance obligations in the contract.
Example 27: Allocating a discount to only one / some performance obligations

Snack Limited signed a contract with a customer, Meal Limited, involving three
performance obligations:
the supply of a manufacturing plant,
the installation of this plant and
the maintenance of this plant over a three-year period.
The consideration promised in the contract is C300 000.
Snack Limited regularly sells this type of plant, regularly provides installation services and regularly
provides maintenance services.
158 Chapter 4
The following are the normal prices for each:

Supply of plant C200 000
Installation of plant C50 000
Maintenance of plant (3 yrs) C80 000
Snack Limited regularly sells the plant together with the installation thereof at a combined, discounted
price of C220 000.
Required: Briefly explain, together with calculations, how the transaction price is to be allocated.
Solution 27: Allocating a discount to only one / some performance obligations

The transaction price must be allocated to each performance obligation in the contract. The entity has
identified 3 performance obligations in the contract and given the stand-alone selling prices for each.
The sum of the 3 stand-alone prices is C330 000 (C200 000 + C50 000 + C80 000) whereas the total
promised consideration is only C300 000. Thus a discount of C30 000 exists in the contract.
In the case of this contract, we do not allocate the discount proportionately to all 3 performance
obligations because there is observable evidence, which meets all three criteria, that suggests that the
entire discount relates to only one or some of the performance obligations.
Each of the three criteria and how they are met follows:
a) The entity must regularly sell each of the distinct goods or services (or bundle thereof) in the
contract on a stand-alone basis.
Snack regularly sells, as separate items, all three of the distinct goods and services that are
contained in the contract (i.e. the entity regularly sells these types of plant and regularly provides
installation services and regularly provides maintenance services).
b) The entity must regularly sell some of these distinct goods or services as a stand-alone bundle and
at a discounted price for this bundle.
Snack regularly sells the plant together with the installation thereof as a stand-alone bundle and at
a discounted price of C220 000 (i.e. instead of C200 000 + C50 000 = C250 000).
c) The discount for the abovementioned bundle of goods or services must be substantially the same as
the discount offered in the contract; and
An analysis of the goods or services in each of the abovementioned bundles must provide
observable evidence of the performance obligation(s) to which the entire discount in the contract
belongs.
Snack sells the abovementioned bundle (i.e. a plant together with installation thereof) for
C220 000, which represents a discount of C30 000 against the sum of the stand-alone selling price
for each item in the bundle (C200 000 + C50 000 = C250 000) and this discount is substantially
the same (in fact, in this case, it is exactly the same) as the C30 000 discount in the contract.
An analysis of the goods and services contained in the stand-alone bundle reveals a plant and the
installation thereof where this plant and the installation thereof provides observable evidence of the
performance obligation to which the entire discount in the contract relates (in fact, in this case, the
plant and installation regularly sold as a bundle are identical to the plant to be supplied and
installed in terms of the contract).
Thus, it is clear that the C30 000 discount relates purely to the supply and installation of the plant (i.e.
it applies to 2 of the 3 performance obligations). Since the discount does not apply to all 3 of the
performance obligations contained in the contract, the transaction price is not allocated based on the
stand-alone selling prices of each of the performance obligations. Instead, the entire discount is first
allocated to the 2 performance obligations that are identified as being the discounted obligations: the
supply of the plant and the installation of the plant.
We do this by allocating C220 000 of the transaction price (being the discounted price for the stand-
alone bundle) to these 2 obligations and allocating the remaining C80 000 of the transaction price to the
3rd obligation, the maintenance of the plant.
If the performance obligations relating to the supply of the plant and the maintenance of the plant will
be satisfied at different times, then the C220 000 transaction price will then need to be allocated
between these two performance obligations.
Chapter 4 159
This allocation will be done based on their relative stand-alone selling prices:
Stand-alone Allocation of Allocation of
selling prices TP discount (
Supply & installation of plant Stand-alone price for the bundle C220 000
supply of plant C200 000 TP for the bundle: C220 000 x C176 000 24 000
200 000 / (200 000 + 50 000)
installation of plant C50 000 TP for the bundle: C220 000 x C44 000 6 000
50 000 / (200 000 + 50 000)
Maintenance of plant (3yrs) C80 000 Stand-alone price for the stand- C80 000 0
alone service
C330 000 C300 000 30 000
Note:
We would still allocate C220 000 of the transaction price (total contract price: C300 000 – stand-
alone price for the maintenance: C80 000) to performance obligation 1 and performance
obligation 2 (the supply of the plant and the installation of the plant, respectively) if the discount
was not exactly the same but was considered to be substantially the same. For example, if:
- the stand-alone bundle (supply of plant plus installation thereof) normally sold for C218 000
(i.e. instead of C220 000), being a discount of C32 000 off the individual stand-alone prices
[sum of the 2 individual stand-alone prices: (C200 000 + C50 000) – Stand-alone price for the
bundle: C218 000]; and if
- this discount of C32 000 is considered to be substantially the same as the discount of C30 000 in
the contract (sum of the 3 individual stand-alone prices: C330 000 – Promised consideration:
C300 000),
we would not allocate C218 000 (being the normal stand-alone discounted price for a bundle) but
would allocate the discounted price per the contract of C220 000, because the normal discount and
the contracted discounted are considered to be substantially the same. See the example 28 (dealing
with Lunch & Dinner).
If all 3 criteria in IFRS 15.82 were not met, we would not have been able to argue that there was
sufficiently observable evidence that the discount applied to one or some of the performance
obligations and thus we would have had to allocate the discounted transaction price across all
performance obligations contained in the contract. For example, if Snack had never sold installation
services on a stand-alone basis before, IFRS 15.82 (a) would not have been met and the total
contract discount of C30 000 would be allocated proportionately to all 3 performance obligations by
allocating the discounted TP based on the relative stand-alone selling prices.
In the above example, the discount offered when regularly selling stand-alone bundles was
exactly the same as the discount offered in the contract (C30 000). However, if the discount
regularly offered on a stand-alone bundle(s) is substantially, but not exactly, the same as the
discount offered in the contract, this full contract discount of C30 000 would still be allocated
to the performance obligations making up that bundle(s).
Example 28: Allocating discount - the regular discount ≠ contract discount
Lunch Limited signed a contract with a customer, Dinner Limited, involving 4 performance
obligations: the supply of A, B, C and D.
Lunch Limited regularly sells A, B, C and D at the following prices:
A C200 000
B C50 000
C C60 000
D C20 000
C330 000
Lunch Limited regularly sells A and B as a bundle, at a discounted price of C230 000. There is
observable evidence (which meets all 3 criteria in IFRS 15.82) that the contract discount should be
allocated to A and B only.
Required: Briefly explain, together with calculations, how Lunch should allocate the transaction price.
160 Chapter 4
Solution 28: Allocating discount - the regular discount ≠ contract discount

identified 4 performance obligations in the contract and given the stand-alone selling prices for each.
The sum of the 4 stand-alone prices is C330 000 (C200 000 + C50 000 + C60 000 + C20 000) whereas
the total promised consideration is only C300 000. Thus a discount of C30 000 exists in the contract.
In the case of this contract, we do not allocate the discount proportionately to all 4 performance
obligations because there is observable evidence, which meets all three criteria, that suggests that the
entire discount relates to only A and B.
As mentioned above, the contract discount is C30 000. However, the regular discount offered when
selling A and B as a bundle is only C20 000 (sum of the stand-alone prices for A and B: C250 000 -
stand-alone prices for the bundle: C230 000). Although the contract discount (C30 000) and the regular
discount for the bundle of A and B (C20 000) are not the same, the fact that the 3 criteria were all met
means that the entity considers them to be substantially the same (i.e. the difference of C10 000 is
immaterial). Thus the full contract discount of C30 000 is allocated to A and B even though A and B
are normally sold as a bundle at a discount of only C20 000. The transaction price is thus allocated as
follows:
Stand-alone Stand-alone Allocation of Allocation of
selling prices: selling prices: transaction price discount
individual bundles (balancing)
A C200 000 TP for the bundle: C220 000 calc 1 x C176 000 C24 000
C230 000 200 000 / (200 000 + 50 000)
B C50 000 (discount of TP for the bundle: C220 000 calc 1 x 50 000 C44 000 C6 000
C20 000) / (200 000 + 50 000)
C C60 000 Individual stand-alone price C60 000 0
D C20 000 Individual stand-alone price C20 000 0
C330 000 C300 000 C30 000
Calculation 1:
The TP for the bundle = C220 000; calculated in a number of ways, as follows:
- Stand-alone price for a bundle: C230 000 – Extra discount contained in the contract: C10 000 = C220 000
- Stand-alone price for A: C200 000 + Stand-alone price for B: C50 000 – Total contract discount: C30 000= C220 000
- Transaction price: C300 000 – Stand-alone price for individual C & D: (C60 000 + 20 000) = C220 000
Comment: Notice that the when we allocate the TP (and related discount) to A and B, we allocated what we
referred to as the transaction price for the bundle of C220 000 (i.e. after deducting the discount per the contract) –
we did not allocate the normal stand-alone price for the bundle of C230 000.
Please note that if we decide we need to allocate a discount to one or some of the performance
obligations (i.e. not to all of them), and we also need to estimate the stand-alone selling prices
of one or more of the other performance obligations using the residual approach, then we
must allocate the discount first before we calculate the estimated stand-alone selling price
using the residual approach.
Example 29: Allocating discount before applying the residual approach
Tea Limited signed a contract with a customer, Cake Limited, involving 3 performance
obligations: the supply of A, B and C.
Tea regularly sells A and B:
on an individual basis for C200 000 and C50 000, respectively
as a bundle for C230 000.
C is a one-of-a-kind product that Tea has never sold before. It has no reliably measure of the costs and
has no idea what the market price for C might be.
There is observable evidence (which meets all 3 criteria in IFRS 15.82) that the contract discount
should be allocated to A and B only.
Required: Briefly explain, together with calculations, how Tea should allocate the transaction price.
Chapter 4 161
Solution 29: Allocating discount - the regular discount ≠ contract discount

We have the stand-alone selling prices for A and B but not for C. There appears to be no way of
estimating the stand-alone selling price for C other than through the use of the residual approach.
However, before we can apply the residual approach, we must allocate the discount to the other known
stand-alone selling prices (A and B) and then balance to the stand-alone price for C.
Stand-alone Stand-alone Allocation of Allocation of
selling prices: selling prices: transaction price discount
individual bundles (balancing)
A C200 000 C230 000 230 000 x 200 000 / (200 000 + 50 000) C184 000 C16 000
B C50 000 (discount of 230 000 x 50 000 / (200 000 + 50 000) C46 000 C4 000
C20 000)
C ? Individual stand-alone price C50 000 0
? C280 000 C20 000
Comment: Notice how when using the residual approach, we first allocate any discounts to the known stand-alone
selling prices. Thus, we did not immediately calculate the estimated stand-alone selling price for product C by
balancing to C30 000 [Transaction price: C280 000 – Known stand-alone selling prices (A: C200 000 + B:
C50 000)]. We first identified that product A and product B were discounted (because the sum of their stand-alone
selling prices exceeded the stand-alone selling price as a bundle) and thus allocated the discounted stand-alone
price for the bundle (C230 000) to product A and product B. The estimated stand-alone selling price for product C
was thus C50 000 (TP: C280 000 – Discounted stand-alone price for bundle of A and B: C230 000).
8.4 Allocating variable consideration (IFRS 15.84-.86)
As we know, the transaction price is normally allocated to

the various performance obligations based on their relative Notice that there is a
difference between:
stand-alone selling prices. However, if the transaction price
includes variable consideration, the total transaction price a discount inherent in a contract
(due to the fact that the contract
may not always be allocated in this way. Variable
price is less than the sum of the
consideration can take many forms, for example, a bonus stand-alone selling prices) – see
for meeting targets or an early settlement discount (i.e. a section 8.3; and
discount for settlement within a certain period). an unsecured discount, being one
that has not yet been secured –
this discount is treated as variable
A transaction price that includes variable consideration is
consideration (e.g. an early
constituted as follows: settlement discount)
TP = fixed consideration + variable consideration.
Now, this variable consideration may apply ‘across the Variable consideration
board’ to all the performance obligations in the contract, in is allocated to only one/
which case there will be no change in how we allocate our some of the POs (or to
transaction price. In other words, the total transaction price, a part of a PO) in the
contract if:
(fixed + variable consideration), will be allocated based on
the discount is specifically
relative stand-alone prices. However, it can happen that the connected to this PO/s (or to part
variable consideration applies to only one/ some of the of a PO) and
performance obligations or may even apply to only part of both criteria in para 85 are met,
a single performance obligation. In this case, the variable indicating that it is appropriate
consideration will be allocated to these certain specific under the circumstances to
performance obligations, or to parts of a single performance allocate it to this specific PO/s (or
part thereof) .
obligation, but only on condition that certain criteria are See IFRS 15.85
met and the remaining fixed consideration would be
allocated based on stand-alone selling prices.
For example: A contract includes the supply of product A (PO #1), the supply of product B
(PO #2) and the supply of a service (PO #3). The transaction price includes fixed
consideration in relation to the supply of the products (PO #1 and #2) but includes variable
consideration relating to the service (the amount of consideration for the service will vary
depending upon how soon the service can be completed).
162 Chapter 4
In this case, the contract includes fixed consideration and variable consideration and where
the variable consideration applies to only one of the performance obligations. The fixed
consideration would be allocated in the normal way (i.e. based on the stand-alone prices for
the two product (PO #1 and #2), but the allocation of the variable consideration may need to
be allocated exclusively to the service (PO #3).
In cases where the transaction price includes variable consideration that does not apply to all
the performance obligations, this variable consideration will be separated out from the
transaction price and allocated to the specific performance obligation/s (or parts of a
performance obligation) to which the variable consideration relates ...but only if both criteria
in IFRS 15.85 are met (see pop-up below). If the variable consideration does not meet both
these criteria, then it may not be allocated to the specific performance obligation/s. This
means that it will not be separated out from the transaction price when allocating the
transaction price based on stand-alone selling prices. In other words, the sum of the ‘fixed
consideration’ and the ‘variable consideration that does not meet the criteria in IFRS 15.85’
will be allocated to all the performance obligations based on their relative stand-alone selling
prices.
The following two criteria must be met before variable consideration may be allocated
to specific POs (or to parts of certain POs):
a) the terms of a variable payment relate specifically to either:
the entity’s efforts to satisfy the performance obligation or transfer the distinct good/ service, or
a specific outcome from satisfying the performance obligation or transferring the distinct good/
service; and
b) allocating the variable amount of consideration entirely to the performance obligation (or to the distinct
good or service) is consistent with the allocation objective (para 73) when considering all of the
performance obligations and payment terms in the contract (i.e. the result of the allocation must depict
the amount of consideration to which the entity would expect to be entitled in exchange for each
IFRS 15.85 (reworded)
promised transfer).
Basically, these two criteria help us prove whether it is appropriate under the circumstances to
allocate the variable consideration to a specific performance obligation/s (or part thereof).
For example:
Variable consideration
If we allocate variable consideration to a specific that does not meet
performance obligation but then find that, by doing so, the both criteria in
portion of the transaction price that is allocated to each and para 85 is:
every performance obligation in the contract would not added to the fixed consideration
actually ‘depict the amount of consideration to which the and
entity expects to be entitled’ for each of those performance allocated in the normal way (i.e.
obligations, the second criteria (IFRS 15.85(b)) would not based on relative stand-alone
be met. This would show us that the allocation of the selling prices).
See IFRS 15.86
variable consideration separately from the other
consideration would not be appropriate. In this case, the variable consideration should simply
remain included in the transaction price (i.e. fixed + variable) and be allocated to all the
performance obligations based on their relative stand-alone selling prices (i.e. in the normal
way). See IFRS 15.86
Example 30: Allocating variable consideration to all/some of the performance

obligations
Coffee Limited signed a contract for C200 000 with a customer, Milk Limited, involving 2
performance obligations: the construction of a building (A) and the supply of unrelated globes (B). The
stand-alone selling prices of each of these performance obligations are as follows:
A C160 000
B C30 000
C190 000
Chapter 4 163
In addition to the contract price of C200 000, the entity will be paid a bonus of C10 000 if it meets
certain criteria. Based on past experience, the entity believes that it is most likely that it will qualify for
this bonus and highly probable that including the bonus in the transaction price will not lead to a
significant reversal of revenue in future.
Required: Briefly explain, together with calculations, how Coffee must allocate the transaction price if:
a) the bonus applies if the entity completes the contract within a certain time period.
b) the bonus applies if the entity completes the building within a certain time period.
Solution 30 A: Allocating variable consideration to all the POs
The bonus is variable consideration since it is not certain the entity can comply with the terms thereof.
Since the terms of the bonus clearly apply to both performance obligations, the bonus must be allocated
to both performance obligations. (i.e. applying criteria (a) of IFRS 15.85)
It is assumed, since no information is given to the contrary, that the final allocation below (C168 000 +
C42 000) depicts the amounts to which the entity expects to be entitled for each performance obligation.
(i.e. being criteria (b) of IFRS 15.85)
(including the bonus)
A C160 000 210 000 x 160 000 / (160 000 + 30 000) C177 000
B C30 000 210 000 x 30 000 / (160 000 + 30 000) C33 000
Note 1
C190 000 200 000 + Bonus 10 000 C210 000
Note 1: notice that the transaction price including the variable consideration was allocated (200 000 + 10 000).
Solution 30 B: Allocating variable consideration to some of the POs

The bonus is variable consideration since it is not certain the entity can comply with the terms thereof.
Since the terms of the bonus clearly apply only to the construction of the building (i.e. one of the
performance obligations), the bonus must only be allocated to this specific performance obligation.
(i.e. applying criteria (a) of IFRS 15.85)
It is assumed, since no information is given to the contrary, that the final allocation below (C168 000 +
C42 000) depicts the amounts to which the entity expects to be entitled for each performance obligation.
(i.e. being criteria (b) of IFRS 15.85)
Stand-alone Allocation of Allocation of Allocation of

selling prices transaction price variable transaction price
excluding the bonus consideration including bonus
A C160 000 200 000 x 160 000 / (160 000 + 30 000) C168 000 0 C168 000
B C30 000 200 000 x 30 000 / (160 000 + 30 000) C32 000 C10 000 C42 000
C190 000 C200 000 C10 000 C210 000
The following example shows that, even if the variable consideration applies to only certain
specific performance obligations, it may be necessary to allocate the variable consideration to
all the performance obligations if, by allocating the variable consideration to just the specific
performance obligations, we land up with an allocation that is not representative of the
consideration per obligation that the entity expects to be entitled to (i.e. if criteria (b) of
IFRS 15.85 is not met).
Example 31: Allocating variable consideration
Supper Limited signed a contract with a customer, Pudding Limited, involving two
performance obligations: the transfer of a machine (A) and the construction of a factory
building (B). The consideration promised in the contract includes a fixed consideration for the machine
of C20 000 and a variable consideration for the construction of a standard warehouse building. The
consideration for the building will vary as follows depending on how quickly it can be completed:
C500 000 if the building takes one month or less to complete;
C400 000 if the building takes more than one month but less than two months to complete; or
. C150 000 if the building takes two months or more to complete.
164 Chapter 4
Supper estimates that it will complete the building in just under two months and thus that C400 000
will be received. This estimate is what the entity expects to be the most likely amount and it is
considered highly probable that, if it is included in the transaction price, a significant reversal of
revenue will not occur in the future).
The entity thus determines the transaction price to be C420 000:
A: Machine: Fixed C20 000
B: Building: Variable (i.e. estimated) C400 000
C420 000
The stand-alone selling prices at contract inception for each performance obligation are as follows:
A: Machine C100 000
B: Building C350 000
C450 000
Required:
Briefly explain, together with calculations, how Supper Limited should allocate the transaction price.
Solution 31: Allocating variable consideration

identified 2 performance obligations in the contract and has the stand-alone selling prices for each.
The promised consideration contains both a fixed consideration (stated in the contract at C20 000 for
performance obligation A) and a variable consideration (the estimated amount to which the entity
expects to be entitled is C400 000 for performance obligation B).
Although the contract states that the variable consideration relates purely to performance obligation B,
before we may allocate it purely to performance obligation B, we must decide whether or not it is
appropriate to allocate this variable consideration entirely to performance obligation B by first
assessing whether it meets the two criteria listed in IFRS 15.85:
a) the terms of the variable consideration must relate specifically to either the entity’s efforts to
satisfy the performance obligation or to a specific outcome resulting from the performance
obligation; and
b) by allocating the variable consideration to just certain POs (instead of all of them), we must be
sure that the allocation objective is met for all the POs (i.e. the portion of the transaction price
allocated to each of the POs must be representative of the amount to which the entity expects to be
entitled for the transfer of the related good or service).
Discussion of the criteria:
a) In this case, the variable consideration depends entirely on the efforts by the entity to meet the
required deadlines. Thus criteria (a) is met.
b) If we allocate the entire variable consideration to performance obligation B, it means that
performance obligation A will be allocated just the fixed consideration of C20 000. However, since
the C20 000 is significantly lower than the stand-alone price of C100 000, it is suggested that the
allocation objective would not be met. Thus, allocating the variable consideration of C400 000
entirely to the building does not meet criteria (b).
Since both criteria are not met, the allocation of the expected variable consideration of C400 000 purely
to the building is not appropriate.
Instead, the expected variable consideration of C400 000 must be added to the fixed consideration of
C20 000 (C400 000 + C20 000 = C420 000) and the total consideration of C420 000 (i.e. the total TP)
should be allocated in the normal way (i.e. based on the relative stand-alone selling prices).
This will result in C93 333 allocated to the supply of the machine and C326 667 to the construction of
the building (see working overleaf).
These allocations are more in line with the relative stand-alone selling prices and thus meet the
allocation objective, since they are a better depiction of the amount to which the entity would expect to
be entitled for the transfer of the related good or service.
Chapter 4 165
A C100 000 TP: C420 000 x 100 000 / 450 000 C93 333
B C350 000 TP: C420 000 x 350 000 / 450 000 C326 667
C450 000 C420 000
Conclusion: Thus, although the contract makes it clear that the variable consideration relates only one
performance obligations (the construction of the building), allocating it on this basis would not result in
an allocation per obligation that would depict the amount of consideration to which the entity would
expect to be entitled (i.e. criteria (b) is not met) and thus the variable consideration must be allocated to
both the performance obligations.
8.5 Allocating a change in the transaction price to performance obligations (IFRS 15.87)
It is possible for a transaction price to change after initial recognition. A transaction price
could change for a number of different reasons including, for example, the resolution of
previously uncertain events (e.g. it is possible that consideration that was previously
considered to be variable consideration is no longer variable – it is now known...fixed).
If the transaction price changes, any change must be allocated to the performance obligations
using the same allocation that was used at contract inception (i.e. if we used stand-alone
selling prices as the basis for the allocation at contract inception, we would allocate the
increase or decrease in the transaction price using these same stand-alone selling prices – even
if these have subsequently changed).
If the transaction price changes after some performance obligations have been satisfied, it
would mean that the revenue for these performance obligations would have already been
recognised. If this happens, the increase or decrease in the transaction price allocated to these
satisfied performance obligations would be recognised immediately as an adjustment to
revenue.
9. Satisfying performance obligations (step 5) (IFRS 15.31-.45)
9.1 Overview
Identifying the date on which (or the periods over which) Knowing when a
we satisfy (or gradually satisfy) our performance performance obligation
is satisfied is
obligations – or in other words, identifying when we have important because...
completed doing what we promised we would do – is very Revenue can only be recognised
important because this is the date when (or period in which) as/when we have satisfied our
we will get to recognise the revenue from that performance performance obligations.
obligation. See IFRS 15.31
Some obligations will take time to complete (i.e. satisfied over time) and some will be
completed in an instant (i.e. satisfied at a point in time).
Some contracts have only one performance obligation whereas others may have more than
one. We need to decide, at the inception of this contract, how each of the performance
obligations will be satisfied (i.e. will it be satisfied over time or in an instant).
The way we decide what kind of performance obligation we are dealing with is to first
ascertain if it meets the criteria that would classify it as a performance obligation satisfied
over time – if it does not meet these criteria, then we classify it as a performance obligation
satisfied at a point in time.
If we believe that our performance obligation will be satisfied over time, we will need to
decide how to measure our progress towards complete satisfaction of the performance
obligation since we will have to recognise this revenue gradually over this period of time.
166 Chapter 4
9.2 How do we assess when a performance obligation has been satisfied? (IFRS 15.31-.33)
A performance obligation will be considered to be
completely satisfied when the goods or services have been A performance
transferred to the customer. See IFRS 15.31 obligation is satisfied
when:
This transfer of goods or services is considered to have the goods or services have
occurred when control over the goods or services has transferred
passed to the customer. See IFRS 15.31 which is when control has passed.
See IFRS 15.31
We assess whether control has passed to the customer by referring to our understanding of the
control over an asset. Interestingly, the standard clarifies that all goods – and even services –
are considered to be assets, ‘even if only momentarily’. See IFRS 15.33
9.3 How do we assess when control has passed? (IFRS 15.33)
Control over assets is evidenced by the ability to dictate how the asset will be used and the
ability to obtain most of its remaining benefits. Conversely, control could be proved by the
ability to prevent others from doing so.
Control over an asset is
Benefits refer to the direct or indirect: evidenced by the ability
cash inflows; or to:
reductions in the cash outflows. direct how the asset will be used;
and the ability to
Our customer could obtain these benefits in many different obtain substantially all of its
ways – such as by using the goods or services or selling remaining benefits.
IFRS 15.33 reworded
them onwards or pledging them as security in order to
obtain a loan. The possibilities are endless.
When we assess whether control over the asset has passed to a customer, we must be careful
to consider any possible repurchase agreements (e.g. where we have sold goods to a customer
but have agreed to buy them back after a period of time – or have the option to do so under
certain circumstances). Although it may look like control has passed to a customer, the
existence of a repurchase agreement may prove that control has not actually passed.
Repurchase agreements are explained in section 9.6. See IFRS 15.34
9.4 Classifying performance obligations as satisfied over time or at a point in time
9.4.1 Overview Performance obligations

are classified (at
contract inception) as:
As already explained, revenue relating to a performance satisfied over time; or
obligation is recognised when the obligation is satisfied – satisfied at a point in time.
and this occurs when control over the promised goods or See IFRS 15.32
services (i.e. assets) is transferred to the customer.

Depending on the kind of obligation, it is possible, as you can probably imagine, for control
over all the promised goods and services to either be transferred in an instant or over time.
Thus performance obligations are classified, at contract inception, as either:
satisfied at a point in time; or
satisfied over time.
We first assess whether the performance obligation is satisfied over time. If it is not a
performance obligation satisfied over time, we conclude that it must be a performance
obligation satisfied at a point in time. In assessing whether a performance obligation is
satisfied over time, we consider whether or not the performance obligation meets any one of
the three core criteria. If it fails to meet any of these three criteria, then we conclude that it
must be a performance obligation that will be ‘satisfied at a point in time’. This process of
deduction is reflected in the diagram overleaf: See IFRS 15.32
Chapter 4 167
Diagram: Overview of the classification of performance obligations
Classification of a
performance obligation (PO)
PO satisfied at a No Does the PO meet any of the Yes PO satisfied

point in time 3 criteria to be classified as over time
a PO satisfied over time?
9.4.2 Performance obligations satisfied over time (IFRS 15.35-.37)
A performance obligation is classified as ‘satisfied over time’ if any one of the three core
criteria given in paragraph 35 is met. These three criteria are presented diagrammatically
below. Each of these 3 criteria are then discussed in more detail in the 3 separate diagrams
that follow thereafter.
Diagram: The 3 core criteria used to classify performance obligations
Classification of a
performance obligation (PO)
Does the PO meet any one of the 3 criteria to be classified as a Yes

PO satisfied over time?
See IFRS 15.35 & B3-B13
No Criterion 1
Does the customer receive the asset & consume its benefits at the
same time that the entity performs its obligations?
See IFRS 15.35(a) & .B3-B4
PO satisfied
Or
over time
Criterion 2
If the entity is creating or enhancing an asset, does the customer
get control of the asset as it is being created or enhanced?
See IFRS 15.35(b) & .B5
Or
Criterion 3
If the entity is creating an asset, does:
the asset have no alternative use for the entity; and does
the entity have an enforceable right to payment for
performance completed to date?
See IFRS 15.35(c) & .B6-B8 & .B9-B13
PO satisfied
at a point in time
As has been explained, if any one of the three criteria is met, then the performance obligation
is classified as ‘satisfied over time’. The following diagrams explain each of the 3 criteria.
168 Chapter 4
9.4.2.1 Criterion 1: Does the customer receive the asset and consume its benefits as the
entity performs? (IFRS 15.35 (a))
The essence of the criteria given in paragraph 35 (a) is that, if the customer receives the asset
and consumes its benefits as the entity is in the process of performing its obligation, then we
conclude that the obligation is being satisfied over time.
Sometimes this is straight-forward such as in the case of an entity providing a customer with
cleaning services. However, it may not always be as straight-forward in which case the
diagram below shows the logic to apply in assessing whether this criterion is met or not.
Diagram: Classifying performance obligations – using criterion 1
Using criterion 1 to classify a performance obligation (PO)
Criterion 1: Yes
Does the customer receive & consume benefits at the same time
that the entity performs its obligations?
See IFRS 15.35(a)
If it is difficult to answer this, ask yourself the following:

Hypothetically, if another entity were to complete our outstanding performance
obligations, would it need to ‘substantially re-perform’ the work we have already
done? If the answer to this is:
Yes, then the answer to criterion (1) is:
No, the customer does not receive & consume the benefits as the entity
performs its obligations = thus, we must also consider criteria (2) and (3)
No, then the answer to criterion (1) is:
Yes, the customer does receive & consume the benefits as the entity
performs its obligations = PO satisfied over time
PO satisfied
over time
In other words: if that other entity would not have to re-perform the work we
have already done, then we conclude that the customer was receiving and
consuming the benefits as we were performing our obligations.
Tip: Typically, the provision of services that are routine would not need re-
performance whereas specialised services probably would. However, the specific
circumstances would have to be considered carefully.
In answering this:
ignore any contractual restrictions or practical limitations that might
prevent us from getting some other entity to complete our PO; and
assume that any asset we have created so far in the performance of
our PO would remain in our control and would not be of benefit to the
other entity.
In other words: we ignore any facts that would contractually or physically

prevent us from actually transferring the remaining obligations to another
entity and assume that any asset we have created to date would not be
available to the entity that takes over the remaining obligations.
See IFRS 15.B3-4
No
Consider criteria 2 and 3 before concluding that the PO is satisfied

at a point in time
Chapter 4 169
Example 32: Classifying performance obligations:

considering the first criterion
Admin & Legal Services provides various services to customers on a contract basis.
During June, it signs contracts with two customers:
a) Contract 1 involves providing a customer with the services of a receptionist for six months.
b) Contract 2 involves providing a customer with legal advice and representation leading up to a
court case in which this customer is being sued.
Required: For each contract, classify the performance obligation by assessing whether or not the
customer receives an asset & consumes its benefits as the entity performs its obligation.
Solution 32: Classifying performance obligations: the first criterion

a) The nature of the receptionist’s tasks is routine, which typically suggests that ‘substantial re-
performance’ of these tasks is unnecessary or even impossible.
Assuming, for example, we provided the customer with only four months of the promised
services, and another entity was to complete our obligation and provide a receptionist for the
remaining two months, this other entity would not be required to (and frankly, could not)
‘substantively re-perform’ the work we did in the first four months.
Since the new entity would not (and, in this case, obviously could not) be required to re-
perform any work, we would conclude that the customer received and consumed the related
benefits of the receptionist services at the same time that they were provided.
Conclusion: This performance obligation would be considered to be ‘satisfied over time’.
b) The nature of the legal advice and representation is not routine, which typically suggests that
‘substantial re-performance’ of these tasks would be necessary.
Assuming, for example, we provided the customer with only four months of legal advice and
representation and, for some reason, another entity was to take over this obligation (e.g.
perhaps the customer was unhappy with the service we had provided), this new entity would
need to ‘substantively re-perform’ the work we had done. This is because all the work done
by us, (for example, the meetings to discuss legal issues plus the ensuing legal paperwork),
is assumed to be our asset (i.e. the original entity’s) that would not be available to the new
replacement entity. Thus, if another entity were to take over our obligation of legal advice
and representation, it would need to start from scratch in order to understand the case against
the customer and prepare its own legal advice.
Since a replacement entity would need to ‘substantively re-perform’ the work we had
already done, we conclude that the customer would not receive and consuming the related
benefits as we perform our obligation.
Conclusion: This criterion is not met and thus, unless it meets one of the remaining two
criteria, this performance obligation would not be considered to be ‘satisfied over time’.
9.4.2.2 Criterion 2: Does the customer get control as the asset is being created or enhanced?
(IFRS 15.35 (b))
The essence of the criteria given in paragraph 35 (b) is that, if the customer gets control over
an asset that the entity is either creating or enhancing, but gets this control during the process
of creation or enhancement (i.e. as opposed to the customer only getting control once the
creation or enhancement of the asset has been completed), then we conclude that the
obligation is being satisfied over time.
This criterion obviously needs us to thoroughly understand when control passes. The
customer is said to have control over an asset when the customer is able to direct the use of
the asset (be able to decide how it will be used) and obtain most of the benefits from that
asset, and obviously includes the ability to prevent others from doing so (see IFRS 15.33). In
deciding when control is expected to pass, we must consider all indicators of control (see the
diagram overleaf for some examples of indications of control passing, per IFRS 15.38).
170 Chapter 4
Criterion 2: Yes
If the entity is creating or enhancing an asset, does the customer get
control during the period that this asset is being created or enhanced?
See IFRS 15.35(b) & .B5
We assess when the customer is expected to obtain control by:

asking ourselves when we expect the criteria for control to be met and checking
that these criteria would not negated by the existence of a repurchase agreement
(see section 9.6 and also IFRS 15.33 and .34); and in the process
considering all indicators of control (examples of which are given in IFRS 15.38).
Remember the control criteria, per IFRS 15.33/4:

The customer is considered to have control if it is able:
to direct the use of the asset &
obtain substantially all of its benefits
(bearing in mind, that repurchase agreements may negate the transfer of
control).
Now, if we assess that these control criteria will be met during the period that
PO satisfied
the asset is being created or enhanced, then criterion 2 is met and thus the PO is
over time
classified as ‘satisfied over time’.
If, however, we assess that these control criteria will not be met during the
period of creation or enhancement (e.g. the criteria will only be met after the
asset has been created or enhanced), then criterion 2 is not met and thus it
suggests that the PO may be satisfied at a point in time – but before we conclude
this, we would need to consider criteria 1 and 3.
Indicators of control, per IFRS 15.38:

The following are indicators (given as examples in IFRS 15.38) which may or may
not be relevant to assessing when control is expected to pass to the customer:
a) When the customer will become obliged to pay for the asset
b) When the customer will obtain legal title over the asset Note 1
c) When the customer will obtain physical possession of the asset Note 2
d) When the customer will obtain the significant risks and rewards of
ownership Note 3
e) When customer acceptance will occur. Note 4
We need to apply our professional judgement when considering these indicators,

and whether they suggest that control passes in an instant or over time (e.g. if our
assessment is that the customer will be obliged to pay for the asset after
completion of the asset, this may suggest that the obligation is satisfied at a point
in time whereas, if our assessment is that the customer will be obliged to gradually
pay for the asset during completion of the asset, this may suggest that the
obligation is satisfied over time).
No

at a point in time
Notes: See the supporting notes overleaf.
Chapter 4 171
Notes:There are a number of important points that we need to bear in mind when assessing the
indicators of control (given as examples in paragraph 38 of IFRS 15):
1. If the passing of legal title is relevant to the asset in question, we must bear in mind that, if we
plan to retain legal title purely to force our customer to pay, this fact would be ignored when
assessing when our customer obtains control. In other words, the possibility that we may end up
retaining the legal title over the asset to force the customer to pay, would not stop us from
concluding that the customer has obtained control and thus this retention would not stop us from
recognising the related revenue. See IFRS 15.38 (b)
2. If physical possession is relevant to the asset in question, we must bear in mind that:
- physical possession may not always indicate control e.g. in the case of certain repurchase
agreements and consignment sales; and
- control can exist without physical possession e.g. in some bill-and-hold agreements. See IFRS 15.38 (c)
3. If the transfer of risks and rewards is relevant to the asset in question, we must be careful when
the risks and rewards are expected to transfer on a piecemeal basis! See IFRS 15.38 (d)
This is because the risks & rewards that remain untransferred for a time may actually relate to a
separate performance obligation.
E.g. a contract involving the obligation to provide a customer with a car plus future maintenance
thereof normally results in the risks and rewards over the car transferring before the risks and
rewards over the maintenance services would transfer, in which case the customer would probably
have control of the car even though not all risks and rewards in the contract have transferred.
4. If customer acceptance is relevant to the asset in question, we must consider whether the
contract includes a customer acceptance clause/s. If so, clauses that can be objectively assessed
by the entity (e.g. the goods must meet certain dimensions) could be used to determine when the
customer acceptance is expected to occur without the need for formal customer acceptance as
well. On the other hand, clauses that are not able to be objectively assessed would still need the
customer’s formal acceptance before concluding that the customer has got control. See IFRS 15.38 (e)

considering the second criterion
Consider the following two contracts:
a) Contract 1 involves providing a customer with onsite developers who will be tasked
with enhancing the customer’s existing live accounting system.
b) Contract 2 involves manufacturing 30 000 widgets over a period of 3 months, with
delivery and full payment expected to take place at the end of the 3-month period.
Required: For each contract, classify the performance obligation by assessing whether or not the
customer gains control during the creation or enhancement of the asset.
Solution 33: Classifying performance obligations: the second criterion

a) Since the enhanced accounting system is being developed onsite and is being developed live,
the customer has physical possession of the asset and will be able to direct the use thereof
and obtain substantially all of its benefits (i.e. be able to control it) while it is being enhanced.
Conclusion: There are indications to suggest that the customer obtains control during the
creation of this asset (i.e. that criterion 2 is met) and thus the performance obligation will be
classified as ‘satisfied over time’.
b) The customer is only obliged to pay at the end of the three-month period at which point the
customer would be considered able to direct the use of the widgets and be able to obtain
substantially all their benefits. Similarly, the customer will only obtain physical possession
at the end of the three-month period at which point the risks and rewards of ownership will
also transfer. Physical possession, in this case, enables the customer to not only direct the
use of the widgets and obtain substantially all their benefits, but also enables the customer to
prevent others from doing so.
Conclusion: The indicators suggest that the customer obtains control after the widgets are
created (i.e. at the end of the three-month period), not during their creation and thus this
second criterion is not met. Thus, unless the obligation meets one of the other two criteria,
this performance obligation will be classified as ‘satisfied at a point in time’.
172 Chapter 4
9.4.2.3 Criterion 3: Does the entity have no alternative use for the asset and an enforceable
right to payment? (IFRS 15.35 (c))
The essence of the criteria in paragraph 35 (c) is that, where a performance obligation requires
an entity to create an asset, this obligation is classified as satisfied over time if the entity:
has no alternative use for this asset (i.e. all it can do with the asset is give it to the
customer in terms of the contract), and
has an enforceable right to payment for performance to date throughout its creation.
The idea behind these two requirements is that if, for example, an entity is required to create a
highly specialised asset for a customer, the entity would probably need to incur significant
extra costs or would need to sell it at a significant discount if it was forced to find another
purpose for this asset. Thus, the IASB felt that, in situations where the entity has no other use
for the asset other than for the purpose in the contract, we should deem that the customer
controls this asset over the period of the contract. However, since we are only deeming the
customer to have control, it was decided that we should also be able to prove that, at all times
during the contract period, we will have a right to be paid for the work completed to date in
the event that the contract is terminated by the customer or some other entity for reasons other
than the entity failing to perform as promised. The reason behind this thinking is that, having
a right to payment for work completed to date gives us added confidence that the customer is
obtaining benefits as the entity is performing its obligations (i.e. that they are being satisfied
over time).
Having no alternative use for an asset occurs if the entity is prevented through either
contractual restrictions (that are substantive) or practical limitations from being able to
readily use it for some purpose other than the purpose in terms of the contract. The
enforceable right to payment must exist throughout the contract term and must be expected to
be sufficient compensation for any performance completed to the date of termination.
Criterion 3:
Yes
If the entity is creating an asset,
See IFRS 15.35 (c)
does the entity have:
No alternative use An enforceable right to payment

for the asset AND for performance completed to
date
PO satisfied
This is evidenced by either: This right to payment must:

over time
Substantive contractual exist continually throughout

restrictions preventing the the period of the contract; and
entity from being able to be sufficient compensation for
readily use the incomplete asset any performance completed to
for something else; or date.
Practical limitations preventing
the entity from being able to
readily use the complete asset
for something else.
See IFRS 15.B6-B8 See IFRS 15.B9-B13
No

at a point in time
Chapter 4 173
9.4.2.3.1 No alternative use (IFRS 15.36 and .B6-B8)
Having an alternative use for an asset means being readily able to use it for some other
purpose (i.e. other than the purpose envisaged by the contract).
An entity is considered to have no alternative use for the asset if it is either:

contractually restricted from readily using the asset during its creation/ enhancement –
and if these contractual restrictions are substantive; or
practically limited from readily using the asset after its completion. See IFRS 15.36
Notice that:
The requirements for contractual restrictions:
- refer only to the use of the incomplete asset (i.e. during its creation or enhancement).
Thus, a contractual restriction that prevents the entity from using the incomplete asset
fulfils this requirement but a contractual restriction that only prevents the entity from
using the completed asset would not fulfil this requirement (because it would then be
possible for this asset, while incomplete, to have an alternative use).
- refer only to contractual restrictions that are substantive:
A contractual restriction would be substantive ‘if a customer could enforce its rights
to the promised asset’ in the event that the entity used it for some other purpose.
In other words, the contractual restriction would be substantive if, by using the asset
for some other purpose, the entity would breach the contract and incur significant
extra contract costs.
The requirement for the practical limitation refers only to the completed asset.
Thus, a practical limitation that prevents the entity from using the completed asset fulfils
this requirement but a practical limitation that only prevents the entity from using the
incomplete asset would not fulfil this requirement (because it would then be possible for
this asset, while complete, to have an alternative use.
We decide whether the entity has no alternative use for the asset at the inception of the
contract and we do not re-assess this decision ... unless a contract modification is approved
that causes the performance obligation to be substantively changed (see section 5.7 for more
about contract modifications). See IFRS 15.36
9.4.2.3.2 Enforceable right to payment (IFRS 15.37)
We conclude that the entity has a right to payment that is enforceable if:
the entity is entitled at all times throughout the contract
to a payment that would be sufficient to compensate for performance completed to date
in the event of a contract termination, for reasons other than a breach by the entity, and
this entitlement is enforceable by either contractual terms and/or any laws that apply.
When we talk about the right to payment, we are not referring to a present right but rather to
the right to be able to demand such payment (or retain payments) if the contract were to be
terminated by another party.
A payment would be considered sufficient to compensate for performance completed to date

if this payment is at least close to the selling price of the goods or services transferred to date:
This selling price is calculated as cost plus a reasonable profit margin; and
The reasonable profit margin is calculated as the lower of:
- the portion of the total expected profit on this specific contract, calculated based on
the performance completed to date of termination; or
- the return that the entity usually earns from similar contracts (e.g. based either on the
entity’s normal expected return on cost of capital or its normal operating margins).
174 Chapter 4
In the event that the customer attempts to terminate the contract without having the right to
terminate, we (the entity) may have the legal right to continue completing our performance
obligations in terms of the contract in which case we would have the right to expect the
customer to complete their obligations (i.e. we would have a right to payment in full).
When assessing whether our right to payment is enforceable, we would not only look at the
contractual terms, but would also need to look at all other laws and/ legal precedent that may
support the contractual terms or negate the contractual terms – or even create a right that is
not referred to at all within the contractual terms.

considering the third criterion
This example follows on from example 32.
Admin & Legal Services provides a customer with legal advice and representation leading up to a court
case in which this customer is being sued for defamation.
The contract includes a clause that, in the event of a termination that is not a result of a breach by
Admin & Legal Services, the customer will be required to compensate Admin & Legal Services for the
performance completed to date, calculated as the costs incurred to date plus a 20% profit.
Admin & Legal Services had calculated the contract price as costs plus a 30% profit margin whereas it
normally applied a profit margin of 10% on costs when quoting on similar contracts.
Required: Classify the performance obligation as either performed over time or at a point in time.
Solution 34: Classifying performance obligations: the third criterion
In order to decide whether the PO is satisfied over time or at a point in time, we need to assess whether
one of the three criteria are met.
Criterion 1 (IFRS 15.35(a)) and criterion 3 (IFRS 15.35(c)) would be relevant to this contract.
Assessment of criterion 1:
The nature of the legal advice and representation is not routine and would require substantial re-
performance of the work by another entity in the event of an early termination of the contract. Thus we
conclude that the customer does not receive the asset & consume its benefits at the same time that the
entity performs its obligations. This first criterion is thus not met. For a full discussion, please see the
solution to example 32.
Assessment of criterion 3:
Since the contract involves defending a customer against a case of defamation, the legal advice and
representation is customer-specific and there would thus be no alternative use for the asset created.
Furthermore, the contract entitles the entity to expect payment for work completed to date. Since this
entitlement is stipulated in the contract, and there is no evidence to suggest that there are laws that
would negate this clause, we can assume that it makes the right to payment enforceable. Since the
compensation will be calculated based on cost plus a 20% profit, we conclude that the payment will be
sufficient compensation since it roughly equates the selling price, where selling price is considered to
be cost plus a reasonable profit and where a reasonable profit is considered to be the lower of the
contract-specific profit (30%) and the normal profit applied to similar contracts (10%). In other words,
the lower of the contract-specific profit and the normal profit is 10% and since the required 20%
payment is higher than this, it is considered to be sufficient compensation.
Note: had the contract profit been calculated at 20% on costs and a normal profit on similar contracts
was 10% on costs but the contract required the customer to pay costs plus 5% profit, then the expected
payment would not be considered to be sufficient compensation.
Conclusion:
The third criterion is met and thus the performance obligation is considered ‘satisfied over time’.
Chapter 4 175
9.5 Measuring progress of performance obligations satisfied over time (IFRS 15.39-.45)
9.5.1 Overview
Where a performance obligation is satisfied at a point in time (PIT), the revenue is recognised
immediately. However, if we have a performance obligation that is satisfied over time (SOT),
we recognise revenue gradually as this obligation is satisfied.
This means that, in the case of a performance obligation that is satisfied over time (SOT), we
will continually need to be able to assess the progress towards complete satisfaction of this
performance obligation and will also need to reassess the progress at the end of each reporting
period so as to establish how much revenue should be recognised.
The methods that may be used to measure this progress towards complete satisfaction of the
performance obligation are categorised as:
input methods; and
output methods.
When deciding which method is most appropriate, we will need to consider the nature of the
underlying good or service. Output methods are normally considered to be superior, but using
an output method may not always be possible and/or may be too costly.
We may only use one method per performance obligations but whichever method is used, it
must be used consistently for all similar performance obligations.
If circumstances change and a different method of measuring progress needs to be adopted,

this must be accounted for as a change in accounting estimate in terms of IAS 8 Accounting
policies, changes in accounting estimates and errors.
When measuring the progress, irrespective of the method chosen, we must only ever include
in our calculations the goods or services over which the customer has obtained control.
9.5.2 Input methods (IFRS 15.B18-.B19)
The input method effectively means calculating progress based on the entity’s efforts. We
look at the effort the entity has put in relative to the total effort required in order to complete
the performance obligation. This effort can be measured in a number of ways. We could
measure the entity’s efforts using costs incurred, or labour hours, or machine hours or time
elapsing. See example 36.
If the entity’s efforts are considered to be evenly expended over the performance period, then
we could simply use the straight-line method to recognise revenue. See example 35.
Example 35: Measure of progress – input methods – straight-lining

Lit-amuse is a business that offers customers access to a private library. It sells ‘any-time
access for a year’ for an annual membership fee of C1 200.
Required: Explain how Lit-amuse should measure the progress relating to the performance obligation.
Solution 35: Measure of progress – input methods – straight-lining
The performance obligation involves Lit-amuse providing access to the library for a period of a year.
The performance obligation is classified as satisfied over time because the customer would receive and
consume the benefits as Lit-amuse performs the obligation of providing access (criterion 1). IFRS 15.35(a)
The entity’s efforts are the same throughout the year – access simply has to be granted. Since the
entity’s efforts are evenly expended over the year, the best measure of progress would be time-based on
the straight-line method. In other words, Lit-amuse would recognise the revenue at C100 per month.
176 Chapter 4
Example 36: Measure of progress – input methods

Scrubbers Limited signed an agreement whereby it is to scrape and re-plaster 50 old
buildings. The total contract price is C80 000. The expected contract cost is C50 000.
The following details were available as at year-end, 31 December 20X3:
according to Scrubbers Limited, 30 buildings had been scraped and re-plastered;
costs of C35 000 have been incurred to date (the total expected cost remains C50 000).
The following details are available as at year-end, 31 December 20X4:
according to Scrubbers Limited, 20 buildings were scraped and re-plastered during 20X4;
costs of C15 000 had been incurred during 20X4 (the total expected cost remains C50 000).
Required: Show the revenue journals for 20X3 and 20X4 for each of the following input methods of
measuring progress:
A. tasks already performed as a percentage of total tasks to be performed;
B. costs incurred to date as a percentage of total expected costs.
Solution 36A: Measure of progress – input method: number of tasks completed

20X3 Debit Credit
Receivable (A) W2 48 000
Revenue from PO satisfied over time: input method: tasks complete
20X4
Revenue from PO satisfied over time: input method: tasks complete
W1. Estimated progress: input method: tasks completed 20X3 20X4
Tasks performed to date 20X3: Given and 20X4: (30 + 20) 30 50
Total tasks to be performed Given 50 50
Percentage progress to date (30 / 50); (50 / 50) 60% 100%
W2. Revenue to be recognised based on estimated progress 20X3 20X4
Revenue recognised to date (80 000 x 60%) (80 000 x 100%) 48 000 80 000
Less revenue recognised in prior years (0) (48 000)
Revenue recognised in current year 48 000 32 000
Solution 36B: Measure of progress – input method: costs incurred

20X3 Debit Credit
Revenue from services satisfied over time: input method: costs
20X4
W1. Estimated progress: input method: costs 20X3 20X4
Costs incurred to date 20X3: Given; 20X4: (35 000 + 15 000) 35 000 50 000
Total expected costs Given 50 000 50 000
Percentage progress to date (35 000 / 50 000); (50 000 / 50 000) 70% 100%
Revenue recognised to date (80 000 x 70%) (80 000 x 100%) 56 000 80 000
Chapter 4 177
Revenue from performance obligations satisfied over time: general comment

Notice that the amount of the revenue recognised changes depending on the method chosen
to measure the estimated progress.
It is essential that you measure the estimated progress on a cumulative basis since the total
revenue and/ or total expected contract costs may change over the period that the PO is
satisfied.
For an example that proves this, please see example 37.
Example 37: Measure of progress – input method: total costs changes

Use the same information from example 36 with the following additional information:
the total expected contract costs changed to C60 000 during 20X4.
Required: Show the journals for 20X3 and 20X4 assuming that the measure of progress is an input
method using costs incurred to date as a percentage of total expected costs.
Solution 37: Measure of progress – input method: total costs changes

Journals: Debit Credit
20X3
20X4
W1. Estimated progress: input method: costs 20X3 20X4
Costs incurred to date 20X3: Given; 20X4: (35 000 + 15 000) 35 000 50 000
Total expected costs Given 50 000 60 000
Percentage progress to date (35 000 / 50 000); (50 000 / 60 000) 70% 83,3%
Revenue recognised to date (70% x 80 000) and (83.3% x 80 000) 56 000 66 667
Comment:
It is essential that you calculate the measure of progress on a cumulative basis since the total
revenue and/ or total expected contract costs may change over the period that the PO is satisfied.
This example involves the situation where the total expected costs change.
If you had not calculated the measure of progress on a cumulative basis (i.e. you had used the costs
incurred in 20X4 as a percentage of total expected costs: 15 000 / 60 000 = 25%), you would have
calculated an incorrect measure of progress for 20X4 as follows:
- 20X3: 70% (35 000 / 50 000): 70% x 80 000 = 56 000 revenue (there is nothing wrong YET)
- 20X4: 25% (15 000 / 60 000): 25% x 80 000 = 20 000 revenue (Here is where you would have
gone wrong: this should have been 10 667! So always remember to calculate the measure of
progress using cumulative figures: cumulative costs to date/ latest total estimated costs).
Whenever we measure the progress, we must always remember that we should only consider
the goods or services over which the customer has obtained control. Thus, a downside to the
use of the input method is that it can happen that there is not always a direct relationship
between the inputs and the transfer of control. Thus care must be taken when using the input
method to make appropriate adjustments to the inputs. For example, we would need to
exclude any input (e.g. cost):
if the input does not contribute to an entity’s progress in satisfying the PO (e.g. we would
exclude all costs that were in effect wasted costs) – see example 38; and
if the input is not proportionate to the entity’s progress in satisfying the performance
obligation – see example 39.
178 Chapter 4
An input would not be considered to be proportionate to the entity’s progress in satisfying the
performance obligation if it effectively distorted the true measure of progress. For example, if
a good was needed in order to satisfy a performance obligation and, at inception of the
contract, the entity expects that all the following conditions will be met:
- the good is not distinct from the rest of the PO;
- the customer is expected to obtain control over the good significantly before receiving
the related services;
- the cost of the transferred good is significant relative to the total expected costs to
completely satisfy the performance obligation; and
- the entity buys the good from a third party and is not significantly involved in the
design or manufacture thereof (but the entity is acting as a principal). IFRS 15.B19 (reworded)
Example 38: Measure of progress – input method – input does not

contribute to entity’s progress
An entity signed a contract for C5 000 000 with a wealthy private individual. The contract
requires the entity to conduct research into an unusual and rare disease.
The performance obligation is considered to be satisfied over time (because the entity has no
alternative use for the research results and the entity has an enforceable right to payment).
The entity decided that an input method based on costs incurred would be the best measure of progress.
The expected cost of this project is C3 000 000.
During the first year, 20X1, costs of C800 000 were incurred. Included in these costs is an amount of
C200 000, being the cost of inventory damaged during a wild-cat strike by the entity’s factory staff.
Required: Explain how the entity should measure the progress relating to the performance obligation.
Solution 38: Measure of progress – input methods – straight-lining

Although costs of C800 000 were incurred, C200 000 of these costs were wasted costs. In other words,
these costs did not contribute to the entity satisfying the performance obligation.
Thus, the progress at the end of 20X1 is measured as:
(Total costs incurred: C800 000 – Wasted costs: C200 000) ÷ Total expected costs: C3 000 000 = 20%
Thus revenue of C1 000 000 will be recognised (20% x C5 000 000) in 20X1.
Example 39: Measure of progress – input method – input is not

proportionate to the entity’s progress
An entity signed a contract for C10 000 000 with a customer. The contract requires the
entity to construct a building to house a specialised plan.
The performance obligation is considered to be a single performance obligation satisfied over time.
The entity decided that an input method based on costs incurred would be the best measure of progress.
The expected cost of this project is C5 000 000.
During the first year, 20X1, costs of C3 000 000 were incurred. Included in these costs is an amount of
C2 000 000, being the cost of purchasing the plant that will still need to be installed as part of this
performance obligation. At reporting date, this plant had not yet been installed but it had been delivered
to the customer’s premises and the customer now has full control thereof.
Required: Explain how the entity should measure the progress relating to the performance obligation.
Solution 39: Measure of progress – input methods – input is not proportionate to

the entity’s progress
Although costs of C3 000 000 were incurred, C2 000 000 of these costs represents the cost of
purchasing the plant which will still need to be installed. The entity was not involved in the design or
manufacture of this plant and was simply required to purchase it. The cost is also a significant portion
of the total expected costs.
Thus, it is submitted that the C2 000 000 cost of purchasing the plant should be excluded from the
estimation of the measure of progress because it would otherwise distort the true measure of progress.
Chapter 4 179
Thus, the progress at the end of 20X1 is measured as:

(Total costs incurred: C3 000 000 – Significant cost unrelated to true progress: C2 000 000) ÷ Total expected costs:
C5 000 000 = 20%
The revenue from the plant will be recognised separately at the cost of the plant.
Revenue (I) Calculation 1 C3 600 000
Contract costs (E) Given (Plant and all other costs) C3 000 000
Profit C600 000
Calculations:
(1) TP excl plant: (C10 000 000 – C2 000 000) x 20% + TP of the plant: C2 000 000 x 100% = C2 600 000
9.5.3 Output methods (IFRS 15.B15-.B17)

The output method effectively means calculating progress based on the value that the
customer has obtained to date. To do this we calculate the value of the goods or services
transferred to date relative to the value of the total goods or services promised. This value can
be measured in a number of ways. We could use surveys of performance completed,
appraisals of results achieved, time passed, units produced or units delivered. See example 40.
Irrespective of which output method we use, we must always bear in mind that our ultimate
objective is to ‘faithfully depict the entity’s performance towards complete satisfaction of the
performance obligation’. Thus we need to be sure that the output method chosen achieves this
objective. For example, an output method based on units delivered may not be a faithful
depiction of the entity’s performance if the entity has also produced units of finished goods
(or even units that are still a work-in-progress) that the entity has not yet delivered but over
which the customer has already obtained control.
As a practical expedient, if the contract gives the entity the right to consideration (i.e. the right
to invoice the customer) for an amount that exactly equals the value of the entity’s
performance to date, (e.g. the contract allows the entity to invoice the customer based on a
rate per hour of work done for the customer), then the entity may simply recognise the
revenue as it invoices the customer (i.e. debit receivable and credit revenue). In other words,
it need not go through the process of estimating the measure of progress.
The disadvantages of output methods include the fact that the relevant outputs are not always
be directly observable and may not be easily available without undue cost. Thus, although
output methods are considered to be superior, the use of an input method may be necessary.
Example 40: Measure of progress – output method: work surveys

Scrubbers Limited signed an agreement whereby it is to scrape and re-plaster 50 old
buildings. The total contract price is C80 000. The expected contract cost is C50 000.
According to the results produced by the independent surveyor :
work performed to 31 December 20X3 is valued at C50 000;
work performed to 31 December 20X4 is valued at C80 000.
Required: Show the revenue journals for 20X3 and 20X4 using an output method based on the surveys
of work performed to date.
Solution 40: Measure of progress – output method: work surveys

20X3 Debit Credit
Receivable (A) Given – or W2 50 000
Revenue from services satisfied over time: output method
20X4
Revenue from services satisfied over time: output method
180 Chapter 4
W1. Estimated progress: output method: surveys performed 20X3 20X4

Work surveyed (to date!) Given: surveys normally ‘to date’ 50 000 80 000
Total contract revenue Given 80 000 80 000
Percentage progress to date (50 000/ 80 000); (80 000/ 80 000) 62,5% 100%

Revenue recognised to date (80 000 x 62.5%) (80 000 x 100%) 50 000 80 000
Note: work surveyed is normally provided on a cumulative basis: the surveyor would say that the work
certified for invoicing is C80 000 in 20X4, not the extra C30 000 that still needs to be invoiced in 20X4.
9.5.4 If a reasonable measure of progress is not available (IFRS 15.44)
Irrespective of the method chosen to measure the progress towards complete satisfaction of
the performance obligation, if the information that we need to apply the method is not
reliable, then we will not be able to say with confidence that we have a reasonable measure of
progress.
If we do not have a reasonable measure of progress, then no revenue at all may be recognised
until a reasonable measure becomes available. In this case, if we receive payments from our
customer, we will have to recognise them as a liability instead (i.e. debit bank and credit
contract liability). See IFRS 15.B44
9.5.5 If a reasonable measure of the outcome is not available (IFRS 15.45)
If the outcome of the performance obligation is not able to be reliably measured (this often
happens in the ‘early stages of a contract’), but the entity believes it will recover the costs that
it has incurred, then revenue may be recognised but only to the extent of these incurred costs.
If the customer happens to have paid us more (or owes us more) than the costs that we have
incurred, this excess would be recognised as a liability until such time that the outcome is
reasonably measurable. See IFRS 15.B44
Example 41: Outcome not reasonably measured
An entity has signed a contract with customer X in which the promised consideration is
C100 000 and the related performance obligation is satisfied over time.
At reporting date, the entity had received C40 000 from the customer and, in terms of the contract, this
customer still owes a further C10 000.
The entity has incurred costs of C20 000 to date. However, given that this is a new contract upon which
the entity has no historic evidence to estimate its total costs, the entity concludes that it cannot measure
the expected outcome of this contract.
Required: Prepare the journal/s to reflect the information provided.
Solution 41: Outcome not reasonably measured

Debit Credit
Bank Given 40 000
Receivable Given 10 000
Revenue from customer contract (I) Max = costs incurred 20 000
Contract liability (L) Balancing: 40 000 + 10 000 – 20 000 30 000
Recording the receipt and receivable from the customer as part revenue
(limited to costs incurred) and part as a contract liability: because
outcome unknown
Chapter 4 181
9.6 Repurchase agreements (IFRS 15.B64-.B76)
9.6.1 Overview
When we assess whether control over the asset has passed to a customer, we must be careful
to consider any possible repurchase agreements (e.g. where we have sold goods to a customer
but have agreed to buy them back after a period of time – or have the option to do so under
certain circumstances). Although it may look like control has passed to a customer, the
existence of a repurchase agreement may prove that control has not actually passed.
A repurchase agreement does not only refer to an agreement where we have committed
ourselves to buying the asset back after a period of time (a forward), but also to an agreement
where we may choose to buy the asset back (a call option) – or where the customer may
choose to force us to buy the asset back (a put option).
IFRS 15 classifies repurchase agreements into those in which:

the customer obtains control; and where
the customer does not obtain control.
9.6.2 Where a repurchase agreement means the customer does not obtain control
Where the entity has an obligation to repurchase (i.e. a forward) or simply a right to
repurchase (a call option), we conclude that the customer does not obtain control. This is
because the entity can insist that the customer return the asset. Thus the customer is limited in
its ability to direct the use of and to obtain substantially all the remaining benefits from the
asset. See IFRS 15.B66
In cases such as these, the repurchase agreement will either be accounted for as a:
Lease agreement in terms of IAS 17 Leases
This happens if the entity can or must repurchase the asset for an amount that is less than
the original selling price of the asset; or
Financing arrangement in terms of IFRS 15 (para B86)
This happens if the entity can or must repurchase the asset for an amount that is more than
or equal to the original selling price of the asset. See IFRS 15.B66
If the repurchase agreement is effectively a financing arrangement, then the asset that has
been sold (and which we are to repurchase at a later date) is not removed from our books.
The amount we receive from the customer will be recognised as a liability (because we are
effectively using our asset to borrow money). The excess of the repurchase price that we will
be expected to pay over the original selling price will be recognised as interest (we will need
to build in to this calculation the effects of the time value of money – thus we would work
with a present valued repurchase price). See IFRS 15.B67-B68
If the repurchase agreement was based on a call option (rather than a forward), and if this
option lapses without the entity choosing to repurchase the asset, then the liability will be
derecognised and recognised as revenue instead. See IFRS 15.B69
9.6.3 Where a repurchase agreement means the customer does not obtain control
Where the customer may choose to force the entity to buy the asset back (i.e. a put option), we
conclude that the customer does obtain control. This is because the customer can choose
whether or not to force the entity to buy the asset back. Thus the customer is not limited in its
ability to direct the use of and to obtain substantially all the remaining benefits from the asset.
See IFRS 15.B66
182 Chapter 4
In such cases, we would need to assess, at contract inception, whether:

the repurchase price is lower or higher than the original selling price; and whether
the customer has a significant economic incentive to force us to buy the asset back.
If the repurchase price is lower than the original selling price and:
the customer has a significant economic incentive to force us to buy the asset back, this
agreement would be accounted for as a lease agreement in terms of IAS 17 Leases. This is
because the customer will have effectively paid for the right to use the asset from the time
the entity ‘sells’ it to the customer to the time the customer forces the entity to buy it
back. See IFRS 15.B70
the customer does not have a significant economic incentive to force us to buy the asset
back, this agreement would be accounted for as a sale with a right of return (see
section 7.2.6.3). See IFRS 15.B72
If the repurchase price is equal to or greater than the original selling price and
is more than the expected market price of the asset, we would account for the agreement
as a financing arrangement (see section 9.6.2). See IFRS 15.B73
is less than or equal to the expected market price of the asset (and yet the customer has a
significant economic incentive to exercise its right), we would account for the agreement
as a sale of a product with a right of return (see section 7.2.6.3). See IFRS 15.B74
If this put option lapses without the customer forcing the entity to repurchase the asset, then
the liability will be derecognised and recognised as revenue instead. See IFRS 15.B76
10. Contract costs (IFRS 15.91-.104)
10.1 Overview
Entities obviously incur costs in connection with their contracts with customers. These costs
can be split into two types:
Costs to obtain the contract; and
Costs to fulfil the contract.
These costs, whether they are to obtain the contract or fulfil the contract, may need to be
recognised as an asset (i.e. capitalised) if they meet certain criteria. If the criteria are not met,
they would be expensed.
If costs are recognised as an asset, this asset will need to be amortised and checked for
impairments.
10.2 Costs of obtaining a contract (IFRS 15.91-.94)
There are frequently costs incurred to obtain a cost, involving aspects of administration,
marketing, legal costs, commissions and the costs of preparing tenders. Some of these costs
may need to be capitalised instead of being expensed.
The following costs of obtaining a contract with a customer must be capitalised (i.e.
recognised as an asset):
the incremental costs of obtaining a contract if the entity expects to recover them; and
the costs that are not incremental costs of obtaining a contract but are costs that are
explicitly chargeable to the customer even if the entity does not get the contract. See IFRS
15.91 & .93
Incremental costs mean extra costs.
Chapter 4 183
Thus the incremental costs of obtaining a contract refer to the extra costs that relate to having
obtained a contract. Thus the cost of preparing a tender would not be an incremental cost of
obtaining a contract since this is a cost that is incurred whether or not the contract is obtained.
Conversely, a commission paid on the successful securing of a contract would be considered

an incremental cost (since it would not have been incurred if we had not secured the contract).
A commission paid on the successful securing of the contract would be capitalised if the
entity expected these costs to be recoverable. The tender costs would not normally be
capitalised – though it is possible to capitalise these if the customer agreed to pay these even
if the contract was not granted to the entity. See IFRS 15.92-93
As a practical expedient, if the asset created would be completely amortised in a year or less,
then the entity may expense the costs instead. See IFRS 15.94
Example 42: Costs of obtaining a contract

An entity incurred the following costs in successfully tendering for a 5-year contract:
Fees paid to lawyers for preparation of relevant contracts C10 000
Travel and accommodation fees for 2 staff members to attend and present the proposalC25 000
Commissions paid to sales manager for securing the contract C5 000
Discretionary bonus paid to sales manager for individual performance evaluation C30 000
C70 000
The customer had agreed to pay for the travel and accommodation fees even if the contract had not
been awarded to the entity.
Required:
Explain which costs should be capitalised in terms of IFRS 15.
Solution 42: Costs of obtaining a contract

The lawyers’ fees would have been paid even if the contract had not been awarded and are thus not
incremental costs of obtaining the contract. Since these costs were not chargeable to the customer,
they must be expensed.
The travel and accommodation fees would have been paid even if the contract had not been
awarded and are thus not incremental costs of obtaining the contract. However, since these costs
were chargeable to the customer, they must be capitalised.
The commissions paid to the sale manager for securing the contract is an incremental cost of
obtaining the contract and it is assumed that the entity expects to recover these through the
contract. Thus these costs must be capitalised.
The discretionary bonus paid to the sales manager pursuant to his individual performance
evaluation is not directly linked to the contract but is based on a variety of other factors. This cost
is thus not an incremental cost of obtaining the contract and must thus be expensed.
The costs capitalised will be amortised over the 5-year period of the contract.
10.3 Costs to fulfil a contract (IFRS 15.95-.98)

Costs that an entity incurs to complete a contract must be recognised:
in terms of the relevant standards; or
in terms of this standard (IFRS 15) if there is no other relevant standard.
For example, if the cost to complete a contract involved the sale of goods to a customer, then
the cost of the sale would be accounted for in terms of IAS 2 Inventories.
It is only if there is no other standard relevant to the specific cost that it would be accounted
for in terms of IFRS 15.
184 Chapter 4
If a cost is to be recognised in terms of IFRS 15, it will be recognised as an asset if the

following criteria are met:
the costs are directly related to a contract (or an expected contract) and are able to be
specifically identified;
the costs will ‘generate or enhance’ the entity’s resources that will be, or are being, used
to complete the contract; and
the entity expects to recover these costs. See IFRS 15.95
If the cost does not meet these criteria, it will be expensed.
Irrespective of the above criteria, the following costs must be expensed immediately:
general and administrative costs – unless the contract enables these costs to be charged to
the customer;
costs of abnormal wastage
costs that have been incurred in relation to a satisfied or partially satisfied performance
obligation (i.e. costs relating to past performance);
costs where the entity is unsure of whether or not it relates to an unsatisfied performance
obligation (i.e. we err on the side of caution and assume it relates to a satisfied
performance obligation.
Example 43: Costs of fulfilling a contract

An entity incurred the following set-up costs relating to a 5-year contract to manufacture
patented product, renewable for a year:
Licence to manufacture patented products C10 000
Purchase of a machine to be used to manufacture the product C40 000
Costs of liaising with the customer to ensure suitable quality of output C20 000
Wages of employees who will be allocated full-time to this contract C30 000
C100 000
Required: Explain which costs should be capitalised in terms of IFRS 15.
Solution 43: Costs of obtaining a contract

The cost of the licence must be accounted for in terms of IAS 38 Intangible assets.
The cost of the machine must be accounted for in terms of IAS 36 Property, plant and equipment.
The costs of assessing the required quality levels of the output would be accounted for in terms of
IFRS 15 – we would need to ascertain whether the these costs meet the criteria laid out in
IFRS 15.95. If the costs meet the criteria, they will be capitalised.
The wages to the employees allocated to the contract would be accounted for in terms of IFRS 15
– we would need to ascertain whether these costs meet the criteria laid out in IFRS 15.95. These
costs would, however, be expensed since they will fail the criteria on the basis that they do not
‘generate or enhance’ the entity’s resources.
The costs capitalised in terms of IFRS 15 will be amortised over 6 years (being the period of the
contract plus any periods of renewal – see section 10.4 below)
10.4 Capitalised costs are amortised (IFRS 15.99-.100)
Costs that are recognised as an asset (i.e. capitalised) will need to be amortised (i.e. expensed
over a period of time) using a method that reflects the transfer of the related goods or services
to the customer. Costs would typically be amortised over the period of the related contract –
and if that contract is expected to be renewed, then the amortisation would be over the period
of the contract, including the expected renewal period/s. See IFRS 15.IE195
If the expected timing of the transfer of these goods or services changes significantly, the
method of amortisation will then need to be changed. A change in the method of amortisation
must be accounted for as a change in accounting estimate (i.e. in terms of IAS 8 Accounting
policies, estimates and errors; see chapter 26).
Chapter 4 185
10.5 Capitalised costs are tested for impairments (IFRS 15.101-.104)

Costs that are recognised as an asset will need to be tested for impairment. The asset will be
considered impaired if its carrying amount is greater than the net remaining consideration that
the entity expects to receive.
This net remaining consideration is calculated as:

The remaining amount of consideration that the entity expects to receive in exchange for
the goods or services to which the asset relates;
Less: the directly related costs that have not been expensed. See IFRS 15.101
If the transaction price does not include variable consideration (i.e. the consideration is
fixed), the consideration is simply calculated using the same principles that we used when
calculating the transaction price (unless it includes variable consideration – see below), but it
must then be adjusted to reflect the credit risk specific to that customer.
If the transaction price includes variable consideration, the consideration must be calculated
using the same principles that we used when calculating the transaction price and adjusted to
reflect the credit risk specific to that customer (i.e. as above), but we must ignore the
principles relating to constraining estimates of variable consideration).
Impairment losses are recognised as an expense in profit or loss.
If, at a later stage, the circumstances that led to the impairment loss reverse or improve, then
the impairment expense may be reversed (i.e. recognised as income in profit or loss). When
reversing an impairment loss, we must be sure that the reversal does not increase the asset’s
carrying amount above the carrying amount that it would have had had it never been
impaired.
11. Specific revenue transactions
11.1 Overview
As you have probably gathered, the 5-step approach to revenue recognition requires a holistic
and integrated approach when considering each of the steps. Thus, it is probably helpful if we
now consider a few interesting and fairly common revenue-related transactions in context of
the 5-step approach.
11.2 Sale with a warranty (IFRS 15.B28-.B33)

Warranties come in
Goods are often sold with warranties. There are two types: two forms:
assurance-type warranties and service-type warranties. assurance-type: account for
An assurance-type warranty is a warranty that assures in terms of IAS 37
the customer than the product will function as intended service-type: account for in
terms of IFRS 15 as a
or that it meets the agreed-upon specifications. separate PO
A service-type warranty offers the customer a service in addition to the mere assurance
that the product will function as intended.
An assurance-type warranty is simply a confirmation that the product is what it purports to
be. In other words, an assurance-type warranty does not promise anything in addition to the
product. Thus the transaction price is allocated entirely to the product. However, the fact that
the assurance-type warranty exists will need to be accounted for in terms of
IAS 37 Provisions, contingent liabilities and contingent assets.
A service-type warranty involves the promise of a service (should the need arise), and is thus
a separate promise - a distinct performance obligation.
186 Chapter 4
Thus if the sale of a product includes a service-type warranty, the transaction price will have
to be allocated between the two performance obligations: the transfer of a good and a service.
If and when this service is provided, it will result in the recognition of revenue.
If a customer is able to purchase a warranty separately, this would indicate that it is a service-
type warranty and should be accounted for as a separate performance obligation. In cases
where the customer is not able to purchase a warranty separately, we will need to carefully
assess which type of warranty we are dealing with. IFRS 15 provides a list of factors that may
need consideration.
Two of the factors are explained below:

the warranty may be a legal requirement – this suggests that it exists purely as protection
for the customer, in which case it is an assurance-type warranty;
the warranty may cover a short period – this suggests it is an assurance-type warranty (the
longer the warranty period, the more likely it is that a service will need to be provided in
which case it is a service-type warranty)
Sometimes a warranty involves both an assurance-type warranty and a service-type warranty,
each of which would need to be accounted for separately. An assurance-type warranty that
cannot be reliably separated from a service-type warranty is accounted for as service-type
warranties (i.e. as a single performance obligation).
Example 44: Sale with a warranty
An entity sells a product for C100 000. Included in the sales contract is a warranty that the
product will function as intended for up to one year. Included in the contract price is a
further extended warranty covering the next two years, during which period the entity promises to
repair the product if necessary. The extended warranty is available for sale separately for C10 000.
Required: Briefly explain how the information should be accounted for.
Solution 44: Sale with a warranty

The first warranty covering the first year simply assures the customer that the product will function as
intended for this first year and thus is considered to be an assurance-type warranty.
The second extended warranty covering the next 2 years offers the customer a service in the event that
the product malfunctions during this period. This warranty is also available for sale separately. Both
factors indicate that it is a service-type warranty.
Thus the transaction price of C100 000 must be allocated to the two POs: the extended warranty
(C10 000) and the product (C90 000, the balancing amount). As soon as control of the product is
transferred to the customer, the following journal will be processed:
Debit Credit
Accounts receivable (A) W1 100 000
Contract liability 10 000
Revenue: sales (I) 90 000
Recording the sale of goods and service-type warranty
11.3 Sale with a right of return (IFRS 15.51 &.55 & B20-B27)
A contract involving a transfer of goods with a right of return is covered in section 7.2.6.3.
11.4 Transactions involving principal – agent relationship (IFRS 15. B34-B38)
11.4.1 Overview
Sometimes contracts are complicated by the involvement of a third party. In such cases, we
must take care in deciding whether the entity is acting as a principal or an agent. The entity:
is a principal if the entity transfers the goods or services to the customer
is an agent if the entity is simply connecting a principal with a customer. See IFRS 15.B34
Chapter 4 187
11.4.2 Where the entity is the principal

For the entity to be a principal, it must be the party transferring the goods or services to the
customer. For this to be possible, it means that it must have had control of the goods or
services immediately before it was transferred to the customer. Control is assessed on many
levels such as who has the risks and rewards of ownership, who has physical control, who has
legal title etcetera. However, IFRS 15 clarifies that, in the case of legal title, we must be
aware that, if an entity simply obtained legal title on a temporary basis for the sole purpose of
being able to transfer this legal title to the customer soon thereafter, this would not necessarily
indicate that the entity had control and was acting as a principal. All facts and circumstances
would need to be carefully considered in deciding whether the entity had full control prior to
transferring the item to the customer. See IFRS 15.B35
The entity would still be the principal in situations where it uses a third party to complete part
or all of a performance obligation, for example, when the entity uses a subcontractor to
perform some of the work.
Where the entity is acting as a principal, it recognises revenue at the gross amount of
consideration to which it expects to be entitled – any commissions payable to the agent would
thus be recognised as a separate expense.
11.4.3 Where the entity is the agent
The entity would be an agent if it did not have control of the good or service prior to the
transfer thereof to the customer. In other words, the entity is an agent if its performance
obligation is satisfied once it has simply arranged for another party (i.e. the principal) to
provide goods or services to the customer.
Facts and circumstances that suggest that an entity is acting as an agent include, for example:
the entity cannot decide the selling price of the good or service;
the entity’s consideration will be in the form of commission;
the entity is not exposed to credit risk in the event that the customer defaults on payment;
the entity does have the risk related to inventory either before or after the goods have
been ordered or during shipping. See IFRS 15.B37
Where the entity is acting as an agent, it recognises revenue being the fee or commission
receivable from the principal. See IFRS 15.B36
11.5 Sale on consignment (IFRS 15.51 &.55 & B77-B78)
When an entity sells goods on consignment, it is effectively using an agent who will sell the
goods onwards to the final customer. An agent simply acts on behalf of the principal (the
entity) thus, although the agent obtains physical possession of the goods while holding them
on consignment, the agent never actually obtains control of the asset. Since IFRS 15 only
allows the recognition of revenue when control passes from an entity to a customer, revenue
may not be recognised until the agent has sold the consignment goods to the final customer.
Indications that a sale is a sale on consignment include:
the product is controlled by the entity until a specified event occurs (e.g. the sale of the
product to a customer of a dealer or until a specified period expires);
the entity is able to insist upon the return of the product or can insist that it be transferred
to a third party (e.g. another dealer); and
the dealer does not have an unconditional obligation to pay for the product (although it
may be required to pay a deposit)
the entity continues to insurance the product while being held by the dealer. See IFRS 15.B78
Revenue may be recognised when a performance obligation is satisfied – and a performance
obligation is satisfied when control has passed to a customer. Thus, if a good is sold on
consignment, no revenue may be recognised (however, a journal may be processed to reflect
the movement of inventory from the warehouse to the dealer on consignment – e.g. debit
inventory on consignment and credit inventory). Revenue will be recognised when the dealer
has, as agent, transferred control from the entity (the principal) to the customer. The revenue
recognised must be the gross amount – not net of any commissions owed to the agent.
188 Chapter 4
Example 45: Sale on consignment

Vital-Drive sells a vehicle on consignment to a dealer, Multi-Car, for C100 000 on
5 January 20X1. The cost of the vehicle is C70 000.
If the dealer succeeds in selling the vehicle to a customer, the dealer retains 10% as a sales commission
and pays Vital-Drive the difference.
Multi-Car sold the vehicle to a customer on 20 January 20X1.
Required: Show all related journals.
Solution 45: Sale on consignment

Inventory on consignment with Multi-Car (A) given 70 000
Inventory (A) 70 000
Recording the transfer of inventory to Multi-Car, on consignment
20 January 20X1
Cost of sales given 70 000
Inventory on consignment with Multi-Car (A) 70 000
Recognising the cost of goods sold
Receivable 100 000 x 90% 90 000
Revenue from customer contract 100 000 x 100% 100 000
Sales commission (E) 100 000 x 10% 10 000
Recognising revenue and sales commission resulting from the sale
11.6 Sale on a bill-and-hold basis (IFRS 15.B79-B82)

A bill-and-hold sale is simply one where the entity has invoiced the customer for a product
but the entity still has physical possession of this product. However, the usual principle
applies – if control has passed to the customer, then the entity may recognise the revenue even
though the entity still has physical possession (remember: physical possession is only one
aspect of control). Thus, in all bill-and-hold situations, we must assess whether control has
passed. Control has passed to the customer if the customer is able to direct the use of the
product and obtain substantially all of the remaining benefits from the product. For control to
have passed in a bill-and-hold situation, we must also ensure that the following additional
criteria are met:
the reason for the bill-and-hold arrangement must be substantive (e.g. the customer must
have requested it);
the product must be identified separately as belonging to the customer;
the product must be ready for physical transfer to the customer; and
the entity must not have the ability to use the product or to direct it to another customer.
If all these criteria are met, then control is said to have passed to the customer and revenue
must then be recognised. However, since the entity is effectively providing storage for the
customer, the entity must assess whether the provision of storage is another separate
performance obligation, in which case the transaction price would need to be allocated
between the obligation to transfer the product (PO#1) and provide storage services (PO#2).
Example 46: Bill-and-hold sale
Lemon-Drop manufactures a specialised vehicle for Rondil, for C100 000. The vehicle is
complete and ready for delivery on 5 January 20X1. On this date, Rondil inspected the
vehicle and accepted that it meets all specifications, and immediately paid in full. Rondil has signed all
paperwork giving it legal title over the vehicle but requested that Lemon-Drop retain the vehicle for a
further 6 months until the construction of Rondil’s garage had been completed. Lemon-Drop has
agreed to this arrangement and has stored the vehicle in the company warehouse and identified it as a
vehicle that had already been sold to Rondil. They agreed that Lemon-Drop would ensure that
absolutely no-one would use the vehicle during the period of storage.
Required: Explain how this should be accounted for.
Chapter 4 189
Solution 46: Bill-and-hold sale

The sale of the vehicle is a bill-and-hold sale since Lemon-Drop has invoiced Rondil and yet still has
physical possession of the vehicle. For revenue to be recognised from this sale, we must prove that
control has passed to Rondil (by referring to the indications of the transfer of control provided in
IFRS 15.38) and decide whether all the additional criteria provided in IFRS 15.B81 have been met.
It is submitted that control over the vehicle has passed to Rondil because (using some of the indicators
in IFRS 15.38):
Rondil was obliged to pay for the vehicle;
Rondil has obtained legal title over the vehicle;
Rondil has inspected the vehicle and accepted that it meets all required specifications.
Furthermore, all criteria in IFRS 15.B81 are met:

Rondil requested that Lemon-Drop retain possession (i.e. the reason for the bill-and-hold
arrangement is substantive);
the vehicle is separately identified as having been sold to Rondil;
the vehicle was ready for delivery on 5 January 20X1;
the vehicle is specialised and thus it is practically not possible for it to be redirected to another
customer and there is also a verbal agreement (legal restriction) preventing Lemon-Drop from
using the vehicle during the period of storage.
Conclusion: Since control passed to Rondil on 5 January 20X1 (in terms of IFRS 15.38) and all further
criteria relevant to a bill-and-hold arrangement (in terms of IFRS 15.B81) have been met, Lemon-Drop
must recognise the revenue from the sale of the vehicle. Before recognising the revenue, however,
Lemon-Drop must assess whether the request for storage results in a separate performance obligation,
in which case the transaction price would first have to be allocated between the two performance
obligations. However, the fact that the requested storage is for such a short period suggests that the
provision of storage facilities is incidental to the contract and may be ignored. The following journal
would be processed:
Bank (A) given 100 000
Recording the receipt from the customer and the related revenue from
the bill-and-hold sale
11.7 Customer options for additional goods and services (IFRS 15.B39-B47)
Sometimes a contract provides a customer with the option to acquire additional goods and
services – these may be offered for free or at a discount. They are often called sales
incentives, loyalty points or award credits, contract renewal options or other discounts on
future goods or services.
An option for additional goods or services must be accounted for as a separate performance
obligation only if it provides the customer with a ‘material right that it would not receive
without entering into that contract’. See IFRS 15.B40
Worked example 7: Customer receives a material right

A contract for the sale of 100 000 units at C3 each could include a clause to the effect that,
if this customer entered into a further contract for a further 100 000 units, then these further
units would be sold at a discounted price of C2 each. Since these further units are at a discounted price,
the customer has received a material right that it would not receive without entering into that contract’
and thus this option must be accounted for as a separate performance obligation.
An option to acquire further goods or services at a price that would reflect the relevant stand-
alone selling prices would not be a material right – even if this option can only be exercised
by entering into the first contract.
190 Chapter 4
Worked example 8: Customer does not receive a material right

A contract for the sale of 100 000 units of product X could include a clause to the effect
that, since this customer has purchased a quantity of product X, the customer is now entitled
to purchase product Y. Since there is no discount being offered on product Y, the customer has not
been given a material right. Instead, the entity has simply marketed product Y. Thus this contract does
not include an option that would be accounted for as a separate performance obligation.
In cases where we conclude that the customer is being given a material right that it would not
receive without entering into that contract, we account for the right as a separate performance
obligation. Thus, the transaction price will need to be allocated between the obligation to
transfer the goods or services per the contract and the obligation to provide the future goods
or services at a discount (or for free). In other words, we will thus be accounting for this first
contract as if the customer is effectively paying in advance a portion of the consideration for
the future goods or services. The revenue from the future goods or services is recognised as
revenue when the future goods or services are transferred (i.e. when the customer orders the
free or discounted goods or services) or when the option expires (i.e. if the customer does not
order the free or discounted goods or services).
The transaction price is allocated based on the relative stand-alone selling prices. Please note
that it is the stand-alone selling price of the option and not the stand-alone selling price of
future goods or services that we use for this allocation. For example, if the contract includes a
clause that stipulates that a customer can purchase further goods, which normally sell for
C100 000, at C80 000 instead, the stand-alone selling price that we would use for the purpose
of allocating the transaction price is the net stand-alone selling price of the option: C20 000.
Example 47: Option accounted for as a separate performance obligation
An entity signed a contract for the sale of a vehicle to a customer at C800 000. This contract
includes a clause to the effect that, if this customer entered into a further contract to
purchase a trailer, this trailer would be sold to the customer at a price of C100 000. This option expires
on 28 February 20X1. The entity normally sells the trailers at C250 000 but, as part of a marketing
campaign, the entity will be offering them to the general public at C180 000 each during this period.
The customer paid and obtained control of the vehicle on 5 January 20X1 and then purchased the trailer
on 20 February 20X1 for cash.
Required: Show the journal entries for the above.
Solution 47: Option accounted for as a separate performance obligation

The contract offers the customer the option of purchasing a trailer at a discounted price. This option
gives the customer a ‘material right that it would not receive without entering into that contract’ and
thus this option must be accounted for as a separate performance obligation. The transaction price must
be allocated based on the relative stand-alone selling prices as follows:
Vehicle C800 000 TP: C800 000 x 800 000 / 880 000 C727 272
(calculated below)
Option C80 000 TP: C800 000 x 80 000 / 880 000 C72 727
C880 000 C800 000
Calculation of the stand-alone selling price of the option:
Price to the public: C180 000 – Price to the customer in terms of the option: C100 000 = C80 000

Revenue from customer contract (I) See allocation of TP above 727 272
Contract liability (L) See allocation of TP above 72 727
Recording the receipt from the customer and the related revenue from
the sale of the vehicle (TP adjusted for the option) and the contract
liability reflecting the obligation in terms of the option offered
Chapter 4 191

Contract liability (L) See allocation of TP above 72 727
Bank (A) Discounted price per the contract 100 000
Recording the receipt from the customer for the trailer at the discounted
price per the contract and reversing the contract liability to revenue
Comment: If the customer had not purchased the trailer by 28 February 20X1 (the time the option
expired), we would have processed a journal (on 28 February 20X1), reversing the liability and
recognising revenue of C72 727.
As a practical expedient, if the material right provided to the customer involves goods or
services that are the same or similar to those in the original contract (e.g. in the case of a
renewal of a contract), then the entity can choose not to bother estimating the stand-alone
selling price of the option for purposes of allocating the initial contract’s transaction price.
Instead, the entity can account for the initial contract and the potential renewal contracts as if
it were one contract. It would then calculate the total expected transaction price for the
combined contracts and then allocate across the total expected goods and services offered
under the combined contract (i.e. allocating it between the goods and services offered under
the existing contract and the future goods and services offered under the renewal contracts).
As mentioned above, this would apply in the case of contract renewals but would also apply if
the option simply involved offering the same product at discounted price. Thus, the practical
expedient would also be available if, in the previous example, the option was to purchase
another vehicle of the same type rather than a trailer.
Example 48: Option involves similar goods or services (e.g. contract renewal)
An entity sells many annual contracts for the provision of weekly home maintenance
services at C10 000 each. The contracts includes a clause to the effect that, if a customer
renews the contract for a further year, that the second year contract would cost C12 000 instead of the
new price which will be C15 000. This option expires on 31 December 20X1 (in other words – the
customer needs to renew the contract by 31 December 20X1 in order to qualify for the discount). The
entity sells 20 contracts during January 20X1 and expects that 80% of these customers will renew their
contracts. All customers paid for the first year of their contracts in 20X1 and 80% thereof, as expected,
renewed their contracts. The entity chooses to measure progress towards complete satisfaction based on
time elapsed.
Required: Show the journal entries for the above using the practical expedient if available to the entity.
Solution 48: Option involves similar goods or services (e.g. contract renewal)
Since the second year contract involves the same or similar services to those in the first year contract,
the entity can choose the practical expedient and thus choose not to estimate the stand-alone selling
price of the option for purposes of allocating the transaction price. Instead, the entity can choose,
instead of allocating the transaction price to the first year contract and option, it can allocate the total
expected consideration and allocate it to the total goods or services that it expects to provide.
At contract inception, the entity expects 80% of its customers to renew their contracts and thus:
the total expected consideration = 20 x C10 000 + 20 x 80% x C12 000 = C392 000
the total services to be provided will be provided over time and thus we will need to estimate the
measure of progress. The entity measures its progress based on time: 24 months.
Total expected Allocation of total Allocation based on
consideration expected consideration measure of progress:
Year 1 C200 000 20 x C10 000 C196 000 C392 000 x 12/24 months
Year 2 C192 000 20 x 80% x C12 000 C196 000 C392 000 x 12/24 months
C392 000 C392 000
192 Chapter 4
Year 1 Debit Credit

Bank (A) Transaction price: 20 x C10 000 200 000
Contract liability (L) Balancing 4 000
Receipt from customers; related revenue from the sale of the contracts
for the 1st year (based on total expected consideration allocated using a
time-based measure of progress) and resultant contract liability
reflecting the obligation to renew the contract at a discounted price
Year 2
Contract liability (L) See above 4 000
Bank (A) 20 x 80% x C12 000 192 000
Receipts from customers; related revenue from the sale of contracts for
the 2nd year and reversal of the contract liability since the option no
longer exists
Comment: If more or less than the 80% of the customers renewed their contracts, then the transaction
price would be adjusted and the adjustments would be accounted for directly in revenue.
Exactly the same principles apply in the case of customer loyalty programmes. The only
complication arises in that we must first assess whether the entity is acting as a principal or an
agent in the transaction. This is because, an entity can provide customer loyalty schemes that
allow the customer to claim discounted or free goods or services from the entity (in which
case the entity is acting as a principal) or can be involved in customer loyalty schemes that
allow the customer to claim discounted or free goods or services from another third party (in
which case the entity is acting as an agent).
Example 49: Option involves customer loyalty programme (entity = principal)

An entity offers a customer loyalty programme (CLP) in which customers earn 1 loyalty
points for every C50 spent in the store. Each point may be redeemed for a C10 discount on
future purchases at the store. Sales during 20X1 by customers who had registered for the CLP totalled
C500 000. The entity estimates that 90% of these points will be redeemed.
Required: Show the journal entries:
a) for 20X1 assuming that, by the end of 20X1, 2 000 of these points had been redeemed and that the
estimation that 90% of the points would be redeemed remained the same
b) for 20X2 assuming that, by the end of 20X2, a further 3 000 of these points had been redeemed
and that the estimation that 90% of the points would be redeemed remained the same
c) for 20X2 assuming that, by the end of 20X2, a further 3 000 of these points had been redeemed
and that the estimation that 90% of the points would be redeemed had changed to 95%.
Solution 49A: Customer loyalty programme (entity is a principal) – first year

The CLP effectively offers a discount on future goods or services and gives the customers a ‘material
right that it would not receive without entering into that contract’. Thus the CLP must be accounted for
as a separate performance obligation and thus the transaction price must be allocated between the PO to
transfer goods and the PO to provide the discount in terms of the CLP.
At contract inception, the entity expects 90% of the customer loyalty points to be redeemed:
selling price transaction price
Goods C500 000 TP: C500 000 x 500 000 ÷ C590 000 C423 729
CLP: Future discount C90 000 TP: C500 000 x 90 000 ÷ C590 000 C76 271
C590 000 C500 000
Calculation of the stand-alone selling price of the future discount under the CLP:
C500 000 / C50 x 1 point x C10 x 90% (expected redemption) = C90 000
Chapter 4 193
During 20X1 (sum of the journals recorded as the sales occurred) Debit Credit
Bank (A) TP: total sales 500 000
Contract liability: CLP (L) See allocation of TP above 76 271
Receipt from customers allocated between sale of goods and future
discount on the expected redemption of CLP points
End 20X1
Contract liability: CLP (L) C76 271 x (C20 000 ÷ C90 000) 16 949
Redemption of 2 000 points at C10 per point means we gave customers a
C20 000 discount off the estimated total discount of C90 000
Or: 10 000 points were granted, 90% or 9 000 are expected to be redeemed – at
year-end, 2 000 of these 9 000 points have been redeemed: thus 2/9 x C76 271
Solution 49B: Customer loyalty programme (entity is a principal) – second year

Comment: When we recognise the revenue from the customer loyalty programme, we must remember
to first calculate the revenue to be recognised on a cumulative basis and work backwards to how much
revenue should be recognised in the current year. This is in case there is a subsequent change in our
estimate of how many points will be redeemed.
End 20X2 Debit Credit
Contract liability: CLP (L) C76 271 x (C70 000 ÷ C90 000) – 42 373
Revenue from customer contract (I) revenue already recognised: 16 949 42 373
Redemption of a further 5 000 points at C10 per point means we have
given a further C50 000 discount off the estimated total discount of
C90 000: total discount to date = C20 000 in 20X1 and C50 000 in 20X2
= C70 000
Solution 49C: Customer loyalty programme (entity is a principal) – second year and
estimated changes
Comment: When we recognise the revenue from the customer loyalty programme, we must remember
to first calculate the revenue to be recognised on a cumulative basis and work backwards to how much
revenue should be recognised in the current year. This is in case there is a subsequent change in our
estimate of how many points will be redeemed.
End 20X2 Debit Credit
Contract liability: CLP (L) C76 271 x (C70 000 ÷ C95 000) – 39 251
Revenue from customer contract (I) revenue already recognised: 16 949 39 251
Redemption of a further 5 000 points at C10 per point means we have
given a further C50 000 discount - however our estimated total discount
has now increased to C95 000: total discount to date = C20 000 in 20X1
and C50 000 in 20X2 = C70 000
12. Presentation (IAS 1.82 and IFRS 15.105-.109)
12.1 Overview
Revenue must be presented as a line-item in the statement of comprehensive income (as part
of profit or loss). See IAS 1.82
In addition to the presentation in the statement of comprehensive income, revenue also affects
the presentation of our financial position (SOFP). In this regard, a customer contract may lead
to the presentation in our statement of financial position (SOFP) of the following line-items:
a contract asset or contract liability; and/or
a receivable (receivables are to be presented separately from contract assets).
Presentation was explained in detail in section 4.5 and is thus not be repeated here.
194 Chapter 4
12.2 Sample presentation involving revenue

Company name
Statement of comprehensive income (extracts)
For the year ending 31 December 20X2
20X2 20X1
Note C C
Revenue See IAS 1.82 15 150 000 80 000
Other income xxx xxx
Cost of sales (xxx) (xxx)
... (xxx) (xxx)
Profit before tax 22 xxx xxx
Company name
Statement of financial position (extracts)
20X2 20X1
ASSETS C C
Contract assets See IFRS 15.105 xxx xxx
Receivables See IFRS 15.105 (unconditional xxx xxx
rights)
LIABILITIES
Contract liabilities See IFRS 15.105 xxx xxx
13. Disclosure (IFRS 15.110-.129)
13.1 Overview
IFRS 15 includes copious disclosure requirements. However, the objective is that there must
simply be enough disclosure that a user can assess the ‘nature, amount, timing and
uncertainty’ of both the revenue and cash flows stemming from the entity’s customer
contracts. See IFRS 15.110
To achieve this, we must disclose both qualitative and quantitative information regarding:
Contracts with customers
Significant judgements (and any changes therein) made when applying IFRS 15
Assets recognised relating to costs to obtain and costs to fulfil a contract.
The level of detail required in presenting the above disclosure requirements is not prescribed
by IFRS 15. Instead, IFRS 15 requires us to use our professional judgement in deciding how
much detail is needed in order to meet the basic objective (i.e. of enabling a user to assess the
‘nature, amount, timing and uncertainty’ of both the revenue and cash flows).
13.2 Contracts with customers (IFRS 15.110(a) and .113-.122)
Contracts with customers will lead to revenue, contract balances (contract assets/ liability and
receivables) and possibly impairment losses, all of which will require certain disclosures. The
revenue and impairment losses that relate to customer contracts must be disclosed separately
from those that relate to other kinds of contracts. Revenue from customer contracts will need
to be disaggregated. Revenue that is recognised depends on when performance obligations are
satisfied and therefore information relating to these performance obligations is required.
Revenue may not be recognised until the performance obligation is satisfied and thus
information relating to the remaining unsatisfied performance obligations at reporting date is
also required.
This is explained in more detail in the table below. A very brief example of how the revenue
amounts from customer contracts would be disclosed is presented after this table.
Chapter 4 195
13.2.7 Disclosure of related revenue and impairment losses to be separate:

Revenue: Revenue from customer contracts must be disclosed separately from revenue
from other sources. See IFRS 15.113 (a)
Impairment losses: Impairment losses relating to customer contracts (receivables and
contract assets) must be disclosed separately from impairment losses on other types of
contracts. See IFRS 15.113 (b)
13.2.8 Disclosure of disaggregated revenue:
Revenue must also be disaggregated in a way that will enable users to assess how
economic factors may affect the ‘nature, amount, timing and uncertainty’ of the customer
contract revenue and related cash flows. See IFRS 15.114
Disaggregation simply means to separate into categories that are relevant to the entity. To
determine the categories that are relevant to the entity, we must consider the ‘facts and
circumstances’ relating to the entity’s customer contracts. See IFRS 15.B87 and see .B88
Thus IFRS 15 is not specific but simply provides guidance by way of examples. We
could, for example, disaggregate our revenue into categories based on:
- Type of good or service (e.g. major product lines: sale of hosepipes and sale of toys)
- Geographical region (e.g. sales in South Africa and sales in Europe)
- Market or type of customer (e.g. government and non-government customers)
- Contract type (e.g. fixed price contracts and variable price contracts)
- Contract duration (e.g. contracts of less than a year and contracts longer than a year)
- Timing of transfer of goods or services (e.g. transfers that occur at a point in time and
transfers that occur over time)
- Sales channels (e.g. wholesale customers and retail customers). See IFRS 15.B89
In order to meet the objective of revenue disclosure, entities may need to disclose the
revenue disaggregated into more than one type of category. See IFRS 15.B87
13.2.9 Disclosure relating to contract balances:
We must disclose the:
- opening and closing balances of the following, if they relate to customer contracts:
- receivables
- contract assets
- contract liabilities;
- revenue recognised in the current year:
- that was included in the contract liability opening balance;
- relating to performance obligations that were satisfied in prior periods (e.g. due to
a change in the estimated transaction price). See IFRS 15.116
Provide a reconciliation showing the significant changes making up the movement
between the contract asset opening and closing balance and the contract liability opening
and closing balance. This reconciliation needs to provide both quantitative and qualitative
information. Examples of the movements in these balances include:
- a decrease in the contract asset caused by an impairment of the contract asset;
- an increase in the contract asset due to an increase in revenue caused by a change in
how we estimated the measure of progress towards satisfaction of the performance
obligation (i.e. a change in estimate resulting in a cumulative catch-up adjustment);
- a decrease in the contract liability due to a transfer to revenue, caused by a change in
time frame that resulted in a performance obligation becoming considered satisfied;
- a decrease in the contract asset caused by a transfer from the contract asset to the
receivable, caused by a change in time frame that resulted in the expected
consideration now becoming regarded as unconditional. See IFRS 15.118
Explain how the timing of the satisfaction of performance obligations compares with the
typical timing of payments and how this affects the contract asset/ liability balances.
196 Chapter 4
13.2.10 Disclosure relating to performance obligations:

We must disclose a description of each of the following:
when the performance obligations are normally satisfied (e.g. upon delivery or as services
are being rendered or when services are complete);
significant payment terms (e.g. whether a significant financing component exists, when
payment is due, whether the consideration is variable etc)
the nature of the goods or services that the entity is obliged to transfer and highlighting
any obligation that the entity will be performing as an agent;
any obligation for returns, refunds or similar items;
warranty obligations and the various types. See IFRS 15.119
13.2.11 Disclosure of the remaining unsatisfied performance obligations and how much of
the transaction price has been allocated to these
For performance obligations that are totally or partially unsatisfied at reporting date, we
will need to disclose:
- the aggregate amount of the transaction price that has been allocated to these
unsatisfied performance obligations (i.e. we are effectively disclosing the amount of
revenue that we have not yet been able to recognise); and
- whether any consideration was excluded from the transaction price and thus not
included in the aggregate amount disclosed (e.g. variable consideration that was
constrained);
- when we expect to be able to recognise this remaining revenue – this information can
either be given quantitatively, using time bands considered appropriate to the
remaining period of the contract, or can be given qualitatively. See IFRS 15.120 and 122
Practical expedients: As a practical expedient, we can ignore the requirement to provide
the information above if:
- the total expected duration of the related contract is one year or less; or
- the revenue from this performance obligation is to be recognised based on the right to
invoice (this aspect is not covered in this chapter, but is explained in IFRS 15.B16).
If we opt for this practical expedient, we must disclose this fact.
13.2.12 Sample disclosure relating to the line-item ‘revenue from customer contracts’
The following example uses hypothetical amounts.
Company name
20X2 20X1
15 Revenue C C
Revenue comprises 150 000 80 000
Revenue from customer contracts – see note 16 See IFRS 113 (a) 120 000 60 000
Revenue from other sources See IFRS 113 (a) 30 000 20 000
16 Revenue from contracts with customers – disaggregation See IFRS 15.114

Revenue from customer contracts has been disaggregated based on geographical areas, since this is how
the company evaluates the performance of its segments, and has also been disaggregated based on product
lines since this was the focus of our presentation to investors when raising financing earlier in the year.
Geographical region: See IFRS 15.B89 120 000 60 000

South Africa xxx xxx
Asia xxx xxx
Product lines: See IFRS 15.B89 120 000 60 000
Sales of hose pipes xxx xxx
Sales of toys xxx xxx
Chapter 4 197
Company name
Notes to the financial statements continued ...
22 Profit before tax
Profit before tax is calculated after taking into account the following separately disclosable income/
(expense) items
Impairment loss on customer contract: receivables * See IFRS 113 (b)
Impairments losses on customer contract: contract assets* See IFRS 113 (b)
Impairments losses on other contract assets See IFRS 113 (b)
* Please note:
The wording of IFRS 113 (b) suggests that impairment losses relating to contracts with customers,
(whether on a customer receivable or on a contract asset) could be combined into one line-item.
13.3 Significant judgements (IFRS 15.110(b) and .123-.126)
Disclosure must be made of the significant judgements (and any changes therein) that were
made when applying IFRS 15. IFRS 15 specifically refers to the judgements (and any changes
therein that significantly affect the timing of revenue and the amount of revenue. This is
explained in more detail in the table below:
13.3.3 Judgements (and changes therein) that significantly affect the timing of revenue
We will need to explain the judgements (and changes therein) that we used when deciding
when performance obligations (POs) were satisfied. See IFRS 15.123 (a)
When POs are satisfied (and thus revenue recognised) over time, we must:
- Disclose the method used (e.g. input method), describe the method (e.g. costs
incurred as a % of total expected contract costs) and how it was applied.
- Provide an explanation as to why this method used is considered to be ‘a faithful
depiction of the transfer of goods or services’. See IFRS 15.124
When POs are satisfied (and thus revenue recognised) at a point in time, we must:
- Disclose the significant judgements used in deciding when control over the goods or
services passes to the customer. See IFRS 15.125
13.3.4 Judgements (and changes therein) that significantly affect the amount of revenue
We will need to explain the judgements (and changes therein) that we used when:
- determining the transaction price (TP); and
- determining how much of the TP should be allocated to each PO. See IFRS 15.123 (b)
As part of the explanation, we must disclose the methods, inputs and assumptions used to:
- determine the TP: including how we estimated variable consideration, how we
adjusted for the time value of money and how we measured non-cash consideration
and how we assessed whether an estimate of variable consideration was limited;
- allocate the TP: including how we estimated the stand-alone selling prices, how we
allocated any discounts and how we allocated any variable consideration;
- measure any obligations, such as returns and refund obligations. See IFRS 15.126
Practical expedients: If the entity chose not to account for a significant financing
component (this option exists when the expected payment date is one year or less from
the contract’s inception date), this fact must be disclosed. See IFRS 15.129
13.4 Contract costs recognised as assets (IFRS 15.110(c) and .127-.128)
Where costs related to a customer contract have been recognised as an asset (i.e. costs
to obtain or costs to fulfil a contract), certain qualitative and quantitative information
needs to be disclosed. This is explained in detail in the table overleaf.
198 Chapter 4
13.4.3 Quantitative information

We will need to disclose the:
- amount of the closing balances for each main category of asset (e.g. costs to obtain a
contract and costs to fulfil a contract);
- amount of amortisation and impairment losses. See IFRS 15.128
13.4.4 Qualitative information
We will need to describe the:
- judgments made in calculating the costs incurred to obtain and to fulfil a contract;
- amortisation method. See IFRS 15.127
Practical expedients: If the entity chose to expense the costs to obtain a contract (this
option exists if the amortisation period for this asset would have been one year or less),
this fact must be disclosed. See IFRS 15.129
Chapter 4 199
14. Summary
Revenue recognition and measurement – the 5-step model
Step 1 Identify if we have a contract with a customer

We must have a contract that involves a customer as defined and the contract must be
enforceable
5 criteria must be met
- all parties approve & are committed
- each party’s rights & obligations are identifiable
- payment terms identifiable
- contract has commercial substance
- probable that the entity will collect the consideration to which it expects to be entitled
if 5 criteria are not met at inception, keep reassessing to see if they are subsequently met (in
the meantime, recognise any receipts as a refund liability)
if 5 criteria are met at inception, but subsequently fail to be met (stop recognising revenue
and recognise as a refund liability from that point onwards)
can be deemed not to exist (if it is wholly unperformed and all parties can terminate without
compensating the other party/ies)
contracts may need to be combined and accounted for as a single contract if certain criteria
are met (see IFRS 15.17)
contract modifications may need to be accounted for as a:
- separate contract (if scope increases due to extra G/S that are distinct and the price
increases by an amount that reflects the SASP of these extra G/S)
- termination of the old contract and creation of a new contract (it is not a single contract
and the G/S are distinct)
- adjustment to the existing contract (it is not a single contract and the G/S are not
distinct)
Step 2 Identify the performance obligations (PO)

POs are the distinct promises in the contract
The promise can either refer to the transfer of:
- distinct G/S or bundles thereof
- a series of distinct G/S that are substantially the same and have the same pattern of
transfer
Revenue will be recognised for each PO that is satisfied
PO can be explicitly stated in the contract or could be implied (e.g. through published policies)
Promises are distinct if the G/S:
- can generate economic benefits for the customer (i.e. is capable of being distinct)
- is separately identifiable from other promises (i.e. is distinct in the context of the
contract)
Step 3 Determine the transaction price (TP)

the TP is the amount of consideration to which the entity expects to be entitled in exchange
for the transfer of G/S, excluding amounts collected on behalf of 3 rd parties
Could include variable consideration (VC) –VC could be explicitly stated in the contract or be
implied
- Eg: bonus (may/ may not increase the TP) and early settlement discount (may/may not
decrease TP)
- We include only the ‘constrained estimate of the VC’ in the TP – this requires us to:
- estimate the VC (using either most likely amount or expected values); and then
- constrain the estimate (i.e. limit the estimate to an amount that has a high probability
of not causing a significant reversal of revenue in the future)
200 Chapter 4
- The VC in excess of the constrained estimate of VC won’t be recognised as revenue

Thus, amts received from the customer in excess of the ‘constrained estimate of VC’ in the
TP are recognised as refund liabilities (i.e. debit bank and credit refund liability) until the
uncertainty is resolved (goes away), at which point, we reverse the refund liability and
either repay the amount or recognise it as revenue
- A sale with a right of return is an example involving VC because we don’t know if the goods
will be returned or not. But it is slightly different to other forms of VC because we must
not only remember to recognise a refund liability for the goods that may be returned (e.g.
debit bank & credit refund liability), but we must also recognise a right of return asset
(for the cost of the goods sold that we think will be returned e.g. debit right of return
asset & credit inventory).
Could include significant financing component
- the principle to apply here is that the TP should reflect the cash selling price
- the difference between the cash selling price and the consideration receivable is
recognised as:
- interest income (if the customer gets the financing benefit)
- interest expense (if the entity gets the financing benefit)
- practical expedient: if the period between payment and tfr of the G/S is less than 1 year,
don’t bother to separate out the interest (leave the TP unadjusted)
Could include non-cash consideration
- only include this in the TP if the entity gets control of the item, in which case measure it at
FV
Could include consideration payable to customer (or to the customer’s customers!)
- reduce the TP by this consideration payable unless it is actually an amount we are paying to
the customer for distinct G/S that the customer is transferring to us and for which FVs
can be reliably determined
We must reassess the VC every year – if it changes:
- we allocate the change in VC on the same basis that the original TP was allocated to the
POs
- and the PO has already been satisfied, we recognise the change in VC immediately as an
increase/decrease in revenue
Step 4 Allocate the TP to the POs

We must allocate the TP to the POs in such a way that the amount of the TP that gets
allocated to each PO reflects the amount of consideration that the entity would have expected
to be entitled to in exchange for that POs underlying transfer of G/S
The TP is allocated to the POs based on the relative stand-alone selling prices (SASP) of the
G/Ss in each PO
The SASP are either based on observable prices (if available) or must be estimated
SASPs may be estimated using any reasonable method, but IFRS 15 suggests using:
- adjusted market price
- expected cost plus an appropriate margin
- residual approach
Allocating a TP that contains an inherent discount:
- a contract has an inherent discount if the sum of the SASP > promised consideration)
- the discount can be allocated to all the POs by simply allocating the discounted TP to all
the POs in the normal way (i.e. based on the relative SASPs of the POs) if the discount
relates to all POs
- the discount can be allocated to a specific PO/s if it relates to certain specific PO/s (and
the required criteria are met – see IFRS 15.82)
- if we have a discounted TP and the discount relates to a specific PO/s and we also have to
estimate the SASP of one of the POs using the residual approach, it is important to
allocate the discount to the specific PO/s first before balancing to the estimated SASP
(i.e. before we estimate the SASP using the residual approach)
Chapter 4 201
Allocating a TP that contains VC:

- the VC can be allocated to all the POs by simply allocating the total TP (fixed consideration
+ variable consideration) to all the POs in the normal way (i.e. based on the relative SASPs
of the POs) if the VC relates to all POs
- the VC can be allocated to a specific PO/s if it relates to certain specific PO/s (and the
required criteria are met – see IFRS 15.85), in which case:
- the TP excluding the VC is allocated on SASP and then
- VC is allocated to the specific PO/s
If the TP has changed, we allocate the change in TP to the POs
- using the same allocation basis that was used at contract inception (i.e. using the same
SASP, even if these have subsequently changed)
- if a PO has already been satisfied, then the change relating to the PO will be immediately
recognised as an increase/ decrease in revenue
Step 5 Recognise revenue when POs are satisfied

POs are satisfied when control over the G/S has passed to the customer
Control has passed to the customer when
- the customer can direct the use of the G/S; and
- obtain substantially all its benefits (see IFRS 15.33/4)
IFRS 15 provides example indicators that may suggest control has passed (see IFRS 15.38)
Control either passes:
- over time (gradually); or
- at a point in time (in an instant)
POs are classified based on how control over the G/Ss transfers:
- PO satisfied over time (SOT)
- PO satisfied at a point in time (SAPIT)
A PO is classified as SOT if any of the 3 criteria in IFRS 15.35 are met:
- if customer receives and consumes benefits as the PO is satisfied; or
- if customer gets control of the asset while the entity creates/ enhances the asset; or
- if the entity has no alternative use for the asset and also has an enforceable right to
payment for performance completed to date (See IFRS 15.35)
A PO is classified as SAPIT if none of the 3 criteria in IFRS 15.35 are met (i.e. if the PO is
not SOT)
If a PO is classified as SOT, measurement of revenue requires us to be able to measure
progress towards complete satisfaction
Methods of measuring progress towards complete satisfaction include:
- input methods:
- measures the entity’s efforts (e.g. costs to date ÷ total expected costs to complete
the PO)
- can use the SL method if the entity’s efforts will be expended evenly over period
that the PO will be satisfied
- output methods:
- considered superior to input methods, but may be impossible or too costly to use
- measures the value received by the customer (e.g. work certified to date ÷ total
transaction price allocated to the PO – referred to as the surveys or work certified
method)
Contract costs
Contract costs may need to be capitalised

Contract costs my need to be capitalised in terms of IFRS 15 – if so, they will also need to be:
- amortised; and
- tested for impairment
202 Chapter 4
There are two types of contract costs

- costs of obtaining the contract
- costs to fulfil the contract
Costs of obtaining a contract are capitalised if they are:
- incremental costs and the entity expects them to be recoverable
- not incremental costs but the entity can recover them from the customer (or potential
customer)
Practical expedient: if the asset created would be amortised within a year or less, then don’t
capitalise
Costs of fulfilling a contract:
- apply other IFRSs first
- if other IFRSs do not apply, then capitalise the costs in terms of IFRS 15 if all the
following criteria are met
- costs relate directly to the contract and can be specifically identified
- costs will generate/ enhance the resources that the entity will be or is using on the
contract
- the entity expects to recover these costs. (See IFRS 15.95)
Presentation and disclosure
SOCI – presentation
Revenue must be presented on the face of the SOCI (IAS 1 requirement)
Revenue from customer contracts must be presented separately from other revenue
The revenue from customer contracts on the face of the SOCI must be disaggregated (either
on the face or in the notes)
SOFP – presentation
Contract asset (represents the entity’s conditional rights): must be presented on the face of
the SOFP
- this is recognised when we have earned revenue because the PO is complete but our right
to consideration is still conditional
- e.g. debit contract asset and credit revenue
Receivable (represents the entity’s unconditional rights): must be presented on the face of
the SOFP
- this is typically recognised when we have earned revenue because the PO is complete and
our right to consideration is unconditional – i.e. at most, all we have to do is wait for time to
pass
e.g. debit receivable and credit revenue
- this can also arise when we the terms of the contract make a sum receivable but we still
have to satisfy the PO (e.g. when the contract is non-cancellable)
e.g. debit receivable and credit contract liability
Contract liability (represents our obligation to perform or return the cash received): must be
presented on the face of the SOFP
- this is recognised when we have not yet completed our POs and thus cannot recognise the
revenue yet, but we either:
- have an unconditional right to receive consideration (i.e. a receivable) (e.g. our
contract is non-cancellable)
e.g. debit receivable and credit contract liability
- have received the cash already
e.g. debit bank and credit contract liability
Chapter 4 203
Gripping GAAP Taxation: various types and current income tax
Chapter 5
Taxation: Various Types and Current Income Tax
Reference: IAS 12 and IAS 1 (including amendments to 10 December 2014)
CHAPTER SPLIT:
This entire chapter revolves around tax. However, it is a long chapter which is easier to manage if you
split it into two parts, one of which deals with the various different types of tax and the second focuses
purely on the intricacies of income tax.
The chapter has thus been split into two separate parts as follows:
PARTS: Page
PART A: Various types of tax 206
PART B: Income tax (current only) 215
PART A:
Various Types of Tax
Contents: Page
A: 1 Introduction 206
A: 2 Transaction tax (VAT) 206
2.1 Overview 206
2.2 The sale of goods 207
Example 1: VAT on sale of goods 207
Example 2: VAT on sale of goods 208
2.3 The purchase of goods 209
Example 3: VAT on purchase of goods 209
Example 4: VAT on purchase of goods 210
A: 3 Employees’ taxation 211
Example 5: Employees’ tax 211
A: 4 Income tax 212
A: 5 Dividends tax 212
5.1 Overview 212
5.2 Measuring dividends tax 213
5.3 Recognition of dividends tax 213
Example 6: Income tax and dividends tax 213
5.4 Using previously unutilised STC credits in the calculation of dividends tax 214
PART B:
Income Tax
Contents: Page
B: 1 Introduction 215
B: 2 Recognition of income tax 215
2.1 Overview 215
2.2 Tax recognised in profit or loss 215
2.3 Tax recognised in other comprehensive income 216
2.4 Presentation of tax recognised in other comprehensive income 216
B: 3 Measurement of income tax (current only) 216
3.1 Overview 216
3.2 Enacted and substantively enacted tax rates 216
Example 7: Enacted and substantively enacted tax rates 217
3.3 Taxable profits versus accounting profits 218
204 Chapter 5
3.4 Non-temporary differences: exempt income and non-deductible expenses 218

3.4.1 Overview 218
3.4.2 Capital profits versus capital gains 219
3.4.2.1 General 219
3.4.2.2 IFRSs: capital profits 219
3.4.2.3 Tax legislation: taxable capital gains 219
3.4.2.4 Difference: exempt capital profit 220
Example 8: Capital profits and capital gains 220
Example 9: Exempt income and non-deductible expenses 220
3.5 Temporary differences 221
3.5.1 Overview 221
3.5.2 Temporary differences caused by the system of accrual 222
Example 10: Income received in advance 222
Example 11: Income receivable 223
Example 12: Expenses prepaid 224
Example 13: Expenses payable 225
Example 14: Provision for leave pay 225
3.5.3 Temporary differences caused by depreciable assets 226
3.5.3.2 Sale of assets in terms of IFRSs: carrying amounts and profit or loss 227
3.5.3.3 Sale of assets in terms of tax legislation: tax bases and recoupments 227
or scrapping allowances 227
Example 15: Depreciation versus capital allowances 227
Example 16: Profit/ loss on sale versus recoupments/scrapping allowances 228
Example 17: Capital profit versus capital gains on sale 229
Example 18: Temporary differences and non-temporary differences 230
3.5.4 Temporary differences caused by tax losses (also known as assessed losses) 232
Example 19: Tax losses (assessed losses) 232
B: 4 Payment of income tax 233

4.1 Overview 233
4.2 Income tax: provisional payments and estimates 233
4.3 The first provisional payment 234
4.4 The second provisional payment 234
4.5 The final estimate of current income taxation 234
Example 20: The provisional payments and tax estimate 235
4.6 The formal tax assessment and resulting under / over provision of current tax 235
4.7 The formal tax assessment and resulting under / over payment of current tax 236
Example 21A: First provisional tax payment in 20X1 236
Example 21B: Second provisional tax payment in 20X1 237
Example 21C: Current tax expense estimated for 20X1 237
Example 21D: Under/over provisions of 20X1 income tax 237
Example 21E: Income tax transactions in 20X2 238
Example 22: Under / over-payments and under/ over-provisions of tax 239
B: 5 Disclosure of income tax – a brief introduction 240
5.1 Overview 240
5.2 Statement of financial position disclosure 240
Example 23: Disclosure of current tax assets and liabilities 240
5.3 Statement of comprehensive income disclosure 240
Example 24: Disclosure involving exempt income and non-deductible expenses 241
Example 25: Disclosure involving an under-provision 242
Example 26: Disclosure involving other comprehensive income 243
B: 6 Summary 245
Chapter 5 205
PART A:
Various Types of Tax
A: 1 Introduction
Many different taxes are levied around the world. The Many types of tax,
for example:
following are some of the common taxes in South Africa:
VAT (value-added taxation): see Section A: 2 VAT
This is a tax on goods bought: the purchaser of the goods Employees tax
Income tax
will pay the VAT and the seller, being the one to receive
Dividends tax
the payment, pays the tax over to the tax authority.
Property tax
Employees’ tax: see Section A: 3 Vehicle licences
This is a tax on an employee’s salary: the entity deducts Fuel levies & toll fees.
the tax from the employee’s salary and pays it to the tax
authority; the employee is paid his salary net of tax.
Income tax on companies: see Sections A: 4 and Part B
This is a tax on a company’s taxable profits. Taxable capital gains (which are calculated
in accordance with Capital Gains Tax legislation) are included in these taxable profits.
Income tax is paid to the tax authority using a provisional tax payment system.
South Africa has recently reduced its income tax rate from 29% to 28%.
Dividends tax: see Section A: 5
Dividends tax is levied on the shareholder receiving the dividends. It is a withholding tax,
meaning the dividend is paid net of tax and the entity declaring the dividend is
responsible for paying the tax to the revenue authorities. Secondary tax was a tax levied
on the entity that declared the dividend.
Other taxes
Countries often have many other hidden taxes, such as property rates, postage stamps,
petrol, unemployment insurance funds, regional levies and many more.
We will concentrate on some of the main taxes affecting a business entity: VAT, employees’
taxes, income tax on profits and dividend withholding tax.
What tax rates should we use?
For consistency and simplicity, the following tax rates will be used throughout this text unless
indicated otherwise:
VAT at 14%;
Income tax on companies at 30% of taxable profit; and
Dividends tax at 15% on the receipt of dividends.
Remember: in an exam, you must obviously use the tax rates given in the question. If none are given, it is
generally advisable to use the latest known rates: VAT is currently 14%, income tax on companies vary widely,
but is generally taken to be 28% and dividends tax is currently 15%.
A: 2 Transaction Tax (VAT)
A: 2.1 Overview
A transaction tax is simply a tax levied on a transaction. 3 categories of supplies
Some countries choose to use General Sales Tax (GST) as (goods/services):
their transaction tax whereas others choose to use value Vatable supplies;
added tax (VAT) instead. We will focus only on VAT. Zero-rated supplies; and
VAT is a levied on the supply of certain goods or services. Exempt supplies.

Goods and services supplied are generally categorised into vatable supplies, zero-rated
supplies and exempt supplies.
206 Chapter 5
Zero-rated and exempt supplies are similar in that there is effectively no VAT paid on these
items, however, there is a practical difference in that zero-rated supplies technically have
VAT levied on them, but at 0%, whereas exempt supplies do not have VAT levied on them at
all. The reason for this is beyond the scope of this chapter.
What makes VAT unique from other forms of transaction taxes, such as General Sales Tax
(GST), is that VAT is levied on every transaction in the supply chain and not just on the final
transaction with the final customer. This means that every purchaser in the supply chain who
is a registered VAT vendor (in terms of the relevant tax legislation) must pay VAT and then
claim it back. If the purchaser is not registered as a VAT vendor, then he will not be allowed
to claim the VAT back and is therefore considered to be the ‘final customer’ for tax purposes.
Worked example: The VAT process

1. A (manufacturer & VAT vendor) sells goods to B (retailer) for 114 (includes 14% VAT).
2. B pays 114 to A.
3. A pays the 14 VAT to the tax authority.
4. B is a VAT vendor so he claims and receives the 14 VAT back from the tax authorities.
5. B (the retailer) sells the goods to C (the man in the street) for 228 (including 28 VAT)
6. C pays B 228.
7. B pays the 28 VAT to the tax authorities
8. C is not classified as a vendor for VAT purposes and may therefore not claim the 28 back.
9. The tax authority gets to keep the final 28.
The following picture shows the flow of cash above. Can you see that it is Mr C (the one who is not smiling!)
who is the only one in the chain of transactions who actually ends up paying the VAT. Mr. C is normally the man
in the street and not a business. Can you see that this system is quite an onerous system in terms of the
paperwork that has to be sent to the tax authorities supporting amounts owing and claimed.
A B C
2: 114 6: 228
3: 7:
4:
14 28
14
Tax authority
A: 2.2 The sale of goods VAT Vendors who sell

vatable supplies must:
Businesses that are registered as VAT vendors in terms of
Charge VAT.
the tax legislation must charge VAT on the sale of all the
goods and services supplied (assuming that the supplies are classified as ‘vatable supplies’).
The law requires that the goods and services that are vatable should be marked at a price that
includes the VAT. Where the goods and services are either zero-rated or exempt, no
additional VAT will be included in the price.
Example 1: VAT on sale of goods

Mr. Seller is a VAT vendor and the goods he sells are vatable (meaning he has to charge
VAT on the sale of the goods).
The selling price ex-VAT is C100 and therefore the marked price has to be C114
(including 14% VAT on the C100).
When the goods are sold, Mr. Seller will receive C114.
Mr. Seller is acting as an agent for the tax authorities in that he must collect the C14
VAT from the customer and pay it over to the tax authorities. Thus, C14 of the C114
is money received on behalf of the tax authorities and does not belong to Mr. Seller.
Required: Record all related transactions in the ledger accounts of the seller.
Chapter 5 207
Solution 1: VAT on sale of goods

Assuming that the original sale is a cash sale, the journal entries will be posted as follows:
Bank (A) Sales (I)

Sales&CTP: VAT 114 Bank 100
Current tax payable: VAT (L)

Bank 14
The seller would then have to pay the tax authorities the C14 in VAT, thus settling the liability owing
to the tax authorities. The net effect is that the seller’s bank increases by only C100 (C114 – C14)
which was why only C100 was recognised as income.
Bank (A) Sales (I)

Sales & VAT 114 CTP: VAT 14 Bank 100

Bank 14 Bank 14
It is clear from the above example that before you can record a sale, you need to know whether you are
a VAT vendor or not. If you are a VAT vendor, so long as the goods are not exempt or zero-rated, you
must charge the customer VAT (i.e. the marked price will include 14% VAT).
Example 2: VAT on sale of goods

Mr. A sells goods to Mr. B for C114 (the marked price). Assume VAT is levied at 14%
Required:
a) Show the relevant journals processed in Mr. A’s ledger assuming:
i) Mr. A is not a VAT vendor
ii) Mr. A is a VAT vendor
b) How would your answer change if:
i) Mr. B is not a VAT vendor
ii) Mr. B is a VAT vendor.
Solution 2A: VAT on sale of goods – seller is a vendor or a non-vendor

i. Mr. A is not a VAT vendor:
Mr. A has therefore not included VAT in the marked price of C114. In this case:
Selling price = Marked price
Bank/ Debtors (A) Sales (I)
114 114
Since the invoiced price does not include VAT, the full invoice value belongs to Mr. A.
ii. Mr. A is a VAT vendor:
Mr. A has thus charged VAT. The marked price therefore includes VAT.
The following equations are useful:
Selling price + VAT = marked price;
If VAT is levied at 14% on the selling price (SP + 14% x SP = MP) then:
selling price = marked price / 114 x 100
VAT = marked price/ 114 x 14
Apply to this example:
Selling price:
SP + 0.14 x SP = C114;
1,14 SP = C114
SP = C114 / 1,14 = C100 (or: C114 / 114 x 100)
208 Chapter 5
Solution 2A Continued…
VAT:
C100 + VAT = C114;
therefore VAT = C114 – C100 = C14 (or: C114 / 114 x 14)
Bank/ Debtors (A) Sales (I)
114 100

14
A total of C114 is received; of which only C100 (100/114 x C114) belongs to Mr. A and the balance of
C14 constituting VAT (14/114 x C114) must be handed over to the tax authorities.
Solution 2B: VAT on sale of goods – purchaser is a vendor or a non-vendor

There would be no difference in the way the journals are recorded in Mr. A’s books, since it is of no
consequence to Mr. A whether or not Mr. B is able to claim back the VAT that Mr. B pays.
A: 2.3 The purchase of goods

VAT Vendors who buy
vatable supplies may:
If the purchaser is a vendor for VAT purposes, the VAT he
pays is generally able to be claimed back from the tax Claim back VAT paid.
authorities.
Example 3: VAT on purchase of goods

Let us continue using the same example 2 above, where the seller was a vendor. Assume that
Mr. A originally purchased these goods (mentioned in example 2) from a VAT vendor
for C57. Bearing in mind that the marked price would have included 14% VAT, means that
he paid C7 in VAT (14/114 x 57) and only C50 for the goods themselves.
Required: Record the related journal entries in Mr. A's ledger.
Solution 3: VAT on purchase of goods
Inventories (A) Bank (A)

Bank 50 Inventories/VAT 57
Current tax receivable: VAT (A)

Bank 7
The tax authorities will now have to refund the purchaser, Mr. A, the C7 VAT. Note that the inventory
is valued at C50 and not C57 since although Mr. A had to pay C57 for the purchase, he will receive the
C7 back from the tax authorities, the net cost to Mr. A being C50 (C57 – C7). The journal entries will
be posted as follows:
Inventories (A) Bank (A)

Bank 50 CTP:VAT 7 Inventories/VAT 57

Bank 7 Bank 7
Comment: Note that the tax authorities will receive a net amount of C7, being 14% of the profits:
Profits = sales: C100 – cost of sales: C50 = C50;
VAT = profit: C50 x 14% = C7
Current tax payable (see example 2): C14 – Current tax receivable (example 3): C7 = C7
Chapter 5 209
Before we can record a purchase, we need to know:

if we, the purchaser, are classified as a ‘VAT vendor'; and
if the supplier (i.e. seller) is classified as a ‘VAT vendor’ or not; and
if the supply of goods or services is considered to be a ‘vatable supply’ or not.
If we, the purchaser, are not classified as a VAT vendor, then we need not worry about
recording VAT. However, if we are a VAT vendor, then must record VAT where it exists. If
the supplier is not a VAT vendor or the goods are not vatable supplies, then there is no VAT
to record. However, if the supplier is a VAT vendor and the goods or services are vatable
supplies, then VAT would have been charged and, since we can claim it back, we must record
this VAT separately.
Example 4: VAT on purchase of goods
Mr. B buys goods from Mr. A for C114 (the marked price).
Required: Show the journals posted in Mr. B’s ledger assuming:

i) Mr. B (purchaser) is a VAT vendor and Mr. A (seller) is not a VAT vendor
ii) Mr. B (purchaser) is a VAT vendor and Mr. A (seller) is a VAT vendor
iii) Mr. B (purchaser) is not a VAT vendor and Mr. A (seller) is not a VAT vendor
iv) Mr. B (purchaser) is not a VAT vendor and Mr. A (seller) is a VAT vendor
Solution 4: VAT on purchase of goods

Comment: This example shows how the only time it is possible for a purchaser of goods to claim VAT
back from the tax authorities is when both the purchaser and the seller are ‘VAT vendors’.
i. Mr. B is a VAT vendor and Mr. A is not a VAT vendor
Bank (A) Inventories (A)

114 114
Explanation: Mr. B is a VAT vendor and would therefore be able to claim back any VAT that he paid –
however, Mr. A is not a VAT vendor and therefore has not charged Mr. B any VAT.
ii. Mr. B is a VAT vendor and Mr. A is a VAT vendor

114 100

14
Explanation: Mr. A is a VAT vendor and will thus have included VAT in the marked price of C114.
Mr. B is a VAT vendor and is thus able to claim this VAT back from the tax authorities. Thus the
inventory costs C100 (C114 less the C14 VAT that will be claimed back from the tax authorities).
iii. Mr. B is not a VAT vendor and Mr. A is not a VAT vendor
114 114
Explanation: Mr. B is not a VAT vendor which means that he is not able to claim back any VAT that
he pays. However, this is a mute point since Mr. A is not a VAT vendor and has thus not charged VAT.
iv. Mr. B is not a VAT vendor and Mr. A is a VAT vendor
114 114
Explanation: Mr. A is a VAT vendor, which means that he will have charged Mr. B VAT. However,
Mr. B is not a VAT vendor, which means that he is not able to claim back any VAT that he pays. Since
Mr. B may not claim back any VAT paid, the inventories purchased cost him the full amount of C114.
210 Chapter 5
A: 3 Employees’ Taxation
This is a tax that the employee effectively incurs. The company, however, generally has the
responsibility of calculating the tax, deducting it from the salary of the employee and paying
it over to the tax authorities within a specified period of time. Thus the company is simply
acting as an agent for the tax authorities and does not incur this tax expense itself: it is a tax
expense incurred by the employee. For this reason, the employees’ tax is not included in the
company’s tax expense on the face of the statement of comprehensive income. The
company’s salaries and wages expense will include this employees’ tax.
Example 5: Employees’ tax
AM Limited is a newly formed company with one employee hired (as a secretary) with
effect from 1 December 20X1.
The employee earns a gross monthly salary of C12 000.
The employee’s tax on his salary has been calculated to be C3 510 per month.
The employee was paid in cash on 30 December 20X1, but the employee’s tax was
only paid to the tax authorities on 7 January 20X1, which was after the financial year
ended 31 December 20X1.
Required:
a) Post the journals in AM Limited’s ledger to 31 December 20X1.
b) Prepare the statement of comprehensive income and statement of financial position at
31 December 20X1.
c) Post the journals in AM Limited’s ledger after the year ended 31 December 20X1.
Solution 5: Employees’ tax

a) Ledger accounts at year-end (i.e. before employee’s tax paid to the tax authority)
Salaries (E) Bank (A)
Bank & CTP (1) 12 000 Salaries (1) 8 490
Current tax payable: employees tax (L)

Salaries(1) 3 510
(1) Payment to the employee of C8 490 (his salary net of employees’ tax) and the balance of C3 510, being
employees’ tax deducted from the employee’s salary, recorded as owing to the tax authorities.
Comment: Notice how the salaries account shows the gross amount of the salary (C12 000). In other
words, the salaries expense includes:
the net amount that will be paid to the employee (C8 490) plus
the employee’s tax that will be paid to the tax authorities on his behalf (C3 510).
b) Financial statements at year-end (i.e. before employees’ tax paid to the tax
authorities)
AM Limited
20X1
Administration expenses C
- Salaries and Wages 12 000
AM Limited
20X1
Current Liabilities C
- Current tax payable: employees’ tax 3 510
Chapter 5 211
Solution 5: Employees’ tax continued...

Comment: Note that the salaries are shown at the gross figure of C12 000 in the statement of
comprehensive income and NOT the net amount received by the employee. The reason is twofold:
the taxes paid may not be claimed back by the company (as in the case of VAT) so the cost to the
company is truly C12 000 (see the bank account after payment is made to the tax authorities) and
employees’ tax is a tax incurred by the employee and is not incurred by the company – therefore
the portion deducted and paid over to the tax authorities should not be shown separately as a tax
expense since the employer does not incur this tax expense, but incurs a salary expense instead.
c) Ledger accounts after year-end (i.e. showing payment of the employee’s tax)
Salary (E) Bank(A)
Bank &CTP(1) 12 000 Salaries (1) 8 490
CTP: ET (2) 3 510
12 000
Current tax payable: employees tax (L)
Bank (2) 3 510 Salaries(1) 3 510
(2) Payment to the tax authorities of the employees’ tax withheld from the employee.
Comment: It is clear from the bank account that a total amount of C12 000 is actually spent to pay the
employee his net salary of C8 490. Therefore the salaries expense in the statement of comprehensive
income is C12 000.
A: 4 Income Tax
Income tax is a term commonly used by the various countries’ tax authorities to refer to the
primary income tax levied on a company’s profits. In South Africa, the standard rate of
income tax applied to companies is currently 28%, but there are many other rates possible
depending on factors such as the industry and the size of the company. For ease of quick
calculations, we will generally use 30% in this textbook instead of the actual rate of 28%.
It is important to understand that the relevant tax rate/s is not levied on the company’s profit
before tax (i.e. what is referred to as accounting profit), but on the taxable profit.
The calculation of the taxable profit and income tax is covered in depth in Section B: 3.
The journal for income tax is illustrated below. Notice how the current tax payable is debited
to the company’s income tax expense account.
Debit Credit
Income tax expense (P/L) xxx
Current tax payable: income tax (current liability: SOFP) xx
Current income tax charge for the current year
A: 5 Dividends Tax
A: 5.1 Overview
Dividends tax was introduced in South Africa from

1 April 2012 (the effective date), prior to which
South Africa was one of very few
secondary tax on companies was levied.
countries around the world that taxed
dividends in the hands of the company
Dividends tax was introduced at 15% on the dividend (i.e. STC)
received. Secondary tax on companies had previously
been levied at 10%.
212 Chapter 5
The reason why South Africa changed from secondary tax on companies to dividends tax was
to bring its tax system in line with international standards. Very few countries levy tax on
dividends by way of secondary tax on companies. By bringing its tax system in line with
international norms, South Africa has made it easier for foreign investors to understand its
economic environment and has thus encouraged investment.
Both dividends tax and the previous secondary tax on companies are taxes on dividends
declared. However, there is a critical difference between these two taxes:
dividends tax is levied on the shareholder; whereas
secondary tax was levied on the company.
The impact of this difference on our financial statements is profound. Since dividends tax is
not a tax on the entity, it does not form part of the entity’s tax expense.
The entity declaring the dividend is simply responsible:

for calculating the dividends tax that is owed by the Dividends tax
shareholder,
for withholding this tax when paying the dividend to Dividends tax is levied at 15%
the shareholder, and then Dividends tax is a tax on the
for paying this tax to the relevant tax authority. shareholder, but it paid by the
company on behalf of the shareholder
A: 5.2 Measuring dividends tax Therefore it does not form part of
the company’s tax expense.
Dividends tax is calculated simply as: dividends received
by the shareholder x the rate of dividends tax. South Africa currently applies a dividends tax
rate of 15%.
A: 5.3 Recognition of dividends tax
The fact that dividends tax is not a tax on the entity is reflected in the journals: instead of the
amount of dividends tax payable being debited to the tax expense account, the dividends tax
payable is debited to the shareholder for dividends account, thus effectively reducing the
amount payable to the shareholders.
Debit Credit
Dividend declared (Distribution of Equity) xxx
Shareholders for dividends (current liability: SOFP) xxx
Dividends declared: payable to shareholders
Shareholders for dividends (current liability: SOFP) xxx
Current tax payable: dividends tax (current liability: SOFP) xxx
Dividends tax: withheld from shareholders to be paid to the tax authority
Example 6: Income tax and dividends tax

The following relates to BI Limited for the year ended 31 December 20X1: C
Profit before tax 250 000
Income tax expense 75 000
Dividends declared 50 000
Retained earnings at the beginning of the year 1 250 000
Dividends tax is 15% of the dividend received by the shareholder.
There are no components of other comprehensive income.
Required:
A Calculate the dividends tax and show all the tax and dividends journals.
B Show the above in the statement of comprehensive income and statement of changes in equity.
Solution 6A: Journals: income tax and dividends tax

Debit Credit
Income tax expense (P/L) Given 75 000
Current tax payable: income tax (SOFP: Current Liability) 75 000
Chapter 5 213
Solution 6A: Continued ...
Debit Credit
Dividend declared (SOCIE: Distribution of Equity) Given 50 000
Shareholders for dividends (SOFP: Current Liability) 50 000
Dividends declared
Shareholders for dividends (SOFP: Current Liability) 50 000 x 15% 7 500
Current tax payable: dividends tax (SOFP: Current Liability) 7 500
Dividends tax on dividends due as a result of declaration are withheld
Solution 6B: Disclosure: income tax and dividends tax

BI Limited
20X1
C
Profit before taxation 250 000
Income tax expense Just the income tax (75 000)
Profit for the year 175 000
Other comprehensive income 0
Total comprehensive income 175 000
BI Limited
Statement of changes in equity (extracts)
Retained Total
earnings
C C
Balance at beginning of the year 1 250 000 xxx
Total comprehensive income 175 000 175 000
Less dividends declared The full dividend even though some is withheld (50 000) (50 000)
and paid to the tax authorities
Balance at end of the year 1 375 000 xxx
A: 5.4 Using previously unutilised STC credits in the calculation of dividends tax
Under STC legislation, unutilised STC credits were allowed to be carried forward from one
year to the next with the purpose of reducing the amount of future STC expenditure. With the
introduction of dividends tax, it was agreed that any unutilised STC credits that an entity
owned on the date that STC was replaced by the new dividends tax legislation (i.e. from
1 April 2012) could be carried forward for use in the new dividends tax system. Thus these
unutilised STC credits may be used to reduce future amounts of dividends tax owing.
There is a critical difference between using previously unutilised STC credits to reduce STC
and using previously unutilised STC credits to reduce dividends tax. In the past, when using
previously unutilised STC credits to reduce secondary tax on companies, one was reducing
the company’s tax expense. They thus met the definition of an asset (i.e. a reduction in future
expenses is considered to be an expected inflow of economic benefits). Now, however, by
using previously unutilised STC credits to reduce dividends tax, which is not the company’s
tax expense but rather the shareholder’s tax expense, we are reducing the shareholder’s tax
expense. Thus these credits no longer help the company reduce its own tax expense and thus
no longer meet the definition of an asset to the company. This means that the company must
derecognise any asset that it had previously recognised based on the expectation that the STC
credits would decrease its future tax. This is covered in the chapter on deferred taxation.
Although the dividends tax legislation allows these unutilised STC credits to be used to
reduce the shareholders’ dividends tax, the legislation states that these credits will expire
within 3 years from the effective date, after which, these unutilised STC credits will no longer
be useful even to the shareholders.
214 Chapter 5
PART B:
Income Tax (current only)
B.1 Introduction
As has already been explained in Part A, income tax is the tax levied on profits. In South
Africa, there are separate tax rates and rules used for calculating the income tax levied on
individuals, companies and various other forms of business. We will focus exclusively on the
income tax applied to companies. The principles of recognition and measurement are the
same no matter whether you are dealing with income tax on an individual, company or other
entity – the only thing that changes is the calculation of this tax in terms of the tax legislation.
I don’t plan to teach you the intricacies of the tax legislation because you will learn this when
you study tax. This chapter simply helps you account for the amount of tax calculated.
However, in order to account for this tax, you will need to know a few of the basic principles
included in the tax legislation, and these we will learn along the way.
B.2 Recognition of Income Tax
B.2.1 Overview
Income tax is a tax on an entity’s income. Income can result from transactions that are:
recognised in profit or loss; or
recognised in other comprehensive income.
If the underlying transaction (or event or item) is recognised in profit or loss, then the tax
thereon must also be recognised in profit or loss. This tax is recognised as an expense and is
referred to as income tax expense. It is possible to have a tax income recognised in profit or
loss. This happens if, instead of a making a taxable profit, we make a tax deductible loss.
If, however, the underlying transaction (or event or item) is recognised in other
comprehensive income, then the tax thereon must also be recognised in other comprehensive
income. We will recognise this tax as tax on other comprehensive income. If the underlying
transaction is income recognised in other comprehensive income, then there will be a tax
expense recognised in other comprehensive income (i.e. a debit to other comprehensive
income). If the underlying transaction is a loss recognised in other comprehensive income,
then there will be a tax income recognised in other comprehensive income (i.e. a credit to
other comprehensive income).
B.2.2 Tax recognised in profit or loss (IAS 12.58)
The tax levied on the entity’s profit or loss must be reflected in a single line item in profit or
loss, called the income tax expense. This ‘income tax expense’ line item must be separately
disclosed on the face of the statement of comprehensive income.
It is possible for there to be a variety of taxes levied on the Remember! The

entity’s profits. Some countries simply have one tax (often following taxes are not
included in the entity’s
referred to as income tax or primary tax) whilst other countries tax expense!
levy more than one tax on profits (e.g. a secondary tax). employees’ tax,
dividends tax and
Since the abandonment of secondary tax on companies in 2012, valued added tax
there is now currently only one type of tax levied on the entity’s profits in South Africa. This
is referred to as income tax.
income tax was introduced in section A: 5;
the calculation of income tax is explained in section B: 3; and the method of payment is
explained in section B: 4.
Chapter 5 215
B.2.3 Tax recognised in other comprehensive income (IAS 12.61A-.62)

The tax on items that are recognised in other comprehensive income (OCI) are also
recognised in other comprehensive income. An example of an item recognised in other
comprehensive income is a revaluation surplus created when revaluing equipment.
B.2.4 Presentation of tax recognised in other comprehensive income (IAS 1.82-.82A & .90-.91)
The tax effect of each item of OCI must be presented separately. This may be done on the
face of the statement of comprehensive income or in the notes. However, although the tax
effect of each item of OCI must be presented separately, IAS 1 allows us to choose to present
each item of OCI (e.g. a revaluation surplus) gross (before tax) or net (after tax):
Option A: Gross: before deducting the related tax. In this case the taxes on all items of
OCI are presented as a single tax line item in the ‘other comprehensive income section’,
called ‘tax on other comprehensive income’. This option means that we will need to
include a note to show the tax effects of each item of OCI separately.
Option B: Net: after deducting the related tax. In this case the total tax on OCI will not
be a separate line item in the statement of other comprehensive income (as is the case in
option A). There are two sub-options here. We could choose to show each item of OCI:
- Option B-1: gross, then show the deduction of its tax effect and then net, in which
case no note will be needed since the tax effect per item is being shown on the face;
- Option B-2: net, with no evidence of how much tax was deducted per item, in which
case a note would be required to show the tax effect per item. See IAS 1.91
Example 26 shows the presentation of the tax effects of items of OCI.
B.3 Measurement of Income Tax (current only)
B: 3.1 Overview Current tax is calculated

as
Current tax or income tax is the tax charged on the taxable taxable profits x
profits for the current period. It is measured by tax rate
multiplying these profits by the tax rate applied by the tax
authorities. In essence, current income tax is measured at the amount that is expected to be
paid to (recovered from) the taxation authorities. This measurement requires us to know the
taxable profits and the relevant tax rate. See IAS12.46 The difference between
taxable profit and
Taxable profits are calculated in terms of the relevant tax accounting profit:
legislation (i.e. the relevant country’s Tax Act). Thus the
accountant needs to convert his accounting profit into the includes:
Temporary differences; &
taxable profit. To be able to do this requires a sound Non-temporary differences
knowledge of this tax legislation and an understanding of
how it differs from the International Financial Reporting Standards. These differences can be
summarised into two categories: non-temporary and temporary. This section will take a look
at the effect of a few non-temporary differences and temporary differences a bit later.
The current income tax charge has to be estimated by the accountant since the official tax
assessment by the tax authorities, indicating the exact amount of income tax owing on the
current year’s taxable profits, will only be received long after the reporting date.
B: 3.2 Enacted and substantively enacted tax rates
Enacted tax rates are rates that are already in law. But, a government could propose to
change the enacted rate, in which case we must assess if the proposal is substantively enacted.
The tax rate to use is:
the enacted tax rate as at the reporting date, or
if a new rate has been proposed, then using the new rate, if it has been substantively
enacted by reporting date (and assuming it will affect the measurement of your current tax
liability at reporting date assuming the rate is eventually enacted). from IAS 12.46 Reworded
216 Chapter 5
If a ‘new’ rate has been enacted on or before reporting date, it means that the relevant
country’s Tax Act has been changed on or before this date, but if a new rate has been
proposed but not legally enacted on or before reporting date, deciding whether it has been
substantively enacted by reporting date may require
professional judgement and a careful assessment of the Enacted or substantively
circumstances. enacted tax rates
For example: Measure your current income tax using:

In some countries, the announcement can lead to a the enacted tax rate, unless there is
new tax rate actually being implemented before the a substantively enacted tax rate that
actual date of legal enactment, where the legal
enactment could take place much later: in this case, existed at reporting date, &
the date the new rate is simply announced would be which will affect the
treated as the date of substantive enactment. See IAS measurement of current income
12.48
tax at reporting date.
In other countries, most or all of the legal stages for formal enactment may need to have
occurred before the new rate can be said to be substantively enacted, in which case the
date of the announcement is not important and can be ignored.
In South Africa, it is commonly held that a new rate is considered to be substantively enacted
on the date it is announced in the Minister of Finance’s Budget Speech. But if this new rate is
inextricably linked to other tax laws, it is only substantively enacted when it has not only been
announced by the Minister of Finance but when it has also been signed into statute by the
President as evidence of his approval of the change.
Whilst current tax is to be measured using either the enacted or substantively enacted tax rate
at reporting date, the over-riding rule is that it must be ‘measured at the amount expected to
be paid to (recovered from) the taxation authorities’. We must therefore use the tax rates that
apply (i.e. enacted rates) or are expected to apply (i.e. substantively enacted rates) to the
current period transactions and must thus consider the effective date of any new rates. When
measuring current tax, one would generally end up using the enacted tax rates.
The income tax rate currently enacted in South Africa is 28%, but for the sake of round
numbers, this book will assume an income tax rate of 30% unless otherwise indicated.
Example 7: Enacted and substantively enacted tax rates
On 20 Jan 20X1, the minister announced a change in the income tax rate from 30% to 28%:
This change in tax rate will only be accepted into legislation (become enacted) if the
VAT rate is increased from 14% to 15%.
If the new tax rate is accepted into legislation, its effective date will be 1 March 20X1
(i.e. it will apply to tax assessments ending on or after 1 March 20X1).
The increase in the rate VAT was accepted into legislation on 15 February 20X1 and the
new income tax rate was accepted into the legislation on 21 April 20X1
Required: State at what rate the current tax should be calculated assuming:
A. The company’s year of assessment ends on 31 December 20X0.
B. The company’s year of assessment ends on 28 February 20X1.
C. The company’s year of assessment ends on or after 31 March 20X1.
Solution 7: Enacted and substantively enacted tax rates

The new income tax rate is enacted on 21 April 20X1. Since this rate change was inextricably linked to
the proposed increase in the VAT rate, the change to the income tax rate was dependent on whether the
VAT rate was allowed to be increased. Thus, the date of substantive enactment does not occur on the
date the change was announced by the minister, but rather on the date when the VAT rate was
legislated: 15 February 20X1. Thus the new rate becomes substantively enacted on 15 February 20X1.
A. The reporting date is 31 December 20X0.
- The currently enacted rate on reporting date is 30%.
- There is no substantively enacted tax rate on reporting date (the new rate only becomes
substantively enacted 15 February 20X1, which is after reporting date).
The current enacted tax rate of 30% should thus be used for the year ended 31 December 20X0.
Chapter 5 217
Solution 7: Continued…
B. The reporting date is 28 February 20X1.
- The currently enacted rate on reporting date is 30%.
- A new rate became substantively enacted on 15 February 20X1 (this rate was only enacted on
21 April 20X1). Since the date it was substantively enacted occurs before the reporting date,
we have a substantively enacted tax rate (28%) on reporting date.
- However, since the effective date of the substantively enacted tax rate means that it will only
affect tax assessments ending on or after 1 March 20X1, the substantively enacted tax rate
would not be appropriate to use for the year ended 28 February20X1.
The currently enacted tax rate of 30% should thus be used for the year ended 28 February 20X1.
C. The reporting date is 31 March 20X1.
- The currently enacted rate on reporting date is still 30%.
- A new rate became substantively enacted on 15 February 20X1 (this rate was only enacted on
21 April 20X1). Since the date it was substantively enacted occurs before the reporting date,
we have a substantively enacted tax rate (28%) on reporting date.
- Since the effective date of the substantively enacted rate means that it will affect tax
assessments ending on or after 1 March 20X1, the substantively enacted tax rate would be
appropriate to use for the year ended 31 March 20X1.
The substantively enacted tax rate of 28% should thus be used for the year ended 31 March 20X1.
B: 3.3 Taxable profits versus accounting profits

It is important to understand that the relevant rate/s of income tax is not levied on the entity’s
profit before tax (i.e. accounting profit), but on its taxable profit.
Accounting profits are determined in accordance with the IFRSs (or other accounting
standards) and taxable profits are determined in accordance with the local tax legislation.
In other words: Taxable profit and
accounting profit (i.e. profit before tax) comprises: Accounting profit differ
income earned because:
less expenses incurred; Accounting profits are calculated in
taxable profit is constituted by: terms of IFRSs; and
income that is taxable Taxable profits are calculated in
less expenses that are deductible. terms of local tax legislation.
Differences between the accounting profit and taxable profit may arise because:
some income may be exempt from tax and some expenses may not be deductible (these
are known as non-temporary differences (i.e. differences that are permanent) as they will
never be taxable or deductible); and/or
some income may be taxable, but in periods different to the periods in which they are
earned and some expenses may be deductible, but in periods different to the periods in
which they are incurred (these are simply issues of timing and are referred to as
temporary differences).
Taxable profits may be calculated from the accounting profits figure as follows:
C
Accounting profit (profit before tax) xxx
Add/(less) non-temporary differences xxx
Profit considered to be taxable per the accountant xxx
Add/(less) movement in temporary differences xxx
Taxable profit (considered to be taxable by the tax authorities) xxx
B: 3.4 Non-temporary differences: exempt income and non-deductible expenses

B: 3.4.1 Overview
Some of the income included in the accounting profit may be exempt from tax per the tax
legislation (meaning that it will never be taxed by the tax authorities).
218 Chapter 5
Non-temporary Conversely, there may be an expense in the statement of

differences are comprehensive income that is not deductible per the tax
the differences between
legislation (meaning that the tax authorities will never allow
taxable profit and accounting it as a deduction against taxable profits).
profit for a period
The total accounting profit and total taxable profit in such
that originate in the current cases will never equal each other, thus we will refer to these
period and never reverse in
differences as non-
subsequent periods Non-temporary
temporary differences. differences include
As a general rule, any item accounted for in accounting exempt income: some of the
profit that the tax authorities will never consider in taxable income according to the
accountant might be exempt
profit is a non-temporary difference (or a permanent
for tax purposes, or
difference as it makes accounting profit and taxable profit
alternatively,
permanently different!) These differences results in the non-deductible expenses:
effective tax rate and applicable tax rate not being equal to some of the expenses
one another. This then requires you to include a rate according to the accountant
reconciliation in the tax expense note. might not be allowed as a
deduction by the tax
B: 3.4.2 Capital profits versus capital gains authority.
B: 3.4.2.1 General
The taxation of capital profits is a contentious issue, as it is effectively a tax on inflation.. In
some countries, the entire capital profit on sale of an item is taxable whereas in other
countries only a certain portion of the capital profit is taxable with the balance thereof being
exempt. In these latter countries, the taxable portion is often referred to as the taxable capital
gain and is included in taxable profits and taxed at the normal rate (30%).
In South Africa 66.6% of a company’s capital gains are taxable, whilst only 33.3% of a
natural person’s capital gains are taxable. For ease of quick calculations, the examples in this
text will assume that 50% of the capital gain is taxable unless otherwise indicated.
B: 3.4.2.2 IFRSs: capital profits
The accountant calculates a profit or loss on the sale of a non-current asset, in accordance
with the International Financial Reporting Standards (IFRSs), as follows:
Proceeds on sale xxx
Less carrying amount (xxx)
Profit or (loss) on sale xxx
The capital profit included in the profit on sale of a non-current asset is as follows:
Less original cost (xxx)
Capital profit xxx
B: 3.4.2.3 Tax legislation: taxable capital gains

A capital gain on the sale of a non-current asset, determined in accordance with the tax
legislation, is generally calculated as follows:
Less base cost (xxx)
Capital gain xxx
The calculation of the base cost is also determined in accordance with the tax legislation but is
outside the scope of this chapter. For simplicity, we shall assume base cost equals the asset’s
cost, unless otherwise stated.
Chapter 5 219
The taxable capital gain is often a percentage of the capital gain, where this percentage
depends on whether or not the taxpayer is a company or an individual. As explained above,
the examples in this text assume that the inclusion rate is 50% for companies, in which case,
the taxable capital gain is calculated as:
Capital gain xxx
Multiplied by inclusion rate for companies @ 50%
Taxable capital gain xxx
B: 3.4.2.4 Difference: exempt capital profit

In summary, the capital profit (calculated by the accountant and thus included in the
accounting profits) may differ from the taxable capital gain (calculated by the tax authorities
and included in taxable profits). Such differences (the exempt portion of the capital profit) do
not go away and are thus often referred to as either permanent or non-temporary differences.
The exempt portion of the capital profit is simply calculated as:
Capital profit xxx
Less taxable capital gain xxx
Exempt portion of the capital profit xxx
Example 8: Capital profits and capital gains

Man Limited sold its plant for C120 000. The carrying amount was C80 000 on date of sale.
It had originally cost C110 000. The base cost on date of sale was C112 000.
Required:
A. Calculate the profit on sale, separating this profit into capital profit and non-capital profit.
B. Calculate the capital gain and the taxable capital gain.
C. Calculate the portion of the capital profit that is exempt.
Solution 8A: Calculation of the profit on sale (capital and non-capital portions)
C
Proceeds on sale 120 000
Less carrying amount (80 000)
Profit on sale 40 000
Capital profit (120 000 – 110 000) 10 000
Non-capital profit (40 000 – 10 000) or (110 000 – 80 000) 30 000
Solution 8B: Calculation of the capital gain and taxable capital gain
C
Less base cost (112 000)
Capital gain 8 000
Inclusion rate @ 50%
Taxable capital gain 4 000
Solution 8C: Calculation of the exempt capital profit

C
Capital profit on sale Example 8A 10 000
Less taxable capital gain Example 8B (4 000)
Exempt capital profit 6 000
Example 9: Exempt income and non-deductible expenses

Retailer Limited had a profit before tax for the year ended 31 December 20X2 of
C100 000, which included:
Dividend income of C30 000 (exempt from tax);
Donations made that were considered to be non-deductible of C10 000; and a
Capital profit of C20 000, of which C8 000 was a taxable capital gain
220 Chapter 5
The income tax rate was 30%.

There were no temporary differences during 20X2 and no components of other comprehensive income.
Required:
A. Calculate the income tax.
B. Show the income tax journal.
C. Disclose the statement of financial position and statement of comprehensive income for 20X2.
Solution 9A: Calculation

Comment: This example shows the calculation of current tax when there are differences between
taxable profit and profit before tax that will never reverse (i.e. these are non-temporary differences).
Calculation of income tax C
Profit before tax (given) 100 000
Less dividend income (not taxable) (30 000)
Add back donations (not deductible) 10 000
Less capital profits (not taxable) (20 000 – 8 000)(1) (12 000)
Taxable profits 68 000
Current income tax (68 000 x 30%) 20 400

(1)
Note that that C12 000 is subtracted because of the C20 000 profit, only C8 000 is taxable.
Solution 9B: Journal

Debit Credit
Income tax expense (P/L) 20 400
Current tax payable: income tax (SOFP) 20 400
Solution 9C: Disclosure

Retailer Limited
Note 20X2
Current liabilities C
Current tax payable: income tax See journals 20 400
Retailer Limited
Note 20X2
C
Income tax expense See journals (20 400)
B: 3.5 Temporary differences

B: 3.5.1 Overview
Certain items of income and expense may be included in taxable profits in periods that are
different to those in which they are included in the accounting profits. These differences arise
mainly due to the following two categories:
the accountant’s system of accrual (e.g. expenses prepaid); and
the accountant’s measurement of depreciation.
Chapter 5 221
This is explained as follows:

the accountant uses the accrual system of accounting whereas the tax authority uses a
mixture between an accrual and a cash system (this difference between this hybrid system
and the system of accrual is discussed below); and
the rate of depreciation/ amortisation calculated by the accountant differs from the rate of
depreciation calculated by the tax authority (the difference between these rates in the
accounting records and in the tax records is discussed below).
There are many areas in the tax legislation that may lead to temporary differences, but for the
purposes of this text, we will limit our examples to temporary differences caused by:
income received in advance;
income receivable; Temporary differences
expenses prepaid; are caused by differences
expenses payable; in the timing of tax and
provisions; and accounting treatment.
depreciation/ amortisation.
These items are adjusted for when converting accounting profits into taxable profits.
Let’s remember at this point that our goal is to convert accounting profits into taxable profits.
This is simply done by removing from accounting profits what the tax authority ‘disagrees
with’ and replacing these items with items that the tax authorities ‘agree with’.
B: 3.5.2 Temporary differences caused by the system of accrual
The tax authority, governed by the tax legislation of the country, generally recognises income
and expenses on a basis that is effectively a hybrid between the accrual basis and the cash
basis. In most cases, income is recorded on the earlier of the date of receipt or earning
(accrual), whereas expenses are recorded on the date that they are incurred unless the expense
has been prepaid, in which case, the prepaid expense may or may not be allowed even though
it has not yet been incurred. The criteria to determine when a prepaid expense may be
allowed as a deduction are outside the scope of this chapter.
A summary of the situation described above is given below:
Accountant recognises: Tax authority recognises:
Income: Income:
When earned (accrual basis) When received (cash basis) or earned (accrual basis),
whichever happens first
Expenses: Expenses:
When incurred (accrual basis) When incurred (accrual basis) unless the expense was
prepaid in which case, it might be allowed.
Example 10: Income received in advance

Gallery Limited received C12 000 in rent income on 31 December 20X1 (the year-end):
The rent related to a building for the month of January 20X2.
There are no temporary differences, no exempt income and no non-deductible expenses
other than those evident from the information provided.
No dividends were declared in either year.
Profit before tax (correctly calculated) was C120 000 in both 20X1 and 20X2.
Required:
A. Show the journal entries in 20X1 and 20X2 relevant to the rent income.
B. Calculate the income tax for 20X1 and 20X2.

Comment: Since the tax authorities tax income in 20X1 but it is only recognised as income in 20X2
(when earned), the accounting and taxable profit in each of these years will differ (i.e. a temporary
difference will arise in 20X1 and reverse in 20X2).
222 Chapter 5

Bank (A) 12 000
Rent income (I) 12 000
Receipt of rental income
Income received in advance (L) 12 000
Deferral of income that had been received in advance at year-end
1 January 20X2
Income received in advance (L) 12 000
Reversal of income received in advance opening balance
Solution 10B: Calculation

Calculation of income tax: Total 20X2 20X1
Profit before tax 240 000 120 000 120 000
Less exempt income/ add non-deductible expenses 0 0 0
Profit deemed taxable by the accountant in the current year 240 000 120 000 120 000
Add/(less) movement in temporary differences
Add inc received in advance (c/ bal): taxed in current year 12 000 (3) 0 12 000 (1)
Less inc received in advance (o/ bal): taxed in a prior year (12 000) (3) (12 000) (2) 0
Taxable profits 240 000(3) 108 000 132 000
Current tax at 30% Dr: Tax expense: NT; Cr: CT payable: NT 72 000 32 400 39 600
Notes:
1) In 20X1: we add C12 000 as the tax authorities will want to tax it in 20X1 (because it was received)
and yet it was not included in the 20X1 accounting profits.
2) In 20X2: deduct C12 000 as it is included in the 20X2 accounting profit and yet the tax authority has
already taxed us on it in 20X1, thus it must not be part of taxable profits again in 20X2.
3) Once again, it can be seen from the above that over a period of time, both the accountant and tax
authorities agree that accounting profit and taxable profit equals C240 000, thus the difference
between accounting and taxable profits are as a result of temporary differences.
Example 11: Income receivable

Compact Limited sold inventory for C80 000 during 20X1 on credit and received payment of
C80 000 in 20X2. The tax authorities tax income when earned or received, whichever
happens first. There is no other income in either 20X1 or 20X2.
Required:
A. Show the journal entries in 20X1 and 20X2 relevant to the income and receipt above.
B. Calculate the income tax expense in each year.

Comment: This example shows how income receivable is journalised.
20X1 Debit Credit
Debtors (A) 80 000
Sales (I) 80 000
Sale on credit
20X2
Bank (A) 80 000
Debtors (A) 80 000
Receipt of balance owed by debtor
Chapter 5 223

Comment: This example shows how income receivable affects taxable profit. Since both the tax
authorities and the accountant recognise the income in 20X1 there is no temporary difference.
Total 20X2 20X1
Calculation of income tax: C C C
Profit before tax 80 000 0 80 000
Subtotal 80 000 0 80 000
Add/(less) movement in temporary differences 0 0 0
Taxable profits 80 000 0 80 000
Current tax at 30% Dr: Tax expense: NT; Cr: CT payable: NT 24 000 0 24 000
Example 12: Expenses prepaid
News Limited paid rent of C22 000 in December 20X1 for the rental of its factory for the
entire year of 20X2. Profit before tax and before taking into account any journal entries for
this payment is C100 000 in both 20X1 and in 20X2. The tax authorities allowed the
prepayment of rent to be deducted in 20X1.
Required:
A. Show the journal entries in 20X1 and 20X2 relevant to the expense and payment above.
B. Calculate the income tax expense for 20X1 and 20X2 and briefly explain your answer.
Comment: This example shows how expenses prepaid are journalised.
20X1 Debit Credit
Rent expense (E) 22 000
Bank(A) 22 000
Payment of rent expense for 20X2
Rental prepaid (A) 22 000
Deferral of the expense (reduce rent expense by the prepaid amount)
20X2
Rental prepaid (A) 22 000
Reversal of expense prepaid opening balance (i.e. now recognising last
year’s prepaid expense as an expense)

Comment: This example shows how expenses prepaid affect taxable profit. Since the rent expense is
recognised in 20X2 but the deduction was allowed in 20X1, the accounting and taxable profit in each of
these years will differ (i.e. a temporary difference arises in 20X1 and reverses in 20X2).
Total 20X2 20X1
Profit before tax 20X2: 100 000 – 22 000 178 000 78 000 100 000
Less expense prepaid (c/bal): deductible in 20X1 (22 000) (3) 0 (22 000) (1)
(3) (2)
Add expense prepaid (o/bal): already deducted in 20X1 22 000 22 000 0
Taxable profits 178 000 (3) 100 000 78 000
Current tax at 30% [Dr: TE (NT); Cr: CTP (NT)] 53 400 30 000 23 400
Notes:
1) In 20X1: the C22 000 is allowed as a tax deduction in 20X1 (but it has not yet been expensed).
2) In 20X2: the C22 000 is expensed thus reducing the accounting profit, so we add back the C22 000 to
avoid duplicating the deduction since it was allowed as a tax deduction in 20X1.
3) It’s clear from the above that over 2 years, the accountant and tax authorities agree that accounting
profit and taxable profit equals C178 000, thus the difference is as a result of temporary differences
224 Chapter 5
Example 13: Expenses payable

Disk Limited incurred rent of C10 000 in December 20X1 but only paid this rent in
January 20X2. Profit before tax and before taking into account any journals relating to the
above is C100 000 in 20X1 and C100 000 in 20X2. The tax authority allowed the rent
payable to be deducted in 20X1.
Required:
B. Calculate the income tax for each year.

Comment: This example shows how expenses payable are journalised.
20X1 Debit Credit
Rent payable (L) 10 000
Rent payable as at 31 December 20X1
20X2
Rent payable (L) 10 000
Bank (A) 10 000
Payment of the rent for 20X1

Comment: This example shows how expenses payable affects taxable profit. Since the rent expense is
recognised in 20X1 and the tax deduction is granted in 20X1, the accounting profit and taxable profit in
20X1 and 20X2 will be the same. Thus there is no temporary difference.
Total 20X2 20X1
Add/(less) movement in temporary differences 0 0 0
Taxable profits 190 000 100 000 90 000
Example 14: Provision for leave pay

Paper Limited estimated that the value of the leave pay owing to its staff at
31 December 20X1 is C150 000. This leave pay was paid to its staff in 20X2. Profit before
tax and before taking into account any journal entries relating to the above is C500 000 in
20X1 and C300 000 in 20X2.
The tax authorities allow provisions to be deducted only when paid.
Required:
B. Calculate the income tax for each year.

Comment: This example shows how a provision for leave pay is journalised.
20X1 Debit Credit
Leave pay (E) 150 000
Provision for leave pay (L) 150 000
Provision for leave pay as at 31 December 20X1
20X2
Provision for leave pay (L) 150 000
Bank (A) 150 000
Payment of the leave pay for 20X1
Chapter 5 225

Comment: This example shows how a provision for leave pay affects taxable profits. Since the
accountant recognises the leave pay as an expense in 20X1 and the tax authority recognises it as a
deduction in 20X2, the accounting profit and taxable profit in 20X1 and 20X2 will differ (i.e. a temporary
difference will arise in 20X1 and reverse in 20X2).
Total 20X2 20X1
Profit deemed taxable by the accountant in the current 650 000 300 000 350 000
year
Add provision (closing balance): not deductible in 20X1 150 000(3) 0 150 000(1)
(3) (2)
Less provision (opening balance): deducted in 20X2 (150 000) (150 000) 0
Taxable profits 650 000(3) 150 000 500 000
Notes:
1) In 20X1: we add C150 000 back as the tax authorities do not allow it to be deducted in 20X1 and yet
it was deducted as an expense in the 20X1 accounting profits.
2) In 20X2: we deduct the C150 000 because we are allowed to deduct it in 20X2 but is not expensed in
the 20X2 accounting profit (it had already been expensed through the 20X1 accounting profit).
3) Once again, it can be seen from the above that over a period of time, both the accountant and tax
authorities agree that accounting profit and taxable profit equals C650 000, thus the difference
between accounting and taxable profits are as a result of temporary differences.
B: 3.5.3 Temporary differences caused by depreciable assets
B: 3.5.3.1 Overview
The IFRSs require that depreciable assets be depreciated at a rate that reflects the entity’s
estimation regarding the asset’s useful life.
Tax legislation, however, requires assets to be deducted
from profits based on the standard rates of ‘depreciation’ Different rates
set out in the tax legislation, irrespective of how fast the
entity expects to use up its asset’s life. The ‘depreciation’
deduction calculated by the tax authorities is often The tax authorities use different
referred to as a capital allowance, wear and tear or rates of depreciation to the
depreciation for tax purposes. accountant
The amount expensed in the accounting records (e.g. Therefore temporary differences
arise on depreciable assets
depreciation) and the amount deducted in the tax records
(e.g. tax deduction) would, however, still equal each other over a period of time, assuming
that the accountant and tax authorities agreed upon the original cost and residual value of the
item of property, plant and equipment. Thus, the difference is only temporary.
Since the amount of depreciation according to the IFRSs generally differs from tax deduction
according to the tax legislation, an asset’s carrying amount (term used by accountants,
calculated in terms of IFRSs) and an asset’s tax base (term used to describe the equivalent of
“carrying amount”, but calculated in terms of tax legislation) will also generally differ.
If the asset is sold where the carrying amount and tax base differ, the profit or loss on sale in
terms of IFRS will differ from the profit or loss on sale calculated in accordance with the tax
legislation. A profit on sale in terms of tax legislation is referred to as a recoupment whereas a
loss on sale in terms of tax legislation is often referred to as a scrapping allowance
Once again, the aim is to “remove” items that the accountant used in his accounting profits
and “process” the items that the tax authority uses when calculating his taxable profits.
226 Chapter 5
The following table summarises the comparison between the tax authorities and the
accountant
Accountant Tax Authorities
Depreciation Tax deduction (also called: a capital allowance/ wear
and tear/ depreciation for tax purposes)
Carrying amount Tax base
Non-capital profit on sale of asset Recoupment
Loss on sale of asset Scrapping allowance
B: 3.5.3.2 Sale of assets in terms of IFRSs: carrying amounts and profit or loss
The carrying amount of a non-current asset is calculated as follows:
Original cost xxx
Less accumulated depreciation (xxx)
Carrying amount xxx
The profit or loss on sale of a non-current asset (capital and non-capital portions) in
accordance with the International Financial Reporting Standards (IFRSs), is as follows:
Profit or (loss) on sale xxx
The non-capital profit included in the profit on sale of a non-current asset is as follows:
Proceeds on sale, limited to original cost xxx
Non-capital profit or (loss) xxx
B: 3.5.3.3 Sale of assets in terms of tax legislation: tax bases and recoupments or
scrapping allowances
The tax base is calculated as follows:
Original cost xxx
Less accumulated capital allowances (xxx)
Tax base xxx
The taxable recoupment (or scrapping allowance) is calculated as follows:
Proceeds on sale, limited to original cost xxx
Less tax base (xxx)
Recoupment or (scrapping allowance) xxx
Example 15: Depreciation versus capital allowances (e.g. wear and tear)
Cost of vehicle purchased on 1 January 20X1 C150 000
Depreciation on vehicles to nil residual value (straight-line method) 2 years
Wear and tear (allowed by tax authorities) (straight line method) 3 years
Income tax rate 30%
Profit before tax (after deducting any depreciation on the vehicle) in C100 000 pa
each of the years ended 31 December 20X1, 20X2 and 20X3
There are no temporary differences, no exempt income and no non-deductible expenses other than
those evident from the information provided.
Required:
Calculate the income tax per the tax legislation for 20X1, 20X2 and 20X3.
Solution 15: Depreciation versus capital allowances

Comment:
It can be seen from the below that in each of the years (20X1, 20X2 and 20X3), the profit before tax
according to the accountant is different to the taxable profit according to the tax authorities.
However, notice that over the 3 year period, both the accountant and tax authorities agree that the
cost of the asset that may be expensed equals C150 000 and thus that the total profit before tax is
C300 000 over these three years and the total taxable profit is also C300 000 over these three years.
Chapter 5 227
Solution 15: Continued …

Therefore the difference between the accounting and taxable profits was simply due to annual differences
that were temporary (i.e. temporary differences).
Calculation of income tax Total 20X3 20X2 20X1
C C C C
Profit before tax 300 000 100 000 100 000 100 000
Add/(less)
Movement in temporary differences
Add back depreciation (150 000 / 2 years) 150 000 0 75 000 75 000
Less wear and tear (150 000 / 3 years) (150 000) (50 000) (50 000) (50 000)
Taxable profit 300 000 50 000 125 000 125 000
Current tax at 30% 90 000 15 000 37 500 37 500
[Dr: TE (NT); Cr: CTP (NT)]
Example 16: Profit/loss on sale versus recoupment/scrapping allowance on sale

A company sells a vehicle on 1 January 20X2 for C110 000.
Details of the vehicle and its sale are as follows:
Depreciation on vehicles to nil residual value (straight line method) 2 years
Wear and tear on vehicle (according to tax authorities) (straight-line) 3 years
Profit before tax (after deducting any depreciation on the vehicle but before taking into account the
profit or loss on sale) was C100 000 in each of the years ended 31 December 20X1 and 20X2.
Income tax is levied at 30%
There are no temporary differences, no exempt income and no non-deductible expenses other than those
evident from the information provided.
Required:
A. Calculate the profit or loss on sale in 20X2 according to IFRS.
B. Calculate the recoupment or scrapping allowance on sale in 20X2 according to the tax legislation.
C. Calculate the income tax for 20X1 and 20X2.
Solution 16A: Calculation of profit or loss on sale (IFRS)

20X2
C
Less carrying amount 150 000 – (150 000 / 2 x 1year) (75 000)
Solution 16B: Calculation of recoupment or scrapping allowance on sale (tax law)

20X2
C
Less tax base 150 000 – (150 000 / 3 x 1year) (100 000)
Recoupment on sale/ (scrapping allowance) 10 000
Comment:
Had the proceeds been less than the tax base:
a scrapping allowance would have arisen, which
would be deducted in determining taxable profit.
Solution 16C: Calculation of income tax

Comment: It can be seen from the below that, over the 2 year period, the accounting records shows that
the asset caused a net loss of C40 000 (Depreciation: 75 000 – Profit on sale: 35 000) and the tax records
show that the asset caused a net loss of C40 000 (Tax deduction: 50 000 – Recoupment: 10 000). This
means that differences in each year are simply temporary differences.
228 Chapter 5
Solution 16C: Continued …

Total 20X2 20X1
Calculation of income tax C C C
Profit before tax 20X2: 100 000 + 35 000 235 000 135 000 100 000
(1)
Add back depreciation 20X1: 150 000 / 2 years 75 000 0 75 000
(1)
Less wear and tear 20X1: 150 000 / 3 years (50 000) 0 (50 000)
Less profit on sale 20X2: above (35 000) (35 000) 0
Add recoupment 20X2: above 10 000 10 000 0
Taxable profit 235 000 110 000 125 000
(1) There is no depreciation or wear and tear as the asset is sold on the first day of the year.
Example 17: Capital profit vs. capital gains on sale (proceeds > original cost)
A company sells a vehicle on 1 January 20X2 for C200 000. Details of this vehicle are as
follows:
Depreciation on vehicles to nil residual value 2 years (straight-line)
Wear and tear on vehicle (allowed by the tax authorities) 3 years (straight-line)
Profit before tax (after deducting any depreciation on the vehicle but before taking into account the profit
or loss on sale) in each of the years ended 31 December 20X1 and 20X2 is C100 000.
Income tax rate is levied at 30%.
There are no temporary differences, no exempt income and no non-deductible expenses other than those
Required:
A. Calculate the profit/ loss on sale in 20X2 per IFRSs: show the capital and non-capital portions.
B. Calculate the recoupment or scrapping allowance on sale in 20X2 per the tax legislation.
C. Calculate the taxable capital gain assuming that the base cost was C130 000 and the inclusion rate of
capital gains in taxable profits is 50% for companies.
D. Calculate the taxable profits and income tax per tax legislation for 20X1 & 20X2.
Solution 17A: Calculation of profit or loss on sale, where it includes a capital profit
20X2
Calculation of the profit or loss on sale according to IFRS C
Less carrying amount Cost: 150 000 – Acc depreciation: (150 000 / 2 x 1year) (75 000)
Capital profit Proceeds: 200 000 – Cost: 150 000 50 000
Non-capital profit Proceeds limited to cost: 150 000 – Carrying amount: 75 000 75 000
Solution 17B: Calculation of recoupment or scrapping allowance on sale (tax law)

20X2
Calculation of the recoupment or scrapping allowance per tax legislation C
Proceeds on sale, limited to cost 150 000
Less tax base Cost: 150 000 – Acc wear & tear: (150 000 / 3 x 1year) (100 000)
Recoupment on sale/ (scrapping allowance) 50 000
Solution 17C: Calculation of taxable capital gain (tax law)

20X2
Calculation of the taxable capital gain per tax legislation C

Less base cost Given (130 000)
Capital gain 70 000
Inclusion rate Given 50%
Taxable capital gain Capital gain: 70 000 x Inclusion rate: 50% 35 000
Chapter 5 229
Solution 17D: Calculation of income tax

Comment: over the 2 year period, the accounting records and tax records will not agree because:
the accounting records show that the asset resulted in a profit over the 2 years of C50 000,
Profit on sale In 20X2 (see Sol 17A) 125 000
Less: depreciation In 20X1: 150 000 / 2 x 1yr (75 000)
Effect on accounting profit 50 000
whereas the tax records show that the asset resulted in a taxable profit over the 2 years of C35 000:
Taxable capital gain In 20X2 (see Sol 17C) 35 000
Recoupment In 20X2 (see Sol 17B) 50 000
Less: wear and tear In 20X1: 150 000 / 3 x 1yr (50 000)
Effect on taxable profit 35 000
Thus, of the accounting profit of C50 000, only C35 000 is taxable. Thus C15 000 will never be
taxed (Acc profit: C50 000 – Taxable profit: C35 000). i.e. a non-temporary (permanent difference).
Many students battle to separate the adjustments between temporary differences and those that are
non-temporary differences (e.g. exempt income/ non-deductible expenses) and thus I have shown the
calculation without this differentiation being required (see first calculation below). But if you can
master the alternative calculation, it is extremely useful in identifying the differences that will appear
as reconciling items in the tax expense note’s rate reconciliation.
Total 20X2 20X1
Profit before tax 20X2: 100 000 + PoS: 125 000 325 000 225 000 100 000
Less profit on sale 20X2: (see 17A) (125 000) (125 000) 0
Add recoupment 20X2: (see 17B) 50 000 50 000 0
Add taxable capital gain 20X2: (see 17C) 35 000 35 000 0
Taxable profit 310 000 185 000 125 000
Total 20X2 20X1

Calculation of income tax: alternative working C C C
Profit before tax 20X2: 100 000 + 125 000 325 000 225 000 100 000
Add/(less) non-temporary differences (i.e. permanent)
[i.e. less exempt income/ add non-deductible expenses]:
Less capital profit 20X2: (see 17A) (50 000) (50 000) 0
Add taxable capital gain 20X2: (see 17C) 35 000 35 000 0
Add/(less) movement in temporary differences:
Less non-capital profit 20X2: (see 17A) (75 000) (75 000) 0
Add recoupment 20X2: (see 17B) 50 000 50 000 0
Taxable profit 310 000 185 000 125 000
Example 18: Temporary differences and non-temporary differences

(i.e. permanent differences)
Coin Limited has profit before tax of C100 000 for the year ended 31 December 20X1. When
calculating this figure, the following information was correctly accounted for in terms of IFRSs:
Rent income received in advance (i.e. in respect of 20X2): C4 000 (taxable in 20X1) (1)
Interest income of C1 600 is still receivable (taxable in 20X1) (2)
Electricity of C2 400 is due for 20X1 but has not yet been paid (deductible in 20X1) (3)
The water bill for the first month in 20X2 has already been paid: C3 200 (deductible in 20X1) (4)
Dividend income of C800 was earned during 20X1 (exempt from tax)
A fine of C4 800 was incurred during 20X1 (not deductible for tax purposes)
230 Chapter 5
Depreciation of C8 000 was expensed during the year. The asset was purchased for C56 000 and is
being depreciated over 7 years. The tax authority allows a capital allowance of 10% of this cost.
Research costs expensed in 20X1 amounted to C6 400. The tax authority allows research costs to
be written-off over 4 years.
The provision for leave pay was increased by C7 200 in 20X1. Leave pay is only tax deductible in
the year that a payment is made to employees. No payments for leave pay were made in 20X1.
Required: Calculate the current tax and show the related journal for the year ended 31 December
20X1.
Solution 18: Temporary differences and non-temporary differences

Comment: This example is a comprehensive calculation of taxable profits involving temporary
differences and non-temporary differences (i.e. differences that are permanent).
Calculation of income tax C
Add/(less) non-temporary differences (i.e. permanent):
Less exempt income: dividend income (800)
Add back non-deductible items: fines 4 800
104 000
Add income received in advance (1) 4 000
Less prepaid expense (4) (3 200)
Add back depreciation (5) 8 000
Less capital allowance (5) (5 600)
Add back research expense (6) 6 400
Less research deduction allowed (6) (1 600)
Add back provision for leave pay adjustment (7) 7 200
Taxable profit 119 200
Current tax at 30% (119 200 x 30%) [Dr: TE (NT); Cr: CTP (NT)] 35 760
The current tax journal will be: Debit Credit

Income tax expense (P/L) 35 760
Current tax for the year
Explanatory Notes:
(1) The accountant treats income receivable as income (debit asset: accounts receivable and credit
income) on the grounds that it has been earned. This amount is therefore already included in the
C100 000 profit. The tax authority taxes income on the earlier date of receipt or earning. In this
case the earning occurred before receipt and the interest income will therefore be taxed in 20X1.
Since both the tax authority and the accountant agree that this amount is income in 20X1 (the
interest income is already included in the profit of C100 000), no adjustment is made.
(2) The accountant treats expenses payable as expenses (debit: expense and credit: liability: expense
payable) on the grounds that the expense has been incurred. The tax authority will allow the
deduction of the electricity expense since it has been incurred. Since both the tax authority and the
accountant agree that this amount is an expense in 20X1 (the electricity expense has already been
deducted in the calculation of the profit of C100 000), no adjustment is made.
(3) The accountant does not treat a prepaid expense as an expense (debit asset: prepayment and credit
asset: bank) on the grounds that it has not yet been incurred. The tax authority, on the other hand,
sometimes allows the payment to be deducted before it has been incurred. Since the tax authority
is allowing this payment to be deducted in 20X1 and yet it is not deducted in calculating the
accounting profit, it must be adjusted for when calculating the taxable profit.
Chapter 5 231
Solution 18 Continued…
(4) The depreciation has already been deducted in order to calculate the accounting profit of
C100 000. Since the tax authority calculates his own form of depreciation called a capital
allowance (or wear and tear), the accountant’s depreciation must first be added back (reversed)
and then the tax authority’s version thereof must be deducted. Both the accountant and the tax
authority agree that the full cost of C56 000 will be deducted – the issue is simply how much will
be deducted each year. The accountant will deduct the C56 000 at C8 000 per year for 7 years
whereas the tax authority will deduct the C56 000 at C5 600 per year for 10 years.
(5) The research costs were expensed by the accountant in 20X1 (i.e. included in the accounting
profit). Although the accountant deducts the C6 400 fully in 20X1, the tax authority deducts the
C6 400 over 4 years at C1 600 per annum, thus only C1 600 is deductible in 20X1. Thus, we
remove (add back) the C6 400 and process (deduct) the C1 600 to calculate taxable profit.
(6) The increase in the leave pay provision was recorded as Dr: Leave pay expense Cr: Provision for
Leave Pay thus the C7 200 is included as an expense in the accounting profit. However, the tax
authorities only deduct the amount when paid. As no amount has been paid by year-end, no
deduction is available for tax purposes and the C7 200 must be removed (added back).
B: 3.5.4 Temporary differences caused by tax losses (also known as an assessed loss)
If when calculating taxable profits you get a negative Deductible tax losses are
figure, it means that the entity has made a tax loss defined as
(assessed loss) and not a taxable profit. In other words, a the amount of loss,
tax loss means that, in terms of the tax legislation, the determined in accordance with tax
entity has made a loss. legislation, which is
available for deduction in determining
No tax is payable in the year of assessment in which there taxable profit in a future period
is a tax loss (i.e. there will be no current tax expense).
Sometimes tax losses are allowed to be carried forward and used as a tax deduction in the
following year/s of assessment. This means that it will be allowed to be deducted against the
taxable profits in the following year/s, thus reducing that year’s taxable profit and therefore
that year’s current tax charge (i.e. it will reduce tax payable in that future year).
If the tax loss is allowed to be carried forward and used as a tax deduction in a future year of
assessment, the tax loss is a temporary difference and is referred to as a deductible tax loss.
If the tax loss is not allowed to be carried forward and deducted in the future, the tax loss is
essentially a non-temporary difference and is referred to as a non-deductible tax loss.
Example 19: Tax losses (assessed losses)

Depreciation on vehicles to nil residual value 2 years straight-line
Wear and tear on vehicle (allowed by the tax authority) 3 years straight-line
Income tax rate 30%
Profit/ (loss) before tax (after deducting any depreciation on the vehicle) for the year ended
31 December 20X1: (80 000)
31 December 20X2: 30 000
31 December 20X3: 100 000
There are no temporary differences, no exempt income and no non-deductible expenses other than
those evident from the information provided.
Required: Calculate the income tax per the tax legislation for 20X1, 20X2 and 20X3.
232 Chapter 5
Solution 19: Tax losses

Comment:
This example shows the calculation of current tax where tax losses are incurred over consecutive years.
20X3 20X2 20X1
Profit/ (loss) before tax 100 000 30 000 (80 000)
Add back depreciation (120 000 / 2 years) 0 60 000 60 000
Less wear and tear (120 000 / 3 years) (40 000) (40 000) (40 000)
Less assessed loss brought forward (10 000) (60 000) 0
Taxable profit/ (tax loss) 50 000 (10 000) (60 000)
Current tax at 30% [Dr: TE (NT); Cr: CTP (NT)] 15 000 0 0
B.4 Payment of Income Tax
B: 4.1 Overview
The payment system regarding income tax is important to understand. It requires
prepayments of tax during the year and thus requires that an estimate of income tax be made
half way through and at the end of the current year. When recognising and measuring the
current tax expense to be included in the financial statements, a further revised estimate must
be made. The final estimate made is assessed by the tax authorities in a subsequent year. The
assessment received by the tax authorities may lead to adjustments having to be made to the
estimated current tax expense recognised.
B: 4.2 Income tax: provisional payments and estimates
Since the income tax charge is generally very large and the calculation of the actual taxable
profits is only finalised after the end of the year of assessment (which is generally the same as
the financial year), tax authorities normally require companies to make two provisional
payments during the year of assessment.
The requirement for provisional payments to be made during the year is intended to reduce
the cash flow shortages of the government during the year and also to ease the company’s
burden of paying an otherwise very large single sum at the end of the year. In South Africa,
these two provisional payments are made as follows:
half the estimated amount owing is paid within the first 6 months of the year of
assessment; and
the balance of the estimated amount owing is paid on or before the end of the last 6
months of the year of assessment.
These payments are based on estimates made during the year of the expected profits for the
year. Since the tax authority generally only finalises the tax charge for the year many months
after the financial statements have been finalised and published, the accountant must estimate
the amount of tax that will be charged.
The estimate is made by applying the tax legislation to the
Provisional tax
profits in the same manner as would be applied by the tax
authority. Companies must make provisional tax
payments
The final accurate amount owing in respect of current tax
will only be known once the tax authority has assessed every 6 months
the estimate made by the company. based on estimated taxable profit.
Since this accurate figure will only be known well after the financial year has ended and the
financial statements have been published, the income tax expense in the statement of
comprehensive income may be over or under-estimated. An adjustment to correct any over-
provision or under-provision will be made in the subsequent period in which the relevant
assessment is received.
B: 4.3 The first provisional payment
Chapter 5 233
The first payment must be made within six months after the beginning of the financial year.
Therefore, if a company has a 28 February year-end, the first provisional payment will fall
due on 31 August (and the second will fall due on the 28 February).
The first provisional tax payment is calculated at half the amount of tax that the company
estimates it will owe for the full year as the payment is usually made halfway through the year
(the rest will be paid when paying the second provisional payment).
The journal for the first provisional payment is as follows:

Debit Credit
Current tax payable: income tax (SOFP) xxx
Bank (A) xxx
Payment of first provisional payment
B: 4.4 The second provisional payment
The second payment must be made on a date not later 1st and 2nd Provisional
than the last day of the financial year. Therefore, if a Payment
company has a 28 February year-end, the second
1st provisional payment = (total
provisional payment must be made not later than estimated taxable profits for the
28 February. year x tax rate) / 2
2nd provisional payment = (total
The second provisional payment is calculated as: estimated income tax) – (1st
the estimated balance owing based on the total provisional payment)
estimated amount of tax owing for the full year
less the amount paid already by way of the first provisional payment.
The journal for the second provisional payment is the same as the first:
Debit Credit
Bank xxx
Payment of second provisional payment
Note: the second provisional payment is still based on estimated taxable profits for the year
(although this estimate will generally differ from the estimated taxable profits when making
the first provisional payment) because, due to the complexities involved in finalising financial
statements for the year, the actual taxable profit is only known with accuracy a few months
after the financial year-end (due date for the second provisional payment).
B: 4.5 The final estimate of current income taxation
The accountant makes the final estimate of current income taxation for the current year while
preparing the annual financial statements for publication.
The journal for the final estimated current tax for the year is:
Debit Credit
Income tax expense (P/L) xxx
Recording estimated current tax in the current year
This estimate is shown as the current portion of the income taxation in the taxation note.
The final estimate of how much tax will be charged by the tax authority for the year is seldom
equal to the sum of the first and second provisional payments. This simply results in either a
balance owing to or by the tax authority. This is shown in the statement of financial position
as a current tax asset or a current tax liability.
234 Chapter 5
Example 20: The provisional payments and tax estimate

A company pays C60 000 as the first provisional payment on 30 June20X1, and C40 000 as
the second provisional payment on 31 December 20X1.
When finalising the 20X1 financial statements, the accountant estimated taxable profits for
20X1 to be C400 000.
No amount of tax was owing to or receivable from the tax authority at the beginning of 20X1.
Required:
A. Calculate the current income tax expense for 20X1 and current tax payable/ receivable in 20X1.
B. Show the relevant ledger accounts.
C. Present the income tax expense and the income tax payable in the financial statements for the year
ended 31 December 20X1. Ignore deferred tax and STC.
Solution 20A: Calculations: current income tax expense/ payable
C
Balance payable to/ receivable from the tax authorities Given 0
Total income tax expense for 20X1 400 000 x 30% 120 000
Total payments made in respect of 20X1 tax 60 000 + 40 000 (100 000)
Balance of 20X1 tax still payable 20 000
Solution 20B: Ledger accounts

Income tax expense Current tax payable: income tax
CTP: NT 120 000 Bank 60 000 Opening bal 0
Bank 40 000 TE: NT 120 000
Balance c/f 20 000
Bank 120 000 120 000
CTP: NT 60 000 Balance b/f 20 000
CTP: NT 40 000

Company name
20X1
C
Profit before taxation xxx
Income tax expense (120 000)
Profit for the year xxx
Company name
20X1
Current liabilities C
Current tax payable: income tax 20 000
In certain instances, a company may need to make a third provisional payment if it is feared
that the first and second provisional payments will be significantly lower than the final tax
charge expected from the tax authority’s assessment. Heavy penalties and interest may be
charged by the tax authority if the provisional payments are significantly less than the final
tax owing per the official tax assessment.
B: 4.6 The formal tax assessment and resulting under/ over provision of current ta
This section, dealing with possible under/ over- Tax assessment
provisions, deals with whether the tax expense had been
appropriately estimated by the accountant. The assessment should provide
confirmation that
Once the company has finalised its estimate of its current the tax authority agrees with
tax charge for the year, the estimate is submitted to the the current tax expense
tax authorities. The tax authorities will assess the estimate calculated by the entity.
Chapter 5 235
made by the company and send a copy of this assessment back to the company. This official
assessment will therefore arrive well after the financial statements have been finalised.
The assessment shows the tax charge for the whole year according to the tax authority, minus
the provisional payments made by the company leaving either a balance owing or receivable.
Generally, the current tax that is estimated by the company should equal the actual current tax
per the assessment. In some cases, however, the tax authority may, for example, not allow the
deduction of certain of the expenses claimed. In an instance like this, it will mean that the
current income tax charged per the assessment will be greater than the estimate of the current
income tax that was recognised in the company’s financial statements.
Since the assessment is received by the company after the financial statements have been
finalised, the adjustment relating to the tax expense of the previous year will have to be
processed in the current financial year. The adjustment will appear as an under-provision or
over-provision of tax in profit or loss. This adjustment is calculated as follows:
Tax charge per the assessment for year 1 (received in year 2) xxx
Less current tax estimated for 20X1 and processed in 20X1 profit or loss (xxx)
Under/ (over) provision in 20X1, journalised in 20X2 profit or loss xxx
The journal adjusting for an under-provision is as follows:
Debit Credit
Income tax (P/L) xxx
The under-provision of tax in yr 1 is adjusted in yr 2
The journal adjusting for an over-provision is as follows:
Debit Credit
Income tax (P/L) xxx
The over-provision of tax in yr1 is adjusted in yr 2
B: 4.7 The formal tax assessment and resulting under/ overpayment of current tax
This section, dealing with any under/over-payment deals with the actual cash outflow made to
the tax authority. Compare this to the previous section that deals with the expenses incurred
and whether these were under/over-provided.
When receiving the tax assessment, it will also become apparent whether or not our
provisional payments were sufficient. We may find that our provisional payments:
were too much, (i.e. we overpaid) in which case the assessment will indicate that a refund
will be paid to us, or
Were too little (i.e. we underpaid), in which case the assessment will indicate that we
need to make a further payment: this is referred to as a top-up payment.
Example 21A: First provisional payment of income tax in 20X1
Carl Limited has a 31 December year-end. For purposes of making the first provisional
payment, which falls due on 30 June 20X1, the accountant estimated the taxable profits for
the whole of the 20X1 year to be C100 000, being 25% higher than 20X0 taxable profits of
C80 000 (C80 000 x 1,25).
Required: Calculate the first provisional payment due and post the entries in t-account format assuming
it was paid on due date. The income tax rate is 30%
Solution 21A: First provisional payment of income tax in 20X1

Comment:
The payment is credited to the current tax payable account. The tax expense is not affected.
Assuming that there was no opening balance owing to the tax authority, the current tax payable
account will temporarily have a debit balance until the tax expense and related credit is journalised,
(this journal will be processed when finalising the financial statements).
236 Chapter 5
Solution 21A: Continued …

The first provisional tax payment (paid on 30 June 20X1): (C100 000 x 30%) / 2 = C15 000
Bank (A) Current tax payable: income tax (A)
CTP: NT (1) 15 000 Bank (1) 15 000
(1) Payment of the first provisional tax payment
Example 21B: Second provisional payment of tax in 20X1

Example continued from example 21A: On 31 December 20X1 (6 months later) the financial
director estimated that the taxable profits for the entire 20X1 year will amount to C112 000
(i.e. not C100 000).
Required: Calculate the second provisional payment due and post the entries in the ledger accounts
assuming it was paid on due date.
Solution 21B: Second provisional payment of tax in 20X1

The second provisional tax payment: (C112 000 x 30%) – C15 000 = C18 600
Bank (A) Current tax payable: income tax (L)
CTP: NT (1) 15 000 Bank (1) 15 000
CTP: NT (2) 18 600 Bank (2) 18 600
(2) Payment of the second provisional tax payment
Example 21C: Current tax expense estimate for 20X1

Example continued from example 21B: The accountant made his final estimate of the taxable
profit for the year (when finalising the financial statements ended 31 December 20X1 on
18 March 20X2) to be C130 000.
Required: Calculate the income tax and show the related ledger accounts for the 20X1 year.
Solution 21C: Current tax expense estimate for 20X1

Comment:
The current tax estimate is part of the tax expense line in the statement of comprehensive income.
The current tax expense estimated by the accountant: C130 000 x 30% = C39 000
Bank (A) Current tax payable: income tax

20X1 year 20X1 year 20X1 year
CTP: NT (1) 15 000 Bank (1) 15 000 Taxation (3) 39 000
CTP: NT (2) 18 600 Bank (2) 18 600
Balance c/d 5 400
39 000 39 000
Balance b/d 5 400
Income tax expense (E)

20X1 year
CTP: NT (3) 39 000
(3) The final estimate of current tax made by the accountant.
Example 21D: Under/ over provisions of 20X1 income tax

Example continued from example 21C:
The official tax assessment was received on 31 May 20X2 showing:
20X1 taxable profits assessed at C150 000 and
20X1 tax assessed at C45 000 (C150 000 x 30%).
Required: Calculate and process the under/ over provision of income tax in 20X1.
Chapter 5 237
Solution 21D: Under/ over provisions of 20X1 income tax

Under-provision of 20X1 current tax expense: Assessed 45 000 – CTExp: 39 000 = C6 000 under –prov.
Bank (A) Current tax payable: Income tax (L)

20X1 year: 20X1 year 20X1 year:
CTP: NT (2) 18 600 Bank (2) 18 600
Balance c/d 5 400
39 000 39 000
20X2 year:
O/ balance b/d 5 400
U/prov tax(4) 6 000

20X1 year: 20X1 year:
CTP: NT (3) 39 000 P & L 39 000
20X2 year:
CTP: NT (4) 6 000
Notes:
(4) The 20X2 tax expense is adjusted for the under-provision of the tax expense in 20X1
Example 21E: Income tax transactions in 20X2

Example continued from example 21D:
The first provisional tax payment of C30 000 is paid in 20X2.
The entity failed to pay a second provisional payment.
The current tax expense for 20X2 was estimated at C50 000.
Required: Post all related entries in the ledger accounts.
Solution 21E: Income tax transactions in 20X2

20X1 year: 20X1 year: 20X1 year:
CTP: NT (2) 18 600 Bank (2) 18 600
Balance c/d 5 400
20X2 year: 39 000 39 000
CTP: CT (5) 30 000 20X2 year: 20X2 year:
Bank (5) 30 000 Balance b/d 5 400
U/prov tax (4) 6 000
Balance c/d 31 400 Taxation (6) 50 000
61 400 61 400
Balance b/d 31 400

20X1 year 20X1 year
CTP: NT (3) 39 000 P & L 39 000
20X2 year 20X1 year
CTP: NT (4) 6 000
CTP: NT (6) 50 000 P & L 56 000
Notes:
(5) payment of the first (and only) provisional payment made in 20X2
(6) recording the accountant’s final estimate of current tax relating to the 20X2 taxable profits.
238 Chapter 5
Example 22: Under / over-payments and under/ over-provisions of tax

A company pays C40 000 as the first provisional payment on 30 June 20X1, and C20 000 as
the second provisional payment on 31 December 20X1.
The accountant estimated the income tax for 20X1 to be C70 000.
No tax was owing to or receivable from the tax authority at the beginning of 20X1.
The 20X1 tax assessment arrives in May 20X2, showing taxable profit to be C240 000.
Income tax is levied at 30%.
Required:
A. Calculate the under or over provision of the 20X1 tax expense.
B. Show the journal entry relating to the under/ over provision processed in the ledger accounts.
C. Calculate the under or over payment relating to 20X1.
D. Show the under/ over payment in the ledger.
E. Process the journals in the ledger accounts assuming any refund is received or top-up is paid.
Solution 22A: Calculation: under/ over-provision in 20X1

Income tax expense in 20X1 (estimate) Given 70 000
Assessed tax for 20X1 (actual) 240 000 x 30% (72 000)
Over/ (under) provision of 20X1 tax expense (2 000)
Solution 22B: Ledger accounts: under-provision

Income tax expense (E) Current tax payable: income tax (L)
20X2 CTP 2 000 O/balance 10 000
20X2 TE 2 000
The 20X2 o/balance in the CTP account of 10 000 is due to payments in 20X1 of C60 000 (cr: 40 000 + 20 000)
and the income tax expense in 20X1 of C50 000 (i.e. cr: 60 000 – dr: 50 000 = net credit of C10 000 at end 20X1).
Notice that the under-provision of the 20X1 tax expense is processed in the 20X2 ledger accounts.
Solution 22C: Calculation: under/ over-payment in 20X1

Provisional payments made in respect of 20X1 40 000 + 20 000 60 000
Assessed tax for 20X1 (actual) 240 000 x 30% (72 000)
(Under-payment)/over-payment in respect of 20X1 tax assessment (12 000)
This example requires a top-up payment since we have effectively underpaid.
Solution 22D: Ledger accounts: under-payment

Comment:
The revised balance in the tax payable account of C12 000 reflects the under-payment of tax. No
journal is processed for an under-payment. All we do is journalise the payment when it is made.
20X2 CTP(1) 2 000 Balance 10 000
20X2 Tax(1) 2 000
Balance 12 000
Solution 22E: Ledger accounts: if top-up payment made

20X2 CTP 12 000 Bank 12 000 Balance 10 000
20X2 Tax 2 000
12 000 12 000
Chapter 5 239
B.5 Disclosure of Income Tax – A Brief Introduction
B: 5.1 Overview
IAS 1 and IAS 12 require certain tax disclosure in the statement of comprehensive income,
statement of financial position and related notes to the financial statements. On occasion, tax
may also be disclosed in the statement of changes in equity. The disclosure of tax in the
statement of changes in equity will be covered in the chapters dealing with items that are
charged directly to equity.
B: 5.2 Statement of financial position disclosure
IAS 1 requires that the amount of current taxes owing or receivable be shown on the face of
the statement of financial position as current assets or current liabilities.
The amount owing to (or from) the tax authority may Disclosure
relate to a variety of taxes, for instance:
VAT; Remember that amounts
Employees’ tax; owing for various types of
Dividends tax; and taxes discussed in the beginning of the
chapter must be disclosed separately.
Income tax.
Each of these balances (asset or liability) must be disclosed separately, unless your entity:
is legally allowed to settle these taxes on a net basis and
either intends to settle the asset or liability on a net basis or intends to settle the liability
and realise the asset at the same time.
Example 23: Disclosure of current tax assets and liabilities (set-off)
The tax authority owes a company an amount of C50 000 VAT.
This same company owes the tax authority an amount of C180 000 in income tax.
Required: Show the disclosure of the current tax asset and liabilities in the statement of financial
position assuming that:
A. the tax authority allows the VAT and income tax to be settled on a net basis and the company
intends to settle on a net basis.
B. the tax authority does not allow the VAT and income tax to be settled on a net basis;
Solution 23: Disclosure of current tax assets and liabilities (set-off)

Comment:
A: Set-off is allowed since there is a legal right of set-off and an intention to settle net.
B: Set-off is not allowed since there is no legal right of set-off.
Company name
As at …
Part A Part B
Current assets Calculations: C C
Current tax receivable: VAT A: N/A (set-off against the liability) 0 50 000
B: Given
Current liabilities
Current tax payable: income tax A: 180 000 liability – 50 000 asset 130 000 180 000
B: Given
B: 5.3 Statement of comprehensive income disclosure
IAS 1 (chapter 3) requires that the taxes levied on the entity’s profits should be disclosed as a
tax expense on the face of the statement of comprehensive income.
This line item in the profit or loss section of the statement of comprehensive income should
be referenced to a supporting note. The supporting note should also provide details of all the
major components of the tax expense (current and deferred).
The note should also provide a reconciliation explaining why the effective rate of tax differs
from the standard or applicable rate of tax (i.e. this chapter mainly used 30%as the income tax
240 Chapter 5
rate being applied). The effective tax rate is simply the

Effective tax rate:
actual tax paid as a percentage of profit before tax. The
effective tax rate will differ from the applicable tax rate taxation expense in the SOCI
due to non-temporary (i.e. permanent) differences, rate expressed as a percentage of
changes or over/under provisions. profit before tax in the SOCI (i.e.
accounting profit ).
The following is an example of the basic layout for this note:

Company name
Notes to the financial statements (extracts)
For the year ended …
20X2 20X1
12. Income tax expense C C
Income tax: current tax xxx xxx
current tax for the current year xxx xxx
current tax under/ over provided in a prior year xxx xxx
Income tax: deferred tax (covered in the next chapter) xxx xxx
Total tax expense per the statement of comprehensive income xxx xxx
Rate reconciliation:
Applicable tax rate (ATR) Standard/ normal rate: 30% x% x%
Tax effects of:
Profit before tax Profit before tax x ATR xxx xxx
Less exempt income Exempt income x ATR (xxx) (xxx)
Add non-deductible expenses Non-deductible expenses x ATR xxx xxx
Under/ (over) provision of current tax Per above xxx xxx
Tax per SOCI (P/L section) xxx xxx
Effective tax rate (ETR) Taxation expense/ profit before tax x% x%
The applicable tax rate differs from that of the prior year because a change to the corporate income
tax rate was substantively enacted on … (date).
Example 24: Disclosure involving exempt income and non-deductible expenses
The detail in example 9 applies to an entity called Retailer Limited. A summary of the
example is as follows:
Profit before tax was C100 000: it included
- dividend income of C30 000,
- donations incurred of C10 000,
- a capital profit of C20 000 of which C8 000 was a taxable capital gain.
Income tax was C20 400.
Required: Disclose this information in Retailer Limited’s statement of comprehensive income and tax
expense note for the year ended 31 December 20X2. Ignore deferred tax.
Solution 24: Disclosure involving exempt income and non-deductible expenses
Comment:
This example shows the disclosure of current tax where there are non-temporary (i.e. permanent)
differences.
Only these non-temporary (i.e. permanent) differences appear as reconciling items in the rate
reconciliation in the income tax expense note.
Temporary differences do not appear as reconciling items in the tax rate reconciliation.
Retailer Limited
Note 20X2
C
Income tax expense 4 (20 400)
Chapter 5 241

Retailer Limited
20X2
4. Income tax expense C
Income tax: current tax for the current year 20 400
20 400
Tax rate reconciliation:
Applicable tax rate 30%
Tax effects of:
Profits before tax 100 000 x 30% 30 000
Dividend income (exempt income) 30 000 x 30% (9 000)
Donations (non-deductible expenses) 10 000 x 30% 3 000
Capital profit (exempt income) (20 000 – 8 000) x 30% (3 600)
Total income tax per the statement of comprehensive income 20 400
Effective tax rate (Actual tax: 20 400/ PBT: 100 000) 20,4%
Example 25: Disclosure involving an under-provision

Use all the information provided in example 21 (A-E). The information from example 21 is
summarised here for your convenience:
Current tax payable at 31 December 20X2 was C31 400 (20X1: C5 400);
Income tax estimated for 20X2 was C50 000 and for 20X1 was C39 000;
It was discovered in 20X2 that the 20X1 income tax estimate of C39 000 was under-
estimated by C6 000.
Assume the following additional information:
Profit before tax is C166 667 in 20X2 (C130 000 in 20X1);
The related income was all taxable and the related expenses were all deductible;
There were no items of other comprehensive income;
There were no temporary differences.
Required: Disclose the above information in the company’s statement of financial position; statement
of comprehensive income and the tax expense note for the year ended 31 December 20X2.
Ignore deferred tax.
Solution 25: Disclosure involving an under-provision

Comment: This shows how to disclose current tax if current tax was under-estimated in the prior year.
A Limited
Note 20X2 20X1
Current Liabilities C C
- Current tax payable: income tax 31 400 5 400
A Limited
Note 20X2 20X1
C C
Profit before tax Given 166 667 130 000
Income tax expense 4 (56 000) (39 000)
Profit for the year 110 667 91 000
Other comprehensive income 0 0
242 Chapter 5

A Limited
For the year ended 31 Dec 20X2
20X2 20X1
Income taxation: 56 000 39 000
Current tax - for the current year 50 000 39 000
Current tax - under-provision of a prior year 6 000 0
Total income tax per the statement of comprehensive income 56 000 39 000
Reconciliation:
Applicable tax rate 30% 30%
Tax effects of
Profits before tax 20X2: 166 667 x 30%; 20X1: 130 000 x30% 50 000 39 000
Under-provision of current tax in a prior year Per above 6 000 0
Total income tax per the statement of comprehensive income 56 000 39 000
Effective tax rate 20X2: Actual tax: 56 000/ PBT: 166 667; 33.6% 30%
20X1: Actual tax: 39 000/ PBT: 130 000
Example 26: Disclosure involving other comprehensive income

The following information relates to Suri Limited for its year ended 31 December 20X2:
Profit before tax C200 000
Income tax expense C60 000
Other comprehensive income (OCI) includes the following: Before tax After tax
- Increase in OCI due to a revaluation surplus on machinery C60 000 C42 000
- Increase in OCI due to a gain on a cash flow hedge C50 000 C35 000
There are no items of exempt income, no non-deductible expenses and no temporary differences.
The income tax rate is 30%. There are no other taxes levied on profits.
Required: Disclose the above in the statement of comprehensive income and related notes showing:
A. Items of OCI after tax (i.e. net) in the statement of comprehensive income.
B. Items of OCI before tax (i.e. gross) in the statement of comprehensive income.
Solution 26A: Disclosure of other comprehensive income after tax

Suri Limited
Notes 20X1
C
Profit for the period 140 000
Other comprehensive income(net of tax) 6 77 000
Revaluation surplus increase, net of tax 42 000
Gain on a cash flow hedge, net of tax 35 000
Suri Limited
20X1
Income taxation expense: current tax for the current year 60 000
60 000
Reconciliation:
Applicable tax rate Given 30%
Effective tax rate (Tax expense: 60 000 / profit before tax: 200 000) 30%
Chapter 5 243

6. Tax effects of other comprehensive income Gross Tax Net
C C C
Revaluation surplus increase 60 000 (18 000) 42 000
Gain on a cash flow hedge 50 000 (15 000) 35 000
110 000 (33 000) 77 000
Solution 26B: Disclosure of other comprehensive income before tax

Suri Limited
20X1
Notes C
Other comprehensive income(before tax) 77 000
Items that may never be reclassified to profit or loss:
Revaluation surplus increase 60 000
Deferred tax on the revaluation surplus increase (18 000)
Gain on a cash flow hedge 50 000
Deferred tax on the gain on the cash flow hedge (15 000)
Solution 26B: Continued ...

Suri Limited
20X1
Income taxation
- Current tax for the current year 60 000
60 000
Reconciliation:
Applicable tax rate Given 30%
Effective tax rate (Tax expense: 60 000 / profit before tax: 200 000) 30%
Notice the following:

The total amount of other comprehensive income is the same for both parts.
The note showing the tax effect of other comprehensive income is only given if the tax effect of
each item of other comprehensive income is not presented on the face of the statement of
comprehensive income. In this case, the tax effect of each item has been shown on the face of the
statement of comprehensive income and thus this note was not required.
There was no difference between the applicable tax rate and the effective tax rate in either part
since there were no items of exempt income, non-deductible expenses and no other factors (e.g.
over-under provision of prior year current tax) that could have caused the effective tax rate to be
any different to the normal applicable tax rate.
Tax effects of OCI do not affect income tax expense (which is a profit or loss item).
244 Chapter 5
Summary
The main types of tax affecting

a business entity
VAT Income tax

14% on vatable supplies 28%* of taxable profits (i.e. the portion of the
profit before tax that is taxable)
VAT vendors: * the examples in this textbook typically
used a 30% tax rate simply to make the
Charge VAT
answers easier for you to calculate in your
Claim VAT head
Non-vendors: Incurred:
Don’t charge VAT Current (charged)
Can’t claim VAT Deferred (next chapter)
VAT vendors must keep a record of VAT Current

Input VAT (VAT on purchases) Estimate of CY assessment
Output VAT (VAT charged on sales) Adjustments to PY estimates
Current tax is calculated as

See summary calculations overleaf
Differences between accounting

profits and taxable profits
Temporary differences: Non-temporary differences (permanent

These cause deferred tax differences):
These cause reconciling items in the rate
recon
Depreciation (IFRS: Expense) (Tax Act: deductible Capital profit (IFRS: Income) (Tax Act: part or
allowance – often a different amt) all of this may be a capital gain, 50% of which is
Income received in advance (IFRS: Liability) (Tax taxable – the rest is exempt, being the non-
Act: income) temporary difference)
Expenses prepaid (IFRS: Asset) (Tax Act: Dividend income (IFRS: Income) (Tax Act:
expense) generally all exempt – i.e. not taxable)
Non-capital profit on sale of asset (IFRS: Fines (IFRS: Expense) (Tax Act: not deductible)
Income) (Tax Act: Recoupment – often a Donations (IFRS: Expense) (Tax Act: generally
different amt) not deductible)
Loss on sale of asset (IFRS: Expense) (Tax Act: a
deductible scrapping allowance - often a different
amt)
Dividends tax (replaces STC)

A tax on the shareholder
The entire 15% is deducted from the dividend declared
The company withholds the tax and pays it over to the tax authorities
The tax is not part of the tax expense line item
Exemptions arise only in a limited number of circumstances
Unused STC credits may be carried forward for use by shareholders in
reducing their dividends tax (expires after 3 yrs)
Chapter 5 245
Summary calculations
Calculation of income tax (converting accounting profits into taxable profits)

Profit before tax xxx
Adjust for non-temporary differences
(less exempt income and add non-deductible expenses):
Less exempt dividend income (xxx)
Less exempt capital profit
- Less capital profit SP - CP (xxx)
- Add taxable capital gain (SP – BC) x 50% xxx
Add non-deductible fines xxx
Add non-deductible donations xxx
Profit before tax that the accountant knows will be taxable at some stage xxx
Adjust for temporary differences:
Add depreciation xxx
Less wear and tear (xxx)
Less non-capital profit on sale (or add loss on sale) SP (limited to CP) - CA (xxx)
Add recoupment on sale; or SP (limited to CP) - TB xxx
Less scrapping allowance on sale
Add income received in advance (c/balance) xxx
Less income received in advance (o/balance) (xxx)
Less expense prepaid (c/balance) (xxx)
Add expense prepaid (o/balance) xxx
Add provision (c/b) xxx
Less provision (o/b) (xxx)
Taxable profits/ (loss) xxx
Income tax (28% of taxable profits) xxx
Useful comparative calculations relating to the sale of non-current assets

Accountant Tax Authority
PoSA = Proceeds – CA = (CP + NCP) TPoSA = TCG + Recoup
CP = Proceeds – Cost; CG = Proceeds – Base cost
TCG = CG X inclusion rate (66,6%* for companies and
Part of the CP may be exempt from tax: 33.3%* for individuals in SA);
Exempt CP = CP - TCG * the examples in this textbook typically used a
50% inclusion rate simply to make the answers
easier for you to calculate
NCP/ (NCL) = Proceeds (limited to cost) – CA Recoup/ (SA) = Proceeds (limited to cost) – TB
CA = Cost - AD TB = Cost –AW&T
Key
POSA: Profit on sale of asset TPoSA = Taxable profit on sale of asset
CP: Capital Profit CG: Capital gain
NCP: Non-Capital Profit on sale BC: Base cost
NCL: Non-Capital Loss on sale TCG: Taxable capital gain
CA: Carrying Amount TB: Tax Base
AD: Accumulated Depreciation Recoup: Recoupment
SA: Scrapping allowance
AW&T: Accumulated wear & tear
246 Chapter 5
Gripping GAAP Taxation: deferred taxation
Chapter 6
Taxation: Deferred Taxation
Reference: IAS 12, IAS 1 and Circular 3/2011 (including any amendments to 10 December 2014)
Contents Page
1. Introduction to the concept of deferred tax 249
1.1 The inter-relationship of current tax, deferred tax and tax expense 249
1.2 Creating a deferred tax asset 249
Example 1A: Creating a deferred tax asset 350
Example 1B: Reversing a deferred tax asset 251
1.3 Creating a deferred tax liability 252
Example 2A: Creating a deferred tax liability 252
Example 2B: Reversing a deferred tax liability 253
1.4 Deferred tax balance versus the current tax payable balance 254
2. Measurement of deferred tax: the two methods 254
2.1 Overview 254
2.2 The income statement approach 255
Example 3A: Income received in advance (income statement approach) 256
2.3 The balance sheet approach 257
Example 3B: Income received in advance (balance sheet approach) 259
Example 3C: Income received in advance (journals) 260
Example 3D: Income received in advance (disclosure) 261
3. Measurement: enacted tax rates versus substantively enacted tax rates 261
Example 4: Enacted and substantively enacted tax rates 263
4. Deferred tax caused by year-end accruals and provisions 264
4.1 Overview 264
4.2 Expenses prepaid 264
Example 5: Expenses prepaid 264
4.3 Expenses payable 268
Example 6: Expenses payable 268
4.4 Provisions 270
Example 7: Provisions 270
4.5 Income receivable 273
Example 8: Income receivable 273
5. Deferred tax caused by non-current assets 275
5.1 Overview 275
5.2 Deductible assets 276
5.2.1 Overview 276
5.2.2 Deductible and depreciable 276
Example 9: Deductible and depreciable assets 277
5.2.3 Deductible but not depreciable 280
5.3 Non-deductible assets and the related exemption 280
5.3.1 Overview 280
5.3.2 The exemption from recognising deferred tax liabilities 280
Example 10: Non-deductible but depreciable assets 282
Example 11: Non-deductible and non-depreciable asset 285
5.4 Non-current assets measured at fair value 287
5.4.1 Overview 287
5.4.2 Non-current assets measured at fair value and the presumed intentions 288
5.4.2.1 Non-depreciable assets measured using IAS 16’s revaluation model 288
5.4.2.2 Investment property measured using IAS 40’s fair value model 288
Example 12: Non-current asset at fair value and presumed intentions 289
5.4.3 Measuring deferred tax based on management expectations 290
5.4.3.1 Intention to sell the asset (actual or presumed intention) 290
5.4.3.2 Intention to keep the asset 290
5.4.4 How to measure the deferred tax if the fair valued asset is also non-deductible 291
Example 13: Revaluation above cost: Non-deductible; depreciable : keep 292
Example 14: Revaluation above cost: Non-deductible; depreciable: sell 294
Example 15: Revaluation above cost: Non-deductible; non-depreciable: keep 295
Chapter 6 247
Contents continued … Page

5.5 Sale of a non-current asset 297
Example 16: Non-current asset sold at a profit with a recoupment 298
Example 17: Non-current asset sold at a loss with a scrapping allowance 298
Example 18: Sale of a deductible, depreciable asset (plant): below cost 299
Example 19: Sale of a deductible, depreciable asset (plant): above cost 301
Example 20: Sale of a non deductible, non depreciable asset: below cost 302
Example 21: Sale of a non-deductible, non-depreciable asset: above cost 305
Example 22: Sale of a non-deductible, depreciable asset: below cost 307
Example 23: Sale of a non deductible, depreciable asset: above cost 309
6. Exemption from deferred tax 311
7. Rate changes and deferred tax 312
Example 24: Rate changes: journals 312
Example 25: Rate changes: journals and disclosure 313
8. Deferred tax assets 315
8.1 What causes a deferred tax asset? 315
8.2 Deferred tax assets: recognition in terms of the Conceptual Framework 316
Worked example: tax losses 316
Example 26: Recognition of deferred tax assets: tax loss to expire: discussion 317
8.3 Deferred tax assets: recognition in terms of the IAS 12 318
Example 27: Recognition of deferred tax assets: deductible temporary differences 319
8.4 Deferred tax assets: measurement 320
8.5 Deferred tax assets: disclosure 320
Example 28: Tax losses: deferred tax asset recognised in full 321
Example 29: Tax losses: deferred tax asset recognised in full then written-down 323
Example 30: Tax losses: deferred tax asset recognised partially 324
9. Deferred tax implications: secondary tax on companies and dividends tax 327
9.1 Overview 327
9.2 Deferred tax on STC credits 327
10. Disclosure of income tax 328
10.1 Overview 328
10.2 Accounting policy note 328
10.3.1 Face of the statement of financial position 328
10.3.1.1 Non-current asset or liability 328
10.3.1.2 Show deferred tax per category of tax 328
10.3.1.3 Setting-off of deferred tax assets and liabilities 329
Example 31: Set-off of deferred tax assets and liabilities 329
10.3.2 Deferred tax note (asset or liability) 330
10.3.2.1 The basic structure of the deferred tax note 330
10.3.2.2 A deferred tax reconciliation may be required 330
10.3.2.3 Extra detail needed on unrecognised deferred tax assets 331
10.3.2.4 Extra detail needed on recognised deferred tax assets 331
10.3.2.5 Extra detail needed on unrecognised deferred tax liabilities 331
10.4.1 Face of the statement of comprehensive income 331
10.4.2 Tax on profit or loss: income tax expense note 332
10.4.2.1 Basic structure of the income tax expense note 332
10.4.2.2 Effect of deferred tax assets on the income tax expense note 333
10.4.2.3 Tax relating to changes in accounting policies and correction of 334
errors 335
10.4.2.4 Extra detail required with regard to discontinuing operations 335
10.4.3 Tax on other comprehensive income
11. Summary 336
248 Chapter 6
1. Introduction to the Concept of Deferred Tax
1.1 The inter-relationship of current tax, deferred tax and tax expense
As mentioned in the previous chapter, the total income tax expense for disclosure purposes is
broken down into two main components:
current tax; and Accounting profit and
deferred tax. taxable profit
Accounting profit is profit or loss

This current tax is the tax charged by the tax authority in for the period before deducting tax
the current period on the current period’s taxable profits. expense. IAS12.5
Taxable profit is the profit or loss
The taxable profits are calculated based on tax legislation for the period, determined in
(discussed in the previous chapter). accordance with the rules established
by the taxation authorities, upon
The total tax expense presented on the statement of which income taxes are payable (or
comprehensive income must reflect the tax incurred on recoverable). IAS12.5
the accounting profits – not the current tax charge on taxable profits.
There is often a difference between the tax expense (tax Tax expense equals:
incurred on accounting profits) and the current tax (tax
Current tax expense (or income); plus
charged on taxable profits). Deferred tax expense (or income).
This is because accounting profits are calculated in accordance with the international financial
reporting standards and taxable profits are calculated in accordance with tax legislation. The
IFRSs are based on the concept of accrual and thus the tax expense must reflect the tax
incurred on the accounting profits (i.e. the tax expense is based on the concept of accrual).
The tax legislation is not based on the accrual concept,
and thus, for example, income could well be included in Tax expense is defined as:
taxable profits before the income is earned (i.e. before it the aggregate amount
is included in accounting profits)! included in the determination of P/L
for the period in respect of
We make an adjustment for the difference between current tax and deferred tax. IAS12.5.
current tax (which is not based on the accrual concept,
but the tax legislation instead), and the tax expense in the statement of comprehensive income
(which is based on the accrual concept). This adjustment is called a deferred tax adjustment.
The deferred tax adjustment is therefore simply an accrual of tax.
In other words: current income tax (i.e. the amount Current tax is defined as:
charged by the tax authority) is debited to the tax
amount of income taxes
expense account and then this account is adjusted payable/(recoverable) in respect of
upwards or downwards so that the final income tax taxable profit/ (tax loss)
expense in the statement of comprehensive income is for the period. IAS12.5
shown at the amount of tax incurred.
Deferred tax is not
This adjustment, referred to as a deferred tax adjustment, defined but the logic of it is
results in the creation of a deferred tax asset or liability that it arises:
when income/expenses (in other
(i.e. if the deferred tax adjustment requires a debit to the words: A/Ls) are treated differently
tax expense account, the credit entry will be to a deferred under IFRSs (accounting profit); and
tax liability account). under tax legislation (taxable profit)
where these differences will reverse.
1.2 Creating a deferred tax asset (a debit balance)
Deferred tax asset are
A debit balance on the deferred tax account reflects the defined as: IAS12.5
accountant’s belief that tax has been charged but which the amounts of taxes recoverable
has not yet been incurred. This premature tax charge must in future periods in respect of:
be deferred (postponed). In some ways, this treatment is - deductible temporary differences
similar to that of a prepaid expense. - unused tax losses carried forward;
- unused tax credits carried forward.
Chapter 6 249
Example 1A: Creating a deferred tax asset (debit balance)

The estimated current tax charged by the tax authority in 20X1 is C30 000.
The accountant calculates that the tax incurred for 20X1 to be C24 000.
The C6 000 excess will be deferred to future years.
Required: Show the ledger accounts and disclose the tax expense and deferred tax for 20X1.
Solution 1A: Creating a deferred tax asset (debit balance)

The tax expense that is shown in the statement of comprehensive income must always reflect the tax
that is believed to have been incurred for the year, thus C8 000 must be shown as the expense.
Ledger accounts: 20X2
Income tax (E) Current tax payable: income tax (L)
CTP: NT (1) 30 000 DT (2) 6 000 Tax (1) 30 000
_____ Total c/f 24 000
30 000 30 000
Total b/f 24 000
Deferred tax: income tax (A)
Tax (2) 6 000
(1) the current tax (the estimated amount that will be charged/ assessed by the tax authority).
(2) deferring a portion of the current tax expense to future years so that the balance in the tax expense
account is the amount considered to have been incurred (i.e. C24 000). The deferred tax account
has a debit balance of C6 000, meaning that the C6 000 deferred tax is an asset. This tax has been
charged but will only be incurred in the future and so it is similar to a prepaid expense.
Disclosure for 20X1: (the deferred tax asset note will be ignored at this stage)
Entity name
As at … 20X1
20X1
ASSETS C
Non-current Assets
- Deferred tax: income tax 6 000
Entity name
For the year ended …20X1
Note 20X1
C
Income tax expense (current tax: 30 000 – deferred tax: 6 000) 3. (24 000)
Profit for the period xxx
Total comprehensive income xxx
Entity name
20X1
Income taxation expense 24 000
- Current 30 000
- Deferred (6 000)
250 Chapter 6
Example 1B: Reversing a deferred tax asset

Use the same information as that given in 1A and the following additional information:
We expect the tax authorities to charge tax of C42 000 in 20X2 (i.e. based on tax
legislation).
The accountant calculates the tax incurred for 20X2 to be C48 000 (i.e. the ‘excess tax’
charged in 20X1 is now incurred).
Required: Show the ledger accounts and disclose the tax expense and deferred tax in 20X2.
Solution 1B: Reversing a deferred tax asset

Tax: income tax (E) Current tax payable: income tax
CTP: NT (1) 42 000 Tax (1) 42 000
DT (2) 6 000
48 000

Balance b/d 6 000 Taxation (2) 6 000
(1) recording the current tax (estimated amount that will be charged by the tax authorities)
(2) recording the reversal of the deferred tax asset in the second year. The total tax expense in 20X2
will be the current tax charged for 20X2 plus deferred tax (the portion of the current tax that was
not recognised in 20X1, is incurred in 20X2).
Disclosure for 20X2:
Entity name
As at … 20X2
Note 20X2 20X1
ASSETS C C
Non-current Assets
- Deferred tax: income tax 0 6 000
Entity name
Note 20X2 20X1
C C
Profit before tax xxx xxx
Income tax expense(20X2: current tax: 42 000 + deferred tax: 6 000) 3. (48 000) (24 000)
Profit after tax xxx xxx
Total comprehensive income xxx xxx
Entity name
For the year ended ……20X2
20X2 20X1
Income taxation expense 48 000 24 000
- Current 42 000 30 000
- Deferred 6 000 (6 000)
Comment: It can be seen that, over the period of 2 years, the total current tax charged by the tax
authorities (30 000 + 42 000 = 72 000) equals the tax expense recognised in the accounting records:
the tax expense in 20X1 of C24 000; plus
the tax expense in 20X2 of C48 000.
Chapter 6 251
1.3 Creating a deferred tax liability (credit balance) A deferred tax liability
is defined as:
A credit balance in the deferred tax account reflects the the income taxes payable
accountant’s belief that tax has been incurred, but which has in future periods, in respect of
not yet been charged by the tax authority. It thus shows the
taxable temporary differences
amount that will be charged by the tax authority in the future. IAS12.5 Reworded
This is similar to the treatment of an expense payable.
Example 2A: Creating a deferred tax liability (credit balance)

The following information relates to the income tax calculations in 20X1:
it is expected that the tax authorities will charge tax of C15 000,
the tax incurred (i.e. based on IFRSs): C22 000.
Solution 2A: Creating a deferred tax liability (credit balance)

Comment: The tax shown in the statement of comprehensive income must always be the amount
incurred for the year rather than the amount charged, thus C22 000 must be shown as the tax expense.
Income tax (E) Current tax payable: income tax
CTP: NT(1) 15 000 Tax (1) 15 000
DT(2) 7 000
22 000
Deferred tax: income tax (L)

Tax (2) 7 000
Calculations:
(1) Recording the current tax (the estimated amount that will be charged by the tax authorities).
(2) Providing for extra tax that has been incurred but which will only be charged/assessed by the tax
authorities in future years (tax owing to the tax authorities in the long term):
we have only been charged C15 000 in the current year, but
we have incurred C22 000, thus
there is an amount of C7 000 that will have to be paid sometime in the future.
Comment: Notice that the deferred tax account has a credit balance of C7 000, (a deferred tax liability).
Entity name
20X1
C
Income tax expense (current tax: 15 000 + deferred tax: 7 000) 3. (22 000)
Profit for the year xxx
Entity name
As at ……..20X1
20X1
LIABILITIES C
Non-current Liabilities
- Deferred tax: income tax 7 000
252 Chapter 6

Entity name
For the year ended ……20X1
20X1
Income taxation expense 22 000
- Current 15 000
- Deferred 7 000
Example 2B: Reversing a deferred tax liability

Use the same information as that given in example 2A as well as the following additional
information:
20X1
the estimated current tax charge by the tax authorities (i.e. based on tax legislation) was
C10 000,
the tax incurred estimated by the accountant (i.e. based on IFRSs): C12 000.
20X2:
the estimated current tax charge by the tax authorities (i.e. based on tax legislation):
C14 000,
the tax incurred estimated by the accountant (i.e. based on IFRSs): C12 000.
Solution 2B: Reversing a deferred tax liability

Comment: The deferred tax liability of C2 000 raised in 20X1 (a non-current liability) will have to be
reversed out in 20X2 since the amount will now form part of the current tax payable liability instead (a
current liability).
Income tax (E) Current tax payable: income tax
CTP: NT (1) 14 000 DT (2) 2 000 Tax (1) 14 000
Total 12 000

Tax (2) 2 000 Balance b/f 2 000
Comments
(1) recording the current tax (charged by the tax authority)
(2) recording the reversal of the deferred tax in the second year.

Entity name
For the year ended …..20X2
20X2 20X1
C C
Income tax expense (current tax and deferred tax) 3. (12 000) (12 000)
Profit for the year xxx xxx
Chapter 6 253

Entity name
As at ……..20X2
20X2 20X1
LIABILITIES C C
Non-current liabilities
- Deferred Tax 0 2 000
Entity name
20X2 20X1
- current 14 000 10 000
- deferred (2 000) 2 000
Comment: It can be seen that over the period of 2 years, the total current tax charged by the tax
authorities (10 000 + 14 000 = C24 000) is recognised as a tax expense in the accounting records:
the tax expense in 20X1 of C12 000, plus
the tax expense in 20X2 of C12 000.
1.4 Deferred tax balance versus the current tax payable balance
The deferred tax balance differs from current tax payable balance in the following ways:
the current tax payable account: reflects the amount currently owing to or by the tax
authorities, estimated based on tax legislation. This payable shows tax that has been
charged by the tax authorities and is thus presented as a current liability or asset; whereas
the deferred tax account: reflects the extra amount that will be owing in the future to or by
the tax authorities, estimated based on tax legislation. Since this tax is not currently owed
to or by the tax authorities, this account is presented as a non-current liability or asset.
A deferred tax adjustment will therefore not affect the current tax payable account.
2. Measurement of Deferred Tax: The Two Methods
2.1 Overview
Deferred tax is measured using the relevant tax rates. The tax rate to be used is explained in
section 3. Although deferred tax is always considered to be a non-current liability (or asset),
IAS 12 expressly prohibits the discounting (present valuing) of these deferred tax balances.
There are two methods of measuring deferred tax: The income statement
the income statement approach; and and balance sheet
the balance sheet approach. approaches:
The previous version of IAS 12 referred to the income Income statement approach:
statement approach. This method required that deferred tax DT adj = (Accounting profits –
Taxable profits) x tax rate
be measured based on the difference between:
accounting profits, and Balance sheet approach:
taxable profits. DT bal = (Carrying amount – Tax
base) x tax rate.
The latest version of IAS 12 refers only to the balance sheet The DT adjustment and balances
approach. This method requires deferred tax to be measured will be the same for both
based on the difference between: approaches.
the carrying amount of the assets and liabilities, and
the tax base of each of the assets and liabilities.
254 Chapter 6
Although the method used will not alter the final answer in any way, you are generally
required to present your workings and discussions using the balance sheet method.
The income statement method is still explained here since it is considered helpful in
understanding that the concept of deferred tax is simply a product of the accrual basis.
Furthermore, to know how to calculate the deferred tax using the ‘income statement
approach’ enables you to check your ‘balance sheet approach’ calculations.
2.2 The income statement approach
Remember the essence that you learned from Chapter 5:

the accountant calculates accounting profits in terms of IFRS; whereas
The tax authorities calculate taxable profit by applying tax legislation.
In order for the accountant to calculate the estimated current tax for the year, he converts his
accounting profits into taxable profits. This is done as follows:
Conversion of accounting profits into taxable profits: C
Profit before tax (accounting profits) A
Adjusted for differences that are non-temporary (i.e. permanent) in nature: xxx
- less exempt income (e.g. certain capital profits and dividend income) (xxx)
- add non-deductible expenses (e.g. certain donations and fines) xxx
Accounting profits that are taxable (B x 30% = tax expense incurred) B
Adjusted for movements in temporary differences: xxx
- add depreciation xxx
- less depreciation for tax purposes (e.g. wear and tear) (xxx)
- add income received in advance (closing balance): if taxed when received xxx
- less income received in advance (opening balance): if taxed when received (xxx)
- less expenses prepaid (closing balance): if deductible when paid (xxx)
- add expenses prepaid (opening balance): if deductible when paid xxx
- add provisions (closing balance): if deductible when paid xxx
- less provisions (opening balance): if deductible when paid (xxx)
Taxable profits (C x 30% = current tax charge) C
As can be seen from the calculation above, the difference between accounting profits and
taxable profits may be classified into two main types:
temporary differences; and
non-temporary differences (i.e. differences that are permanent in nature).

Accounting Profits (A) = Profit before tax

Exempt income/ non-
+/-
deductible expenses
Taxable Accounting profits Portion of the accounting Tax
(B) = profits that are fully taxable X 30% = Expense
although not necessarily now
Deferred tax
+/- Temporary differences X 30% =
expense/ income
Taxable Profits (C) = Profits that are taxable now, Current tax
X 30% =
based on tax laws expense
The difference between accounting profits (A) and the taxable accounting profits (B) include
those differences that will never reverse (e.g. income that is included in the accounting profit
but that will never be taxed and expenses that are included in accounting profit but that will
never be deducted). These are called non-temporary differences (i.e. permanent differences).
Chapter 6 255
The difference between taxable accounting profits (B above) and taxable profits (C above) is
caused by the movement in temporary differences. This movement relates to timing issues,
e.g. when income is taxed versus when it is recognised in the accounting records.
A deferred tax adjustment is made for the movement relating to temporary differences only.
Example 3A: Income received in advance (income statement approach)
A company receives rent income of C10 000 in 20X1 that relates to rent earned in 20X2 and
then receives C110 000 in rent income in 20X2 (all of which was earned in 20X2). The
company has no other income. The tax authority taxes income on the earlier of receipt or
earning.
Required: Calculate, for 20X1 and 20X2, the current tax expense, the deferred tax adjustment and the
tax expense to appear in the statement of comprehensive income and show the related ledger accounts.
Solution 3A: Income received in advance (income statement approach)

W1. Current income tax calculation 20X1 20X2
Profits Tax at Profits Tax at
30% 30%
Profit before tax (accounting profits) (1) (6)
0 120 000
Adjusted for exempt income and non-deductible expenses: 0 0
Taxable accounting profits and tax expense (3) (9) 0 0 120 000 36 000
Adjusted for movement in temporary differences: (5) (10) 10 000 3 000 (10 000) (3 000)
add income received in advance (c/balance): taxed now (2) 10 000 0
less income received in advance (o/bal): previously taxed (7) (0) (10 000)
Taxable profits and current income tax (4) (8)

10 000 3 000 110 000 33 000
Comment: Since the C10 000 received in 20X1 is not recognised as income in 20X1, it does not make
sense to recognise the related current tax expense of C3 000 in 20X1. It makes more sense to recognise
this C3 000 tax expense when the related income is recognised (the C10 000 is recognised as income in
20X2). Thus the recognition of this current tax (C3 000) is deferred to 20X2.
(1) 20X1: The receipt in 20X1 is not yet earned and is thus not recognised as income but as a liability.
(2) 20X1: The income is taxed by the tax authority on the earlier date of receipt or earning: the
amount is received in 20X1 and earned in 20X2 and is therefore taxed in 20X1 (the earlier date).
(3) 20X1: The tax that appears on the face of the statement of comprehensive income is zero since it
reflects the tax owing on the income earned. Since no income has been earned, no tax is reflected.
(4) 20X1: The difference between the current tax charged (3 000) and the tax expense (0) is the
deferred tax adjustment, deferring the current tax to another period.
(5) 20X1: Notice that the deferred tax account has a debit balance at the end of 20X1 and is thus an
asset: tax has been charged in 20X1 for taxes that will only be incurred in 20X2. We are
effectively being forced to prepay our taxes, so it may help you to understand this debit by
likening it to an expense prepaid asset.
(6) 20X2: The income in 20X2 includes the C10 000 received in 20X1 since it is earned in 20X2.
Thus income earned in 20X2 = 110 000 received in 20X2 + 10 000 received in 20X1 = 120 000
(7) 20X2: The income received in advance in 20X1 is reversed and recognised as income in 20X2
since it is earned in 20X2.
(8) 20X2: Notice that the tax authority charges current tax in 20X2 on just the C110 000 received
since the balance of C10 000 was received and taxed in an earlier year.
(9) 20X2: The accountant believes that the C36 000 tax should be expensed in 20X2 (together with
the related income of C120 000).
(10) 20X2: This requires that the C33 000 current tax recorded in the books in 20X2 be adjusted to
include the tax of C3 000 that was charged in 20X1 but not recognised in 20X1. This results in a
reversal of the deferred tax balance of C3 000 brought forward from 20X1.
256 Chapter 6

Bank (A) Rent received in advance (L)
RRIA (1) 10 000 Bank (1) 10 000

CTP: NT (2) 3 000 DT (4) 3 000 Tax (2) 3 000
Total b/f (3) 0

Tax (4 & 5) 3 000

Bank Rent received in advance (L)
Rent inc. 110 000 Balance b/f 10 000
Rent (6) 10 000
10 000 10 000
Balance b/f 0

CTP:NT (8) 33 000 Balance b/f 3 000
DT (10) 3 000 Tax (8) 33 000
Total (9) 36 000
Deferred tax: income tax (A) Rent (I)

Balance b/f 3 000 Tax (10) 3 000 RRIA (7) 10 000
Bank 110 000
Total (6) 120 000
For an explanation of the debits and credits, refer to the numbered explanations above.
2.3 The balance sheet approach
The income statement approach involved calculating Temporary differences are

the deferred tax adjustment. This adjustment is made to defined as:
the deferred tax opening balance to obtain the closing differences between
balance. The balance sheet approach, on the other an asset’s or a liability’s:
hand, is the method whereby we first calculate both the - carrying amount; and
opening and closing deferred tax balances; and then - tax base. IAS 12.5 reworded
balance back to the deferred tax adjustment (i.e. we calculate the adjustment by comparing
the opening deferred tax balance with the closing deferred tax balance).
The idea behind the balance sheet approach is that the Taxable temporary
deferred tax balance (asset or liability) represents the differences are defined as:
expected future tax payable or receivable on the those that will result in
expected future transactions that have already been taxable amounts
recognised in the financial statements. The expected in determining taxable profit (tax loss)
future transactions that have already been recognised are of future periods
when the CA of the asset or liability is
reflected in the assets and liabilities in our statement of recovered or settled. IAS 12.5
financial position:
assets represent the expected future inflow of economic benefits, or future income, and
liabilities represent the expected future outflow of economic benefits, or future expenses.
Chapter 6 257
Let us consider a couple of examples: Deductible temporary

the carrying amount of plant (an asset) represents differences are defined as:
future income from future transactions involving the those that will result in
plant (inflow of future economic benefits); and amounts that are deductible
in determining taxable profit (tax loss)
the carrying amount of a loan represents the future of future periods
costs from future transactions involving the loan when the CA of the asset or liability is
(outflow of future economic benefits). recovered or settled. IAS 12.5
It surely makes sense that if we have already recognised the expected future income (assets)
and future expenses (liabilities), that we also recognise the expected future tax (deferred tax)
on the future profit or loss (future income less future expenses).
If the future income exceeds the future expenses, we have an expected future profit and thus
there would be a future tax payable (deferred tax liability). Conversely, if the future expenses
exceeded the future income, we have an expected future loss and thus there would be a future
tax saving (deferred tax asset).
Tax base is defined as:
This balance sheet approach thus requires that we
compare the carrying amount of each of the assets and the amount attributed to that A or L
liabilities with its tax base: for tax purposes. IAS 12.6
The carrying amount of an asset or liability is the balance recognised in the statement of
financial position based on International Financial Reporting Standards;
The tax base of an asset or liability is its balance calculated based on the tax legislation.
The definition of a tax base of an asset (see pop-up) The tax base of an asset is
refers to two types of assets: an asset that represents an defined as:
future inflow of economic benefits that will be taxable the amount that will be deductible for
and an asset that represents a future inflow of economic tax purposes
benefits that will not be taxable. Simply speaking: against any taxable economic benefits
that will flow to an entity
If the inflow will be taxable (e.g. a plant earning
when it recovers the CA of the asset.
taxable profits), the tax base is the future deductions.
If the inflow will not be taxable (e.g. an investment If those economic benefits
earning exempt dividend income), the tax base will will not be taxable,
be its carrying amount. the TB of the A is its CA. IAS 12.7 Reworded
The definition of a tax base of a liability (see pop-up) The tax base of a liability is
refers to two types of liabilities: liabilities that represent defined as:
income received in advance and other liabilities (i.e. its carrying amount,
those that represent expenses). Simply speaking,: less any amount that will be deductible
if the liability is income received in advance, for tax purposes
- in respect of that liability
the tax base will be its carrying amount less the
- in future periods.
portion that won’t be taxable in the future (i.e. the
portion of the carrying amount that will be taxed in If the L is income received in advance,
the future); the tax base of the resulting liability is:
its carrying amount,
in the case of any other liability, less any of the revenue that will not be
the tax base will be its carrying amount less any taxable in future periods. IAS 12.8 Reworded
portion that represents future deductions (i.e. the portion of the carrying amount that will
not be allowed as a tax deduction in the future).
Thus, in summary:
The difference between the carrying amount and tax base is called a temporary difference.
Temporary differences multiplied by the tax rate give us the deferred tax balance (SOFP).
The difference between the opening and closing deferred tax balance in the statement of
financial position will give you: the deferred tax journal adjustment (SOCI).
258 Chapter 6
Carrying amount: Tax base:

Temporary difference X 30% =
Deferred tax balance: beginning of year
Opening balance Opening balance
Movement:
DT journal
adjustment
Carrying amount: Tax base:

Temporary difference X 30% =
Deferred tax balance: end of year
Closing balance Closing balance
A useful format for calculating deferred tax using the balance sheet approach is as follows:
Carrying Tax base Temporary Deferred Deferred
amount (per IAS difference tax tax
(SOFP) 12) (b) – (a) (c) x 30% balance/
(a) (b) (c) (d) adjustment
Opening balances X A/ L
Movement: deferred tax adjustment Dr Tax: SOCI
Dr/ Cr: DT asset/ liability; and X Cr DT: SOFP
Cr/Dr: Tax income/ expense Or vice versa
Closing balances X A/ L
Example 3B: Income received in advance (balance sheet approach)

A company receives rent income of C10 000 in 20X1 that relates to rent earned in 20X2 and
then receives C110 000 in rent income in 20X2 (all of which was earned in 20X2).
The company has no other income.
The tax authority taxes income on the earlier of receipt or earning (i.e. same info as 3A).
Required: Calculate the deferred income tax adjustment using the balance sheet approach for both years.
Solution 3B: Income received in advance (balance sheet approach)

Comment: The carrying amounts are the same as those in the statement of financial position. You now
need to calculate the tax bases. To calculate the tax bases you need to know the rules per IAS 12.
W1. Calculation of deferred income tax (balance sheet approach):
Income received in advance Carrying Tax base Temporary Deferred Def tax
amount difference tax at 30% balance/
(SOFP) (IAS 12) (b) – (a) (c) x 30% adj
(a) (b) (c) (d)
Opening balance – 20X1 0 0 0 0
(3)
Deferred tax adj. – 20X1 (10 000) 0 10 000 3 000 Dr DT
(balancing: movement) Cr TE
Closing balance – 20X1 (1) (10 000) 0 10 000 3 000 Asset (2)
(5)
Deferred tax adj. – 20X2 10 000 0 (10 000) (3 000) Cr DT
(balancing: movement) Dr TE
Closing balance – 20X2 (4) (6)
0 0 0 0
Notes:
1) During 20X1, the C10 000 rent is received in advance.
The accountant treats this as a liability whereas the tax authority treats it as income. Thus the
accountant reflects an income received in advance account (L) with a carrying amount of C10 000.
Since the tax authority treats it as income, it will have no such liability, and thus the tax base is zero.
This results in a temporary difference of C10 000 and therefore a deferred tax balance of C3 000.
Chapter 6 259

2) The tax base of a liability that represents income received in advance is that portion of the liability
that will be taxed in the future. As the tax authority taxes the income now (upon receipt, which in
this example, is earlier than earning), there will be no future tax payable. Hence, the tax base is nil.
The difference between the carrying amount and the tax base represents the portion of the liability
that won’t be taxed in the future with the result that the deferred tax balance is an asset to the
company: the tax that has been ‘prepaid’.
3) The deferred tax adjustment in 20X1 will be a credit to the statement of comprehensive income.
4) During 20X2, the C10 000 rent that was received in advance in 20X1 is now recognised as income
(the accountant will debit the liability and credit income) with the result that the accountant’s
liability reverses out to zero. As mentioned above, the tax authority had no such liability since he
treated the receipt as income in 20X1. The carrying amount and the tax base are now both zero,
with the result that the temporary difference is now zero and the deferred tax is zero.
5) The deferred tax adjustment in 20X2 is a debit to the statement of comprehensive income.
6) The carrying amount is zero since the income was earned in 20X2 so the balance on the liability
account was reversed out to income
W2. Calculation of the tax base (revenue received in advance – a liability): 20X1 and 20X2
20X1 20X2
Carrying amount at year end 10 000 0
Less that which won’t be taxed in the future (10 000) (0)
(20X1: all 10 000 won’t be taxed in future because all of it is taxed in 20X1)
(20X2: not applicable since there is no carrying amount to consider)
This means that there will be no related current tax charge in the future. 0 0
W2.1 Tax base rule for a liability: revenue received in advance (per IAS 12):
The tax base of revenue received in advance is the carrying amount of the liability less the portion
representing income that will not be taxable in future periods.
Example 3C: Income received in advance (journals)

Current income tax is (see current income tax calculation in example 3A for workings):
20X1: 3 000 and 20X2: 33 000.
Required: Show the tax journals using the above and the deferred tax calculation done in example 3B.
Solution 3C: Income received in advance (journals)

20X1 Debit Credit
Income tax expense (SOCI) 3 000
Current tax payable per tax law (see calculation in Example 3A)
Deferred tax: income tax (SOFP) 3 000
Deferred tax adjustment (see calculation in Example 3B)
20X2
Current tax payable per tax law (see calculation in Example 3A)
Deferred tax adjustment (see calculation in Example 3B)
260 Chapter 6
Example 3D: Income received in advance (disclosure)

Current income tax expense is (see current income tax calculation in example 3A):
20X1: 3 000 (this was paid in 20X2) and 20X2: 33 000 (this was paid in 20X3)
Deferred tax balances are (see journal in example 3A or 3B for the deferred tax table)
20X1 opening balance: nil;
20X1 closing balance: 3 000 (debit) and
20X2 closing balance: nil.
Required: Calculate the deferred income tax adjustment using the balance sheet approach for both
years.
Solution 3D: Income received in advance (disclosure)
Company name
ASSETS Note 20X2 20X1
Non-Current Assets C C
Deferred tax: income tax 6 0 3 000
LIABILITIES
Current Liabilities
Current tax payable: income tax 33 000 3 000
Income received in advance 0 10 000
Company name
Note 20X2 20X1
C C
Profit before taxation 120 000 0
Income tax expense 15 (36 000) (0)
Profit for the year 84 000 0
Total comprehensive income 84 000 0
Company name
20X2 20X1
6. Deferred tax asset C C
The closing balance is constituted by the effects of:
Year-end accruals 0 3 000
15. Income tax expense
Income taxation 36 000 0
Current 33 000 3 000
Deferred 3 000 (3 000)
Tax expense per the statement of comprehensive income 36 000 0
Comment: It can be seen that the deferred tax expense has a zero effect on profits over the two years:
3 000 – 3 000 = 0
3. Measurement: Enacted Tax Rates Versus Substantively Enacted Tax Rates
The measurement of current tax and deferred tax is essentially the same: they are both
measured at the amount we expect to pay (or recover from) the tax authorities. See IAS 12.46 -.47
Chapter 6 261
The current income tax is the estimated tax that will be charged for the current period:
the current period’s taxable profits (current year Deferred tax assets or
transactions per the tax legislation); liabilities are measured at:
multiplied by the tax rates that we expect will be tax rates that are expected to
applied by the tax authorities. apply to the period when
the A is realised or the L settled;
The measurement of deferred tax differs only in that is based on tax rates (& tax laws)
the estimated future tax payable/ receivable. Deferred tax that are
relates to the estimate of the future tax on future - enacted at reporting date, or
transactions (i.e. future taxable income and future tax - substantively enacted at
deductions) or in other words, the future tax expected on reporting date. IAS 12.47 Reworded
the future recovery of assets and settlement of liabilities.
Current tax and deferred tax are both measured at the amount we expect to pay (or recover
from) the tax authorities. Thus, if there is an enacted rate at year end that the government
proposes to change, we measure the current tax or deferred tax, using the:
enacted tax rate at the reporting date, or the
proposed new rate, if it has been substantively enacted by reporting date. Re-worded IAS 12.46-47
In other words, if there is an announcement proposing to change the tax rate currently enacted
at reporting date, we will generally measure our current tax using the rate currently enacted at
reporting period (if this is the rate that we expect the tax authorities will use to tax our current
taxable profits) but will often measure our deferred tax, because it relates to the future, using
the proposed new rate if it is probably the rate that will be used by the tax authorities when
the taxable income or tax deductions arise. We assume this will be the case if the proposed
new rate is substantively enacted by reporting date.
A substantively enacted
Professional judgement is needed when deciding if a rate tax rate that has an
effective date that won’t
that has been proposed (i.e. announced but not enacted) affect the current tax assessment but
on or before reporting date, is substantively enacted by will affect future assessments,
reporting date. We will need to consider all circumstances the current tax payable will be
around the proposal. See chapter 5, section B: 3.2 for an measured using the enacted rate,
example. In South Africa, it is commonly held that a new whereas
the deferred tax liability (or
rate is considered to be substantively enacted on the date asset) will be measured using the
it is announced in the Minister of Finance’s Budget substantively enacted tax rate.
Speech. But if this new rate is inextricably linked to other
tax laws, it is only substantively enacted when it has not only been announced by the Minister
of Finance, but also been signed into statute by the President, as evidence of his approval of
the change.
If the new rate is enacted after the reporting date but had not already been substantively
enacted by reporting date, then our deferred tax balance at reporting date must remain
measured using the old rate (i.e. the rate that was currently enacted at reporting date).
This is interesting because a new tax rate that is enacted after the reporting period means that
we now know that our taxes payable in the future will no longer be based on the old rate.
However, the deferred tax balance at reporting date must not be adjusted to reflect the new
rate because a change in tax rate in the period after reporting period but before publication of
the financial statements is what is referred to as a non-adjusting event.
To compensate for the problem of not being allowed to adjust our deferred tax balances to
reflect this newly enacted rate, our notes disclose the new rate and the effect that the change
in tax rate will have on our deferred tax balances if we think that this information would be
useful to our users. See IAS 10.21
At time of writing, the currently enacted tax rate in South Africa was 28% for most
companies and no new tax rates had been proposed. For sake of ease of calculation, however,
we will use 30% as the income tax rate.
262 Chapter 6
Example 4: Enacted and substantively enacted tax rates

A change in the income tax rate from 30% to 29% is announced on 20 January 20X1.
No significant changes were announced to other forms of tax.
The new tax rate will apply to tax assessments ending on or after 1 March 20X1.
The new tax rate was enacted on 21 April 20X1.
Required:
State at what rate the current and deferred tax balances should be calculated assuming:
A. The company’s year of assessment ends on 31 December 20X0.
B. The company’s year of assessment ends on 28 February 20X1.
C. The company’s year of assessment ends on or after 31 March 20X1.
Solution 4: Enacted and substantively enacted tax rates
Tax rates to be used in measuring the Ex 4: A Ex 4: B Ex 4: C

following balances: Year end: Year end: Year end:
31 December 20X0 28 February 20X1 31 March 20X1
Current tax payable/ receivable 30% 30% 29%
Deferred tax liability/ asset 30% 29% 29%
Comments in general:
The date of substantive enactment is 20 January 20X1 (no significant changes to other taxes were
announced at the time).
The effective date is 1 March 20X1.
Whilst current tax is to be measured using the enacted or substantively enacted tax rate at reporting
date, the over-riding rule is that it must be ‘measured at the amount expected to be paid to
(recovered from) the taxation authorities’.
We must use the tax rates that apply or are expected to apply to the current period transactions and
must therefore take cognisance of the effective date of any new rates. When measuring current
tax, we will normally use the enacted tax rates.
Whilst deferred tax is also to be measured using the enacted or substantively enacted tax rate at
reporting date, the over-riding rule is that it must be ‘measured at the tax rates that are expected to
apply to the period when the asset is realised or the liability is settled’. We must use the tax rates
that are expected to apply to the future period transactions and must therefore take special notice of
substantively enacted tax rates but still take cognisance of the effective date of these new rates.
When measuring deferred tax, we will normally use the substantively enacted tax rates.
Explanations for each part (A, B and C):
A. The new tax rate is not enacted at reporting date (enacted on 21 April 20X1) and it is not even
substantively enacted at reporting date (substantively enacted on 20 January 20X1).
Thus the current tax payable/ receivable balance will remain measured on the old rate (being the
currently enacted tax rate).
The deferred tax balance will also remain measured on the old rate (the currently enacted tax
rate). A note disclosing the fact that a new rate will apply to the deferred tax balances in future
and showing the expected amount of the reduction in the balances should be included (this is
referred to as a ‘non-adjusting event after the reporting event’).
B. The new tax rate is not enacted at reporting date (enacted on 21 April 20X1) but it is substantively
enacted at reporting date (substantively enacted on 20 January 20X1).
The current tax payable will be based on the old rate (being the currently enacted tax rate at
reporting date), since although the new rate was substantively enacted before reporting date, it
was not also effective before reporting date (the over-riding rule is that current tax is to be
‘measured at the amount expected to be paid to the taxation authorities’).
The deferred tax balance will be based on the new rate since the new rate was substantively
enacted before reporting date.
Chapter 6 263
Solution 4: Continued ...

C. The new tax rate is not enacted at reporting date (enacted on 21 April 20X1) but it is substantively
enacted at reporting date (substantively enacted on 20 January 20X1).
The current tax payable is to be measured using the substantively enacted tax rate because the
effective date thereof (tax assessments ending on or after 1 March 20X1) was before reporting
date which means that this new rate will be apply to the current year taxable profits. The current
tax payable will thus be based on the new rate, since the new rate was substantively enacted and
effective before reporting date.
The deferred tax balance will be based on the new rate since the new rate was substantively
enacted before reporting date.
4. Deferred Tax Caused By Year-End Accruals and Provisions
4.1 Overview
There are five potential balances in the statement of financial position that result directly from
the use of the accrual system, each of which can cause deferred tax:
income received in advance;
expenses prepaid;
expenses payable;
provisions; and
income receivable.
Income received in advance has already been covered in example 3 above. The deferred tax
effect of each of the remaining four examples will now be discussed. Since IAS 12 refers only
to the use of the balance sheet approach, this is now the only approach shown from now.
4.2 Expenses prepaid
An expense prepaid is an asset and thus, when we

Tax base of an asset –the
measure its tax base, we apply the definition of the tax essence of the definition is:
base of an asset (the essence of this definition is in the
pop-up alongside). If the asset’s FEB are taxable the:
TB = future deductions
Remember that, although the tax authority normally If the asset’s FEB are not taxable, the
allows a deduction of expenses when the expenses are TB = CA See IAS 12.7
incurred, he may allow a deduction of a prepaid expense (i.e. an expense that has been paid
but not yet incurred) depending on criteria in the tax legislation. If this happens, deferred tax
will result.
Example 5: Expenses prepaid

Profit before tax is C20 000 in 20X1 and in 20X2, according to the accountant and the tax
authority, before taking into account the following information:
An amount of C8 000 in respect of electricity for January 20X2 is paid in December 20X1.
The tax authority allows the full payment as a deduction against taxable profits in 20X1.
The company paid the current tax owing to the tax authorities for 20X1, in 20X2.
There are no differences between accounting profit and taxable profit other than those that
may be evident from the information provided and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax for 20X1 and 20X2 using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the related journal entries in ledger account format.
D. Disclose the tax adjustments for the 20X2 financial year.
264 Chapter 6
Solution 5A: Expenses prepaid (deferred tax)
Expenses prepaid Carrying Tax Temporary Deferred Deferred tax

amount base difference tax at 30% balance/
(per SOFP) (IAS 12) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)
Opening balance: 20X1 0 0 0 0
Movement (balancing) 8 000 0 (8 000) (2 400) Cr DT; Dr TE (3)
Closing balance: 20X1 (1) 8 000 0 (8 000) (2 400) Liability (2)
Movement (balancing) (8 000) 0 8 000 2 400 Dr DT; Cr TE (5)
Closing balance: 20X2 0 0 0 0
(4)
Notes: For an explanation of the amounts above (notes 1 – 5), see at the end of solution to example 5C.
W2. Calculation of the tax base (expenses prepaid – an asset):

20X1 20X2
i.e. applying the definition of a tax base of an asset that represents an C C
expense
Carrying amount 8 000 0

(1) (2)
Less amount that won’t be deducted for tax purposes in the future (8 000) 0
Amount that will be deducted from taxable profits in the future 0 0
Notes:
1) 20X1: The C8 000 will not be deducted in the future since it is all deducted in 20X1
2) 20X2: There is no adjustment to the carrying amount since there is no carrying amount: the
carrying amount is now zero since the expense was incurred in 20X2 with the asset balance
transferred to an expense account (see journal 4 in the 20X2 ledger accounts below).
Solution 5B: Expenses prepaid (current tax)
W3. Calculation of current income tax: 20X1 20X2

Profits Tax at 30% Profits Tax at 30%
Profit before tax (accounting profits) 20 000 12 000
Adjust: exempt income/ non-deductible expenses: 0 0
Taxable accounting profits and tax expense 20 000 12 000
Adjust: movement in temporary differences: (8 000) (3) 8 000 (5)
Add expense prepaid (o/bal): deducted in 20X1 0 8 000
Less expense prepaid (c/bal): deductible in 20X1 (8 000) (0)
(6) (7)
Taxable profits and current income tax 12 000 3 600 20 000 6 000
Explanation:
For an explanation of the amounts above (notes 3, 5, 6 & 7), see notes at the end of solution 5C.
Comments:
20X1: The tax authority allows the prepayment of C8 000 as a deduction in 20X1 (20 000 – 8 000
= 12 000 taxable profit), but the accountant recognises the C8 000 as a prepaid expense, an asset,
not an expense, (20 000 – 0 = 20 000 profit before tax). This causes a temporary difference.
20X2: The accountant recognises (deducts) the C8 000 as an expense in 20X2 since this is when it
is incurred (20 000 – 12 000 = 8 000 profit before tax) but the tax authority, having already
allowed the C8 000 as a deduction in 20X1, will not deduct it again in 20X2, (20 000 – 0 = 20 000
taxable profit). The temporary difference in 20X2 reverses the temporary difference in 20X1.
Chapter 6 265
Solution 5C: Expenses prepaid (ledger accounts)
Comment:
It can be seen that over the 2 years:
the accountant recognises tax expense of C9 600 (6 000 + 3 600) as incurred; and this equals
the actual tax charged by the tax authority over the 2 years is C9 600 (3 600 + 6 000).
The difference relates purely to when the tax is incurred versus when the tax is charged, thus the
difference reverses out once the tax has both been charged and incurred (see the zero deferred tax
balance at the end of 20X2).
Bank (A) Expenses prepaid (A)

Exp Prepaid(1) 8 000 Bank (1)
8 000

CTP: NT(6) 3 600 Tax (6) 3 600
DT (2&3) 2 400
Total 6 000

Tax (2&3) 2 400
Electricity and water Expenses prepaid (A)

EP(4) 8 000 Balance b/f 8 000 E&W (4) 8 000

CTP: NT(7) 6 000 DT (5) 2 400 Bank (8) 3 600 Balance 3 600
_____ Total c/f 3 600 Tax (7) 6 000
6 000 6 000
Total b/f 3 600
Deferred tax: income tax (L) Bank(A)

Tax (5) 2 400 Balance b/d 2 400 CTP: NT (8) 3 600
Notes:
1) The accountant treats the payment as an asset since the expense has not yet been incurred whereas
the tax authority treats the payment as an expense and therefore has no asset account.
2) This represents a deferred tax liability since it represents a premature tax saving (i.e. much like
income received in advance which we recognise as a liability instead of as income). The tax
saving is considered to be premature because we are granted the tax deduction and thus receive the
tax saving before the related electricity expense is incurred.
3) In order to create a deferred tax credit balance, the deferred tax liability must be credited and the
tax expense debited.
4) The expense is incurred in 20X2, so the expense prepaid (asset) is reversed out to electricity
expense (reducing profits). Now both accountant and tax authority have zero balances on the
expense prepaid (asset) account and so there is no longer a temporary difference and thus a zero
deferred tax balance.
266 Chapter 6
Solution 5C: Continued ...

5) In order to adjust a deferred tax credit balance to a zero balance, the liability must be debited and
the tax expense credited.
6) Current tax charged by the tax authority in 20X1.
7) Current tax charged by the tax authority in 20X2.
8) Payment of the balance owing to the tax authority for 20X1 (the prior year).
Solution 5D: Expenses prepaid (disclosure)

Company name
Note 20X2 20X1
C C
ASSETS
Current assets
Expense prepaid 0 8 000
LIABILITIES
Current liabilities
Company name
Note 20X2 20X1

C C
Profit before taxation 20X2: 20 000 – 8 000 12 000 20 000
Company name
20X2 20X1
C C
6. Deferred tax asset/ (liability)
Year-end accruals 0 (2 400)

Income taxation 3 600 6 000
current 6 000 3 600
deferred (2 400) 2 400
Tax expense per the statement of comprehensive income 3 600 6 000
Comment: Note the deferred tax effect on profits is nil over the period of two years (2 400 – 2 400)
Chapter 6 267
4.3 Expenses payable Tax base of a liability –

the essence of the
An expense payable is a liability and thus, when we definition is: See IAS 12.8
measure its tax base, we apply the definition of the tax If the L represents expenses:
base of a liability (the essence of this definition is in the TB = (CA – future deductions)
pop-up alongside). This is an example of a liability that
If the L represents income received in
represents expenses (as opposed to a liability that advance:
represents income). TB = (CA – non-taxable portion)
The tax authority generally allows expenses to be deducted when they have been incurred
irrespective of whether or not the amount incurred has been paid. This is the accrual system
and therefore there will be no deferred tax on an expense payable balance.
Example 6: Expenses payable

A telephone expense of C4 000, incurred in 20X1, is paid in 20X2.
The tax authority will allow the full expense to be deducted in 20X1.
The current tax owing to the tax authorities is paid in the year after it is charged.
There are no other temporary differences, no exempt income and no non-deductible
expenses and no taxes other than income tax at 30%.
There are no components of other comprehensive income
Required:
A. Calculate the deferred income tax for 20X1 and 20X2 using the balance sheet approach.
C. Show the related journal entries in ledger account format.
D. Disclose the tax adjustments for the 20X2 financial year.
Solution 6A: Expenses payable (deferred tax)

Carrying Tax Temporary Deferred tax Deferred
amount base difference at 30% tax balance/
Expenses payable
(a) (b) (c) (d)
Opening balance: 20X1 0 0 0 0 N/A
Movement (balancing) (4 000) (4 000) 0 0 N/A
Closing balance: 20X1 (3) (4 000) (4 000) 0 0 N/A
Movement (balancing) 4 000 4 000 0 0 N/A
Closing balance: 20X2(7) 0 0 0 0 N/A
Notes:
For an explanation of the amounts above (notes 3 & 7), see the notes at the end of solution 6C.
W2. Calculation of the tax base (expenses payable – a liability): 20X1 20X2
i.e. apply the definition of a tax base of a liability that represents an expense C C
(1) (2)
Less deductible in the future 0 0
4 000 0
Notes:
1) 20X1: None of the C4 000 will be deducted in the future since it is deducted in 20X1 (as an
incurred expense)
2) 20X2: There is no adjustment to the carrying amount since there is no carrying amount: the
carrying amount will now be zero since the expense was paid in 20X2 with the balance on the
liability account therefore being reversed.
268 Chapter 6
Solution 6B: Expenses payable (current tax)

Profit before tax (accounting profits) (1) (4) 16 000 20 000
(20 000 – 4 000) and (20 000 – 0)
Exempt income and non-deductible expenses: 0 0
Taxable accounting profits and tax expense 16 000 4 800 20 000 6 000
Movement in temporary differences: (3) (3) 0 0 0 0
Taxable profits and current income tax (2) (5) 16 000 4 800 20 000 6 000
Notes:
For an explanation of the amounts above (notes 1 – 5), see the notes at the end of solution 6C.
Comments:
20X1: The tax authority allows the expense of C4 000 as a deduction in 20X1 (20 000 – 4 000 =
16 000 taxable profit), and the accountant recognises the C4 000 as an incurred expense, (20 000 – 4
000 = 16 000 profit before tax). There is therefore no difference and therefore no deferred tax.
20X2: The accountant recognised (deducted) the C4 000 as an expense in 20X1 and therefore there
is no expense in 20X2 (20 000 – 0 = 20 000 profit before tax), and the tax authority, having also
already allowed the C4 000 as a deduction in 20X1, will not deduct it again in 20X2, (20 000 – 0 =
20 000 taxable profit). There is therefore no difference and therefore no deferred tax.
Solution 6C: Expenses payable (ledger accounts)

Ledger accounts - 20X1
Telephone (E) Expenses payable (L)
EP(1) 4 000 Tel (1) 4 000

(2&3)
CTP: NT 4 800 Tax (2) 4 800
Ledger accounts – 20X2

Bank Expenses payable (L)
EP(4) 4 000 Bank(4) 4 000 Balance b/f 4 000
CTP: NT (6) 4 800

CTP: NT(5) 6 000 Bank (6) 4 800 Balance 4 800
Tax (5) 6 000
Notes:
(1) The telephone expense is incurred but not paid in 20X1 and is thus recognised in 20X1 as an
expense (debit) and expense payable (credit).
(2) Current tax charged by the tax authority in 20X1.
(3) Since the accountant and tax authority both treat the expense payable as an expense in the
calculation of profits, there is no temporary difference and therefore no deferred tax adjustment.
(4) Although the telephone expense is paid in 20X2, there is no telephone expense in 20X2. The
payment of the expense in 20X2 simply results in the reversal of the expense payable account.
(5) Current tax charged by the tax authority in 20X2.
(6) The balance owing to the tax authority at the end of 20X1 is paid in 20X2.
(7) The carrying amount and tax base is nil, thus there is no deferred tax balance (See 6A: W1).
Chapter 6 269
Solution 6D: Expenses prepaid (disclosure)

Company name
Note 20X2 20X1
LIABILITIES C C
Current liabilities
Expense payable 0 4 000
Company name
Note 20X2 20X1
C C
Profit before taxation 20X1: 20 000 – 4 000 20 000 16 000
Company name
20X2 20X1
C C
current 6 000 4 800
deferred 0 0
Total tax expense per the statement of comprehensive 6 000 4 800

income
4.4 Provisions
A provision is a liability and thus, when we measure its Tax base of a liability –
tax base, we apply the definition of the tax base of a the essence of the
definition is: See IAS 12.8
liability (the essence of this definition is repeated
alongside). A provision is a liability that reflects expenses. If the L represents expenses:
TB = (CA – future deductions)
Although the tax authority generally allows expenses to
be deducted when they have been incurred, he often If the L represents income received
advance:
in
treats the deduction of provisions with more ‘suspicion’.

TB = (CA – non-taxable portion)
Thus, although the expense may have been incurred, the
tax authority may refuse to allow the expense provided for to be deducted until it is paid.
If this happens, a temporary difference will arise because the accountant has a liability
balance but the tax authority does not recognise the liability (in other words, the accountant
recognises an expense but the tax authority does not recognise the expense).
Example 7: Provisions
A provision for warranty costs of C4 000 is journalised in 20X1 and paid in 20X2.
The tax authority will allow the warranty costs to be deducted only once paid.
The current tax owing to the tax authority is paid in the year after it is charged.
There are no differences between accounting profit and taxable profit other than those
evident from the information provided and no taxes other than income tax at 30%.
270 Chapter 6
Required:
A. Calculate the deferred income tax using the balance sheet approach.
C. Show the related ledger accounts.
D. Disclose the above information.
Solution 7A: Provisions (deferred tax)
Calculation of deferred income tax (balance sheet approach):

Provision for warranty Carrying Tax Temporary Deferred Deferred tax
costs amount base difference tax at 30% balance/
(a) (b) (c) (d)
(3)
Movement (balancing) (4 000) 0 4 000 1 200 Dr DT; Cr TE
Closing balance – 20X1 (1) (4 000) 0 4 000 1 200 Asset
(2)
(6)
Movement (balancing) 4 000 0 (4 000) (1 200) Cr DT; Dr TE
Closing balance – 20X2 (5) 0 0 0 0
Explanation:
For an explanation of the amounts (notes 1 – 6), see at the end of Solution to example 7C.
Calculation of the tax base (provisions) 20X1 20X2
i.e. applying the definition of a tax base of a liability representing an expense C C
(1) (2)
Less deductible in the future (4 000) (0)
Tax base 0 0
Notes:
1) All will be deducted in the future (20X2) since the liability is a provision (something the tax authorities
consider to be ‘suspicious’ and therefore a liability/ expense that may only be deducted when paid)
2) All of the provision is deducted in 20X2 (therefore nothing further to deduct in the future) since the full
provision was paid for in 20X2. PS. The carrying amount will now be zero since the expense was paid
in 20X2 with the balance on the liability account being reversed.
Solution 7B: Provisions (current tax)

20X1 20X2
Calculation of current income tax: Profits Tax at 30%
Profit before tax (accounting profits) (1) 16 000 20 000
(20 000 – 4 000) and (20 000 – 0)
Movement in temporary differences: (3) (6) 4 000 1 200 (4 000) (1 200)
Less provision opening balance (0) (4 000)
Add provision closing balance 4 000 0
Taxable profits and current income tax (4) (4)
20 000 6 000 16 000 4 800
Notes: For an explanation of the amounts, see at the end of Solution to example 7C.
Comments:
20X1: The tax authority disallows the expense of C4 000 as a deduction in 20X1 (20 000 – 0 =
20 000 taxable profit), but the accountant recognises the C4 000 as an incurred expense, (20 000 –
4 000 = 16 000 profit before tax). There is thus a temporary difference and related deferred tax asset.
20X2: The accountant recognised (deducted) the C4 000 as an expense in 20X1 and therefore there
is no expense in 20X2 (20 000 – 0 = 20 000 profit before tax), but the tax authority allows the
C4 000 as a deduction in 20X2 since it is now paid, (20 000 – 4 000 = 16 000 taxable profit).
There is therefore a temporary difference and deferred tax. This deferred tax adjustment reverses
the deferred tax in 20X1
Chapter 6 271
Solution 7C: Provisions (ledger accounts)

Warranty costs (E) Provision for warranty costs (L)

Provision(1) 4 000 WC (1) 4 000

CTP: NT(4) 6 000 Def. Tax (3) 1 200 Tax (4) 6 000
Total c/f 4 800
6 000 6 000
Total b/f 4 800
Deferred tax: income tax (A) (2)

Taxation(3) 1 200
Bank Provision for warranty costs (L)

Provision(5) 4 000 Bank(5) 4 000 Balance b/f 4 000
CTP: NT (7) 6 000

CTP: NT(4) 4 800 Bank (7) 6 000 Balance b/f 6 000
Def. Tax (6) 1 200 Tax (4) 4 800
Total b/f 6 000

Balance b/f 1 200 Tax (6) 1 200
Notes:
1) Warranty costs of C4 000 are incurred but not paid in 20X1 and therefore an expense and expense
payable are recognised in 20X1 (reducing 20X1 profits). Although the accountant recognises the
C4 000 as an expense, the tax authority does not allow a deduction (therefore the accountant
recognises an expense and expense payable whilst the tax authority does not).
2) This represents a deferred tax asset since the expense (already incurred) will result in a future
reduction in taxable profits (a future tax saving).
3) In order to create a deferred tax asset, the deferred tax account is debited and the tax expense is
credited. Since the tax authority disallowed the deduction of the warranty costs in 20X1, the 20X1
current tax is greater than the tax expense incurred, thus requiring a deferral of tax to future years.
4) Current tax charged by the tax authority in 20X1 and 20X2.
5) The 20X2 payment of C4 000 reverses the provision and thus both the accountant and tax authority
have balances of zero in the liability account at the end of 20X2. When the balances are the same,
there are no temporary differences meaning that the deferred tax balance must be zero.
6) In order to reverse a deferred tax asset, it is necessary to credit deferred tax and debit tax expense.
7) Payment of the current tax for 20X1 in 20X2.
Solution 7D: Provisions (disclosure)

Company name
Note 20X2 20X1
Non-current assets C C
Current liabilities
Provision for warranty costs 0 4 000
272 Chapter 6
Solution 7D: Continued …

Company name
Note 20X2 20X1
C C
Profit before taxation (20X1: 20 000 – 4 000) 20 000 16 000
Company name
20X2 20X1
6. Deferred tax asset/ (liability) C C
Year-end accruals 0 1 200
current 4 800 6 000
deferred 1 200 (1 200)
Comment: Notice that the deferred tax effect on profits is nil over the two years (-1 200 +1 200).
4.5 Income receivable

Income receivable is an asset and thus, when we measure Tax base of an asset –the
its tax base, we apply the definition of the tax base of an essence of the definition is:
asset (the essence of this definition is in this pop-up).
If the asset’s FEB are taxable the:
Tax authorities generally tax income on the earlier of the TB = future deductions
date the income is earned or the date it is received. If the asset’s FEB are not taxable, the
Income receivable reflects income that has been earned TB = CA that is not taxable
but not yet received and thus will have been taxed by the tax authority (since it was earned).
Let’s apply the definition: the income receivable carrying amount reflects future inflows that
are no longer taxable (because they have already been taxed). Thus the tax base is measured
at its carrying amount. To calculate the portion of a carrying amount that represents future
benefits that are not taxable (which will then represent the tax base), we simply deduct from
the carrying amount the income that has already been taxed (i.e. TB = CA that is not taxable
= CA – portion of CA that will be taxed in the future = CA that won’t be taxed in future).
Since the tax base and carrying amount are equal, there is no temporary difference and no
deferred tax. Another explanation: both accountant and tax authority recognise income in the
same year and thus there will be no difference between accounting profit and taxable profit.
Example 8: Income receivable
Interest income of C6 000 is earned in 20X1 but only received in 20X2.
The tax authority will tax the interest income when earned.
The current tax owing to the tax authorities is paid in the year after it is charged.
There are no differences between accounting profit and taxable profit other than those evident from
the information provided and no taxes other than income tax at 30%.
Required:
D. Disclose the above information.
Chapter 6 273
Solution 8A: Income receivable (deferred tax)

Carrying Tax Temporary Deferred Deferred
Income receivable amount base difference tax at 30% tax
(per SOFP) (IAS 12) (b) – (a) (c) x 30% balance/
Opening balance – 20X1 0 0 0 0 N/A
Movement (balancing) 6 000 6 000 0 0 N/A
Closing balance – 20X1 (1) 6 000 6 000 0 0 N/A
Movement (balancing) (6 000) (6 000) 0 0 N/A
Closing balance – 20X2 (3) 0 0 0 0 N/A
Notes: For an explanation of the amounts (notes 1 & 3), see at the end of the solution to example 8C.
W2. Calculation of the tax base (income receivable – an asset): 20X1 20X2
i.e. applying the definition of the tax base of an asset that represents income C C
(1) (2)
Less portion that will be taxed in the future (0) (0)
Tax base 6 000 0
Notes:
1) Nothing will be taxed in the future since all of the income receivable will be taxed when it is
earned – i.e. in the current year (20X1).
2) The carrying amount will now be zero since the income receivable was received in 20X2 (see
journal 1 in the 20X2 ledger). No amount is taxable in the future since it was all taxed in 20X1.
Solution 8B: Income receivable (current tax)
Profit before tax (accounting profits) (1) (3) 26 000 20 000
(20 000 + 6 000) and (20 000 + 0)
Movement in temporary differences: (1) (3) 0 0 0 0
Taxable profits and current income tax (2) (2) 26 000 7 800 20 000 6 000
Notes: For an explanation of the amounts (notes 1 – 3), see at the end of the solution to example 8C.
Comments:
20X1: Since the tax authority taxes income either on the date it is received or on the date it is
earned, whichever is earlier, the interest income will be taxable in 20X1 (20 000 + 6 000 =
26 000). The accountant records income when it is earned and since the interest income is earned
in 20X1, the accountant will record the income in 20X1 (20 000 + 6 000 = 26 000). Thus the
accountant and tax authority treat the interest income in the same way with the result that there are
no temporary differences and therefore no deferred tax consequences.
20X2: Since the tax authority taxed the income in 20X1, the interest income will not be taxed in
20X2 (20 000 + 0 = 20 000). Since the accountant recognised the income in 20X1, the interest
income will not be recognised in 20X2 (20 000 + 0 = 20 000). Thus the accountant and tax
authority treat the interest income in the same way with the result that there are no temporary
differences and therefore no deferred tax consequences.
Solution 8C: Income receivable (ledger accounts)
Income receivable (A) Interest income (I)
Int income(1) 6 000 Inc receivable(1) 6 000

CTP: NT(2) 7 800 Tax (2) 7 800
274 Chapter 6

Income receivable (A) Bank (A)
Balance b/d 6 000 Bank (3) 6 000 Int receivable (3) 6 000 CTP (4) 7 800

CTP: NT(2) 6 000 Bank (4) 7 800 Balance b/d 7 800
Tax (2) 6 000
Notes:
1) Since the income is treated as income by both the accountant and the tax authority in 20X1 and yet
it hasn’t been received, both the accountant and the tax authority have the same income receivable
account. There are therefore no temporary differences or deferred tax.
2) Current tax for 20X1 and 20X2.
3) Since the income is received, the receipt reverses the income receivable account to zero (in both
the accountant’s and tax authority’s books). There is thus no temporary difference or deferred tax.
4) Payment of current tax for 20X1 in 20X2.
Solution 8D: Income receivable (disclosure)

Company name
Note 20X2 20X1
Current assets C C
Income receivable 0 6 000
Current liabilities
Company name
Note 20X2 20X1
C C
Profit before taxation (20X1: 20 000 + 6 000) 20 000 26 000
Company name
20X2 20X1
current 6 000 7 800
deferred 0 0
5. Deferred Tax Caused By Non-Current Assets
5.1 Overview
There are many kinds of non-current assets, for example, property, plant, equipment,
investment property and intangible assets. To explain the deferred tax consequences of these
non-current assets, we will initially separate them into two basic categories:
Deductible assets: the cost of these assets is deductible for tax purposes; and
Non-deductible assets: the cost of these assets is not tax deductible for tax purposes.
Chapter 6 275
Deductible assets are discussed in section 5.2. Non-current assets could

be:
Non-deductible assets and the related exemption are
discussed in section 5.3. The acquisition of non- deductible for tax purposes; or
deductible assets leads to an exemption from deferred tax. non-deductible for tax purposes.
This exemption from deferred tax simply means that no deferred tax is recognised on the
initial temporary difference that arises when initially acquiring an asset that is non-deductible.
Since the deferred tax balance reflects the expected future tax, and since the amount of tax we
will pay is affected by how we earn our profits (e.g. capital profits on a sale of the asset may
be taxed in a different manner to profits from the use of the asset), the measurement of the
deferred tax balance must reflect management’s expectations as to how it intends to earn the
future profits. This becomes very important if the asset is revalued to a fair value that exceeds
cost. This will be discussed under section 5.4 (Non-deductible assets measured at fair value).
If we sell an asset, the price we sell it at affects only our current tax payable and will not
affect the deferred tax liability (or asset) balance. This is explained in section 5.5.
However, the measurement principles are unchanged:

Tax base of an asset –the
the deferred tax balance is measured as: essence of the definition is:
Temporary difference x tax rate
If the asset’s FEB are taxable the:
the temporary difference is measured as: TB = future deductions
Tax base (of the asset) If the asset’s FEB are not taxable, the :
Less carrying amount (of the asset) TB = CA See IAS 12.7
5.2 Deductible assets

5.2.1 Overview
Deductible assets are assets that the tax authorities allow the cost thereof to be deducted from
taxable profits over a period of time. This tax deduction is often called a capital allowance or
wear and tear.
These deductible assets could be assets that:
are depreciated; or
are not depreciated (e.g. land is typically not depreciated).
5.2.2 Deductible and depreciable Deductible & depreciable

assets cause temporary
If the rate and method of calculating depreciation and the differences over time because:
tax deduction are the same, it will result in the carrying the CA will reduce to zero and
amount and tax base being equal to one another. Where the TB will reduce to zero
the carrying amount and tax base are the same, there is no but the CA and TB will reduce by
temporary difference and thus no deferred tax. different amounts each year.
However, if the rate and/ or the method of calculating depreciation differ from the rate and/ or
method of calculating the tax deduction, the carrying amount and tax base will not be equal
during the life of the asset and thus deferred tax arises.
For example, differing rates and methods include:
depreciation is calculated at 10% pa but the tax deduction is calculated at 20% pa; or
depreciation is calculated using the diminishing balance method but the tax deduction is
calculated using the straight-line method.
The difference between the carrying amount and tax base is temporary because, as soon as the
asset has been fully written off by both the accountant and the tax authorities (or if the asset is
disposed of), the carrying amount and tax base will be the same: both will be zero. Since these
differences are temporary differences, deferred tax must be recognised. This deferred tax will
have reversed to zero by the time the carrying amount and tax base are zero.
276 Chapter 6
Example 9: Cost model: PPE:

Deductible and
Depreciable assets
Profit before tax is C20 000, according to both the accountant and the tax authority, in each of the years
20X1, 20X2 and 20X3, before taking into account the following information:
A plant was purchased on 1 January 20X1 for C30 000
The plant is depreciated by the accountant at 50% p.a. straight-line.
The tax authority allows a tax deduction thereon at 33 1/3 % straight-line.
This company paid the tax authority the current tax owing in the year after it was charged.
The income tax rate is 30% and if an asset is sold above cost, 50% of the capital gain is taxable.
Required:
B. Calculate the current income tax for 20X1, 20X2 and 20X3.
D. Disclose the above in as much detail as is possible for all three years.
Solution 9A: Deferred tax
Plant: Carrying Tax Temporary Deferred Deferred

Depreciable amount base difference tax at 30% tax
Deductible (per SOFP) (IAS 12) (b) – (a) (c) x 30% balance/
Purchase 30 000 30 000 0 0
Deprec/ deduction (1) (15 000) (10 000) 5 000 1 500 Dr DT; Cr TE
Closing balance: 20X1 (2) 15 000 20 000 5 000 1 500 Asset (2)
Deprec/ deduction (1) (15 000) (10 000) 5 000 1 500 Dr DT; Cr TE
Closing balance: 20X2 (2) 0 10 000 10 000 3 000 Asset (2)
Deprec/ deduction (1) 0 (10 000) (10 000) (3 000) Cr DT; Dr TE
Closing balance: 20X3 (5) 0 0 0 0
Notes (1) – (5): See end of solution 9C
W2. Calculating the tax base (depreciable assets):

20X1 20X2 20X3
i.e. applying the definition of the tax base of an asset C C C
Original cost 30 000 30 000 30 000
Less accumulated tax deductions 20X1: 30 000 x 33 1/3 % x 1 yr (10 000) (20 000) (30 000)
20X2: 10 000 x 2 years
20X3: 10 000 x 3 years
Future deductions (i.e. deductions still to be made) 20 000 10 000 0
Comment: Although management’s intentions are always considered when measuring the deferred tax
balance, they had no effect in this example since the cost model is used and thus the asset’s carrying
amount will not exceed cost. Thus:
if the intention is to sell the asset, income tax rates would have applied to the temporary difference
since there are no capital profits possible (the TD = expected recoupment or scrapping allowance);
if the intention had been to keep the asset, income tax rates would have applied to the temporary
difference (TD = taxable profit from the sale of goods).
Chapter 6 277
Solution 9B: Current tax

W3 Calculation of current income tax: 20X1
20X1 20X2 20X3
Profits Tax: Profits Tax: Profits Tax:
30% 30% 30%
(1) (1) (4)
(20X1 & 20X2: 20 000 - 15 000)
(20X3: 20 000 - 0)
Exempt income/ non-deductible exp’s: 0 0 0

Taxable accounting profit 5 000 5 000 20 000
Movement in temporary differences: (1) 5 000 5 000 (10 000)
- add back depreciation: 30 000 x 50% 15 000 15 000 0
- less tax deduction: 30 000 x 33 1/3% (10 000) (10 000) (10 000)
Taxable profit & current income tax (3) 10 000 3 000 10 000 3 000 10 000 3 000
Notes (1, 3 and 4): See end of solution 9C
Solution 9C: Ledger accounts

20X1 20X1 Tax (3) 3 000
CTP: NT (3) 3 000 DT (2) 1 500 Balance c/f 3 000
P & L (6) 1 500 3 000 3 000
20X2 20X2 Bank 3 000 20X1 Bal b/f 3 000
(3)
CTP: NT 3 000 DT (2) 1 500 Balance c/f 3 000 20X2 Tax (3) 3 000
P & L (6) 1 500 6 000 6 000
20X3 20X2 Bal b/f 3 000
CTP: NT (3) 3 000 20X3 Bank 3 000 20X3 Tax (3) 3 000
DT (5) 3 000 P & L (6) 6 000 Balance c/f 6 000 6 000
20X3 Bal b/f 3 000
20X1 Tax (2) 1 500
20X2 Tax (2) 1 500 Balance c/f 3 000
3 000 3 000
20X2 Bal b/f 3 000
20X3 Tax (5) 3 000
3 000 3 000
20X3 Bal b/f 0
Depreciation (E) Plant: cost (A)
20X1 20X1 Bank 30 000
Plant: AD (1) 15 000 P&L 15 000
20X2
Plant: AD (1) 15 000 P&L 15 000
Plant: accumulated depreciation (A)

20X1 Depr(1) 15 000
20X2 Depr(1) 15 000
20X2 Bal 30 000
Notes:
(1) The tax authority allows a capital allowance at 33 1/3% of the cost per year whereas the accountant
allows depreciation at 50% of the cost per year in 20X1 and 20X2.
(2) The fact that the depreciation and capital allowance are not the same amount results in temporary
differences and deferred tax.
This represents a deferred tax asset since the future tax deductions (20X1: C20 000 and 20X2:
C10 000) are greater than the tax effect of the future economic benefits recognised in the statement
of financial position (20X1: C15 000 and 20X2: C0): a deductible temporary difference. This asset
is similar to an expense prepaid since the current tax (which the company is required to pay) has
been greater than the tax incurred in 20X1 and 20X2.
278 Chapter 6

(3) Current tax of C3 000 is recorded in 20X1, 20X2 and 20X3 (C9 000 in total).
(4) The tax authority allows a capital allowance at 33 1/3% of the cost per year whereas the accountant
allows depreciation at 50% of the cost per year.
Notice that the accountant did not expense depreciation in 20X3 since the asset was fully
depreciated at the end of 20X2.
(5) At the end of 20X3, both the carrying amount and tax base of the asset are zero. This means there
is no longer a temporary difference and therefore the deferred tax asset balance of C3 000 is
reversed.
(6) The tax expense is C1 500 in both 20X1 and 20X2 and C6 000 in 20X3 (C9 000 in total).
Notice that this total tax expense is the same as the total current income tax of C9 000, being the
amount of tax actually charged (C3 000 pa for 3 years: W3).
Solution 9D: Disclosure
Entity name
For the year ended 20X3
Note 20X3 20X2 20X1
C C C
Income tax expense 12 (6 000) (1 500) (1 500)
Profit for the period 14 000 3 500 3 500
Other comprehensive income 0 0 0
Total comprehensive income 14 000 3 500 3 500
Entity name
As at …20X3
Note 20X3 20X2 20X1
ASSETS C C C
Non-current assets
Deferred tax: income tax 4 0 3 000 1 500
Property, plant and equipment 0 0 15 000
LIABILITIES
Current liabilities
Current tax payable: income tax 3 000 3 000 3 000
Entity name
20X3 20X2 20X1
C C C
4. Deferred tax asset
Property, plant and equipment 0 3 000 1 500
Income taxation expense 6 000 1 500 1 500
Current 3 000 3 000 3 000
Deferred 3 000 (1 500) (1 500)
Comment: Notice that over the three years:
The total capital allowances (tax deductions) of C30 000 (C10 000 x 3 years: see income tax
expense note) equals the total depreciation of C30 000 (C15 000 x 2 years).
Similarly, the current tax charged by the tax authority (C3 000 x 3 years = C9 000: see Sol 9B)
equals the tax expense (1 500 + 1 500 + 6 000 = 9 000: see the income tax expense account and the
tax expense note above).
Chapter 6 279
5.2.3 Deductible but not depreciable

Sometimes an asset is deductible (i.e. the asset’s cost will Deductible but non-
be allowed as a deduction against taxable profits) but it is depreciable assets
A non-temporary difference
not depreciated (i.e. the asset’s cost will not be expensed arises over time because:
against profits). Where the cost of an asset is allowed as a the tax base will reduce to zero over
deduction against taxable profits, but the cost of the asset time (through tax deductions), but
is never expensed against accounting profits, differences the CA remains equal to cost
will arise over the period that will never reverse: (because it is not depreciated)
the tax base will reduce to zero over time, but
the carrying amount will remain equal to cost.
Since these differences will never reverse, they are not temporary differences and since these
are not temporary differences, no deferred tax should be recognised.
5.3 Non-deductible assets and the related exemption
5.3.1 Overview
Non-deductible assets refer to non-current assets that are Non-deductible assets with
not deductible for tax purposes. This means that the tax taxable FEB result in
temporary differences on
authorities do not allow the cost of these assets to be acquisition date because:
written off against taxable profit. the CA starts off at cost (and may
reduce to zero if it is depreciable)
Sometimes these assets are depreciated and some are not the TB will start off at zero.
depreciated (e.g. land is typically not depreciated).
Irrespective of whether or not the asset is depreciated, the carrying amount of a non-current
asset always starts off at its cost (or fair value), but an asset Tax base of an asset –the
that is non-deductible has a tax base on acquisition date essence of the definition is:
that starts off at zero. This is because, by definition, the tax If the asset’s FEB are taxable
base of this kind of asset (e.g. land) reflects the future tax the:
TB = future deductions
deductions, which are obviously zero if the asset is non-
If the asset’s FEB are not taxable, the :
deductible. The essence of the definition of an asset’s tax TB = CA See IAS 12.7
base is repeated alongside for your convenience.
Thus non-deductible assets are interesting because the carrying amount starts off at cost and
yet the tax base starts off at zero (and remains zero), and thus a temporary difference arises
immediately on acquisition.
This temporary difference that arises on the acquisition An exempt temporary
(e.g. purchase) of a non-deductible asset is generally difference is a temporary
difference on which we will
exempted from deferred tax in terms of IAS 12.15. The not recognise deferred tax.
next section explains the exemption from deferred tax.
5.3.2 The exemption from recognising deferred tax liabilities (IAS 12.15 and IAS 12.24)
IAS 12.15 states that (the following is slightly reworded): A taxable TD on acquisition
a deferred tax liability shall be recognised for all date is an exempt TD if it
relates to:
taxable temporary differences, the initial acquisition of an A
except where the deferred tax liability arises from: or L:
goodwill; or - does not relate to goodwill
the initial recognition of an asset or liability which: - does not relate to a business
- is not a business combination and combination; and
- does not affect accounting profit
- at the time of the transaction, affects neither or taxable profit. IAS 12.15 reworded
accounting profit nor taxable profit.
Please note: There is a similar exemption from recognising deferred tax assets: for more
information relating to both exemptions, please see section 6.
IAS 12.15 simply means that a deferred tax liability should always be recognised on taxable
temporary differences except if it meets the requirements to be exempted from deferred tax.
280 Chapter 6
Please note: Although we are focussing on non-current assets in this section, the
exemption from recognising deferred tax liabilities could arise on the acquisition of
goodwill and/ or a variety of others assets or liabilities.
Let us apply IAS 12.15 to the example of a non-deductible asset that is not acquired through
a business combination:
A taxable temporary difference will arise on the initial recognition thereof because:
- A non-deductible asset is an asset whose cost is not allowed as a deduction when
calculating taxable profits. In such cases, the tax base on date of purchase is zero.
- The carrying amount on date of purchase is, as always, the asset’s cost.
- Our tax base and carrying amount are usually the same on initial recognition (i.e. date
of purchase) but as you can see, in the case of a non-deductible asset, we have a
temporary difference that arises on initial recognition (TB: zero - CA: cost).
- This temporary difference is taxable since these future economic benefits (CA of an
asset = future economic benefits = cost) exceeds the future tax deductions (TB = 0).
The initial recognition (i.e. purchase) does not affect accounting profit or taxable profit:
- It does not affect accounting profit (the purchase involves a debit to the asset account
and a credit to bank or a liability account – it does not affect income or expenses), and
- It does not affect taxable profit (the purchase itself does not cause taxable income and
there are no tax deductible expenses flowing from this purchase).
Thus, although a deferred tax liability is normally recognised on taxable temporary
differences, no deferred tax is recognised on this taxable temporary difference since it
meets the requirements in IAS 12.15 to be exempted from deferred tax.
You may be wondering why this taxable temporary difference was exempted from the
requirement to recognise a deferred tax liability. Let us consider this question with specific
reference to the purchase of a non-deductible asset. As already explained, the purchase of a
non-deductible asset leads to a taxable temporary difference that would normally have led to
the recognition of a deferred tax liability, which would have required a credit to the deferred
tax liability account. But let’s think where we could have put the corresponding debit...
We cannot debit ‘tax expense’ since: Why do we have an
- deferred tax adjustments made to the tax expense exemption?
account are those relating to temporary It is interesting to consider
differences that cause taxable profits to differ the reason why such an exemption was
required at all.
from accounting profits, so debiting tax expense
In order to recognise a DTL on a
would clearly be inappropriate because the taxable TD we obviously need to credit
purchase of the asset: the DTL and debit something else.
o did not affect accounting profit, and The problem was that, in certain
o did not affect taxable profit. situations, such as the acquisition of a
non-deductible asset, no-one agreed on
We cannot debit the asset’s cost since: what we should debit!
- an asset may only be recognised if the item meets And so the exemption from having to
the asset definition: obviously the creation of a recognise this DT liability arose!.
deferred tax liability cannot possibly represent an inflow of future economic benefits
to the entity and thus the asset definition is not met; and
- an asset should be measured at its cost, being its purchase price and any other cost
necessary to bring the asset to a location and condition enabling it to be used in the
manner intended by management: a deferred tax liability is definitely not part of the
purchase price nor a cost necessary to enable an asset to be used.
The mystery behind exempt temporary differences is thus simply this: where there is no
logical contra-account, the deferred tax on the temporary difference was simply ignored.
Let us consider the effect of the exemption on non-deductible items that involve property,
plant and equipment, by way of example.
Non-deductible items of property, plant and equipment may either be depreciable or non-
depreciable, which means that we could be faced with the following possible combinations:
Non-deductible but depreciable: see example 10; and
Non-deductible and non-depreciable: see example 11.
Chapter 6 281

Non-deductible and
Depreciable asset
A building was purchased on 1 January 20X1 for C30 000
This building is depreciated by the accountant at 50% p.a. straight-line to a nil residual value.
The tax authority does not allow a tax deduction on this type of building.
The income tax rate is 30%.
Required:

Building: Carrying Tax Temporary Deferred tax Deferred tax

Non-deductible amount base difference at 30% balance/
Depreciable (SOFP) (IAS 12) TD x 30% adjustment
(2)
Purchase 30 000 0 (30 000) 0 Exempt IAS 12.15
Depreciation/ deduction (1) (15 000) (0) 15 000 (2)
0 Exempt IAS 12.15
Closing balance: 20X1 (2) 15 000 0 (15 000) (2)
0 Exempt IAS 12.15
Depreciation/ deduction (1) (15 000) (0) 15 000 (2)
0 Exempt IAS 12.15
Closing balance: 20X2 (2) 0 0 0 (2)
0
Depreciation/ deduction (1) (0) (0) 0 0
Notes:
(1) The accountant allows depreciation at 50% of the cost per year in 20X1 and 20X2 whereas the cost
of the building is not allowed as a tax deduction at all. Notice that there is no depreciation in 20X3
since the asset was fully depreciated at the end of 20X2.
(2) A temporary difference arises on acquisition since there will be no tax deductions on the asset.
There is no deferred tax on this temporary difference due to the IAS 12.15 exemption.
The exemption applies to all aspects of the original cost, including the depreciation, which (if you
think about it) is simply a reallocation of part of this original cost.
This depreciation causes the temporary difference balance to reduce each year (i.e. the original
temporary difference will eventually reverse, once this asset is fully depreciated).
But while a portion of the exempt temporary difference still exists, the fact that no deferred tax is
raised on it means that it will cause the applicable tax rate and the effective tax rate to differ. You
will therefore find exempt temporary differences in the tax rate reconciliation in the tax expense
note (they act much like a non-deductible expense).
W2. Calculation of the tax base (depreciable assets): 20X1, 20X2 and 20X3 C
i.e. applying the definition of the tax base of an asset
Original cost that will be allowed as a tax deduction Not allowed as a deduction at all 0
Less accumulated tax deductions (e.g. wear & tear) Not allowed as a deduction at all 0
Deductions still to be made (decrease in taxable profits in the future) 0
282 Chapter 6

20X3 20X2 20X1
W3. Calculation of current income tax: Profit Tax at Profit Tax at Profit Tax at
30% 30% 30%
Profit before tax (accounting profits) (1) 20 000 5 000 5 000
(20X1 and 20X2: 20 000 - 15 000),
(20X3: 20 000 - 0)
Exempt income & non-deductible expenses: 0 0 0
Movement in temporary differences: exempt
Building – exempted (2) 0 15 000 15 000
- add depreciation (20X1 & 20X2: 30 000 x 50%) 0 15 000 15 000
- less tax deduction (e.g. wear and tear) (0) (0) (0)
Taxable accounting profits 20 000 20 000 20 000
Movement in temporary differences: normal 0 0 0
Taxable profits and current income tax 20 000 6 000 20 000 6 000 20 000 6 000
Notes:
(1) The profit was given before depreciation had been processed and must therefore first be adjusted.
Notice that there is no depreciation in 20X3 since the asset was fully depreciated in 20X2.
(2) The depreciation and tax deduction are not the same amount resulting in a temporary difference
but there is no deferred tax on this temporary difference due to the IAS 12.15 exemption.

20X1 20X1
CTP: NT (W3) 6 000 Tax (W3) 6 000
P&L 6 000 Balance c/f 6 000
6 000 6 000 6 000 6 000
20X2 20X2 Bank 6 000 Balance b/f 6 000
CTP: NT 6 000 Balance c/f 6 000 20X2
(W3)
P&L 6 000 Tax (W3) 6 000
6 000 6 000 12 000 12 000
CTP: NT (W3) 6 000 20X3
P&L 6 000 Tax (W3) 6 000
6 000 6 000 Balance c/f 12 000 12 000
Balance b/f 6 000
Depreciation (E) Building: cost (A)
20X1 20X1 Bank 30 000
Plant: AD (W1) 15 000 P & L 15 000
20X2
Plant: AD (W1) 15 000 P & L 15 000
Building: accumulated depreciation (A)

20X1 Depr(W1) 15 000
20X2 Depr(W1) 15 000
Balance 30 000
Chapter 6 283

Entity name
20X3 20X2 20X1
Note C C C
Profit before tax Ex 10B 20 000 5 000 5 000
Profit / (loss) for the period 14 000 (1 000) (1 000)
Other comprehensive income Given 0 0 0
Total comprehensive income / (loss) 14 000 (1 000) (1 000)
Entity name
As at …20X3
20X3 20X2 20X1
Note C C C
ASSETS
Non-current assets
Deferred tax: income tax Ex 10A 0 0 0
Property, plant and equipment Ex 10A 0 0 15 000
LIABILITIES
Current liabilities
Current tax payable: income tax Ex 10C 6 000 6 000 6 000
Entity name
20X3 20X2 20X1
C C C
Current Ex 10B 6 000 6 000 6 000
Deferred Ex 10A: W1 0 0 0
Reconciliation:
Applicable tax rate 30% 30% 30%
Tax effects of:

Profit before tax 20X1 & 20X2: 5 000 x 30% 6 000 1 500 1 500
20X3: 20 000 x 30%
Exempt non-temporary difference:
depreciation on cost of non-deductible asset 0 4 500 4 500
20X1 & 20X2: 15 000 x 30%
Tax expense 6 000 6 000 6 000
Effective tax rate 20X1 & 20X2: 6 000 / 5 000 30% 120% 120%
20X3: 6 000 / 20 000
Comments
Note there is a reconciling item in the tax rate reconciliation for 20X1 and 20X2.
This is because the depreciation will never be deductible, i.e. it is a non-temporary difference. This
means the difference will not reverse in future years. Deferred tax on this temporary difference is thus
not recognised. We say: the temporary difference is exempt from deferred tax.
284 Chapter 6

Non-deductible and
Non-depreciable asset
Land was purchased on 1 January 20X1 for C30 000
Land is not depreciated.
The tax authority does not allow a tax deduction on land.
Required:

Land: Carrying Tax Temporary Deferred Def tax

Non-deductible amount Base(3) difference tax at 30% balance/
Non-depreciable (SOFP) (IAS 12) TD x 30% adjustm
ent
(2)
Purchase: cost 30 000 0 (30 000) 0 Exempt IAS 12.15
Depreciation/ deduction (1) (0) (0) 0 0

0 Exempt IAS 12.15
(1)
Depreciation/ deduction (0) (0) 0 0
0 Exempt IAS 12.15
(1)
Depreciation/ deduction (0) (0) 0 0
(2)
Closing balance: 20X3 30 000 0 (30 000) 0 Exempt IAS 12.15
Notes:
(1) The carrying amount remains at C30 000 since it is not depreciated.
The tax base is zero from the start since there are no future deductions allowed on the cost of land.
(2) A temporary difference arises since there will be no tax deductions on the asset.
There is no deferred tax on this temporary difference due to the IAS 12.15 exemption.
Since there is no depreciation, the original temporary difference will never reverse.
The exemption of the related temporary difference acts much like a non-deductible expense and
you will therefore find it in the tax rate reconciliation in the tax expense note.
(3) The tax base is calculated in the same way as in example 10A, (see working 2).

20X3 20X2 20X1
W2. Calculation of current income tax: Profit Tax: 30% Profit Tax: 30% Profit Tax:
30%
(1)
Profit before tax (accounting profits) 20 000 20 000 20 000
Exempt income & non-deductible expenses 0 0 0
(2)
Exempt temporary differences: movement 0 0 0
Taxable accounting profits 20 000 20 000 20 000
Normal temporary differences: movement 0 0 0
Taxable profits and current income tax 20 000 6 000 20 000 6 000 20 000 6 000
Chapter 6 285
Solution 11B: Continued…
Notes:
(1) Profit was given before depreciation had been processed, but no adjustment is necessary since
there is no depreciation on land.
(2) Although there is an exempt temporary difference, being the original cost, there is no exempt
temporary difference in the taxable profit calculation since there is no depreciation and therefore
no movement in temporary differences.

20X1 20X1
CTP: NT (W2) 6 000 Tax (W2) 6 000
P&L 6 000 Balance c/f 6 000
6 000 6 000 6 000 6 000
CTP: NT 6 000 Balance c/f 6 000 20X2
(W2)
P&L 6 000 Tax (W2) 6 000
6 000 6 000 12 000 12 000
CTP: NT (W2) 6 000 20X3
P&L 6 000 Tax (W2) 6 000
6 000 6 000 Balance c/f 12 000 12 000
Balance b/f 6 000
Bank Land: cost (A)

20X1 Land: cost 30 000 20X1 Bank 30 000

Entity name
Note 20X3 20X2 20X1
C C C
Profit before tax (W2 – unadjusted) 20 000 20 000 20 000
Other comprehensive income (given) 0 0 0
Entity name
As at …20X3
Note 20X3 20X2 20X1
C C C
ASSETS
Non-current assets
Deferred tax: income tax W1 0 0 0
Property, plant and equipment W1 30 000 30 000 30 000
LIABILITIES
Current liabilities
Current tax payable: income tax 11C 6 000 6 000 6 000
286 Chapter 6
Solution 11D: Continued…

Entity name
20X3 20X2 20X1
3. Income tax expense (2) C C C
Current W2 6 000 6 000 6 000
Deferred (1) W1 0 0 0
Notes:
(1) Since there is no movement in temporary differences (see W1), there is no deferred tax adjustment.
(2) Although an exempt temporary difference arose on the original cost, there is no need for a rate
reconciliation since there is no movement in the temporary difference and therefore no effect on
either accounting profit (there is no depreciation) nor taxable profit (there is no tax deduction).
Compare this to example 10D where a rate reconciliation was required since the asset subsequently
affected accounting profits (through the depreciation charge) while no deferred tax was recognised.
5.4 Non-current assets measured at fair value (IAS 12.51A-C)

5.4.1 Overview (IAS 12.51A-C)
As we know, the deferred tax balance must be measured in a way that is
‘consistent with the expected manner of recovery or settlement’ of the underlying asset.
IAS 12.51A
If the manner in which management expects to recover the carrying amount of an asset (e.g. a
management intention to use the asset or to sell the asset) is expected to affect the
measurement of the future tax payable, then we must take these management intentions into
account when measuring the deferred tax balance.
In other words, management intentions become important when the tax authority taxes
income differently depending on how the income is generated. For example, different tax
calculations may apply to:
Capital profits made on the sale of an asset (i.e. profit made by selling at above cost); and
Profits other than capital profits.
If the asset is measured using the cost model (e.g. cost less accumulated depreciation), the
carrying amount will obviously be less than the original cost. If management intends to sell the
asset but its carrying amount is less than cost, it means that, even if the asset is expected to be
sold at more than its cost (i.e. at a capital profit), the measurement of the asset does not reflect
this potential capital profit on sale. This means that the measurement of the deferred tax balance
will not be complicated by a potential capital profit and the related taxable capital gain.
Although all prior examples have involved only the cost model, it is possible for non-current
assets to be measured at fair value instead, for example:
An item of property, plant and equipment may be measured at fair value using the
revaluation model offered by IAS 16 Property, plant and equipment (read chapter 8); or
An investment property may be measured at fair value using the fair value model offered
by IAS 40 Investment property (read chapter 10).
If the asset is measured at fair value (whether using the aforementioned revaluation model or
fair value model), the carrying amount could end up being:
greater than the asset’s original cost; or
less than the asset’s original cost.
A carrying amount that is greater than cost when our intention is to sell that asset means that
we are expecting to sell the asset at an amount greater than cost. Remember that, if the
intention is to sell the asset, the carrying would reflect the expected selling price (i.e. as
opposed to sales income from the sales of the asset’s output) and thus, if the carrying amount
Chapter 6 287
exceeds cost, it means that a capital profit is expected. Deferred tax &
This could affect our tax calculation: measurement at fair value:
If the tax authority taxes capital profits in a different
manner to non-capital profits, this intention will If the carrying amount of an asset is
measured at a FV greater than cost:
affect the measurement of the deferred tax balance
we must account for deferred tax on
(obviously, if we actually sell it for this expected the portion above cost (i.e. CA – Cost)
selling price, it will be the measurement of our actual measured at the rate at which it will
current tax payable that will be affected). be taxed in the future.
The expected accounting profit on sale of the asset
would have to be split into the portion that would be taxed as normal taxable profits and
the portion that would be taxed as capital profits (part of taxable capital gains).
If the carrying amount is less than cost, the possibility that the expected future economic
benefits could include a capital profit obviously does not exist.
Although the deferred tax balance is normally measured based on how management intends to
earn the future economic benefits, there are two exceptions, where despite management’s real
intentions, the deferred tax balance is measured based on a presumed intention to sell the
asset. This presumed intention to sell is applied in the case of the following assets:
non-depreciable assets measured at fair value in terms of the revaluation model
(IAS 16 Property, plant and equipment), and
investment property measured at fair value in terms of the fair value model
(IAS 40 Investment property).
Before we look at how to measure deferred tax based on management’s various possible
expectations (i.e. intentions), let us first consider the two situations in which management’s
actual intentions are ignored and presumed intentions are applied instead.
5.4.2 Non-current assets measured at fair value and presumed intentions (IAS 12.51B-C)
Although we normally measure the deferred tax balance based on the expected tax
consequences relevant to the manner in which management expects to recover the asset, we
ignore the actual management intentions and presume the intention is to sell the asset if it is a:
Non-depreciable asset measured using the revaluation model in IAS 16 (IAS 12.51B); or
Investment property measured using the fair value model in IAS 40 (IAS 12.51C).
5.4.2.1 Non-depreciable assets measured using IAS 16’s revaluation model (IAS 12.51B)
If the asset is a non-depreciable asset that is measured in terms of the revaluation model in
IAS 16 Property, plant and equipment, then the presumption is always that the management
intention is to sell the asset. IAS 12.51B
The presumption that the asset will be sold is irrespective of management’s actual intentions
and would even apply if the asset’s fair value was measured based on usage.
The reasoning for this presumption is based on the
Study tip
reasoning behind depreciation:
Revise IAS 16’s revaluation
depreciation reflects that part of the carrying amount model in chapter 8
that will be recovered through use (i.e. depreciation (section 4).
is expensed during the same periods in which
revenue is earned through usage); and thus
if you can’t depreciate an asset, it means that it can’t be used up and thus the presumption
is that carrying amount can only have been measured based on the sale of the asset.
Land is generally a non-depreciable asset.
5.4.2.2 Investment property measured in terms of IAS 40’s fair value model (IAS 12.51C)
If the asset is an investment property that is measured in terms of the fair value model in
IAS 40 Investment property, then the presumption should be that the management intention is
to sell the asset. However, the presumption in the case of investment property is a rebuttable
presumption (notice that the presumption in the case of property, plant and equipment was not
rebuttable). The presumption that this asset would be sold would be rebutted if the:
288 Chapter 6
Investment property is depreciable (i.e. had the cost model been used, this particular
property would have been depreciated – in other Study tips
words, the presumption could never be rebutted in Revise IAS 40’s fair value
the case of land since land would not have been model in chapter 10
depreciable); and (section 4.4 & 5.3).
The investment property is held within a business model the objective of which is to
consume substantially all of the economic benefits embodied in the investment property
over time, rather than through sale. IAS 12.51C
Example 12: Non-current asset measured at fair value and presumed intentions
An entity owns a non-current asset that it intends to keep and use.
This asset is measured at its fair value of C140 which exceeds its original cost of C100.
The tax authorities levy tax of 30% on taxable profits, and only 50% of a capital profits are taxable.
Required: Indicate how the deferred tax balance should be measured and briefly explain assuming:
A. The non-current asset is a plant measured in terms of IAS 16’s revaluation model.
B. The non-current asset is a land measured in terms of IAS 16’s revaluation model.
C. The non-current asset is a building measured in terms of IAS 40’s fair value model.
D. The non-current asset is a land measured in terms of IAS 40’s fair value model.
Solution 12: Non-current asset measured at fair value and presumed intentions
Comment: Normal profits are taxed at 30% whereas only 50% of a capital profit is taxed at 30%.
Since capital profits are taxed differently, we must pay attention to management’s intention – or
presumed intention.
A. The asset is plant (depreciable) revalued in terms of IAS 16 Property, plant and equipment.
IAS 12.51B applies to revalued property, plant and equipment but only to non-depreciable assets.
Since plant is depreciable, IAS 12.51B does not apply to the plant. We must thus measure the
deferred tax balance in terms of IAS 12.51A using management’s real intention: the deferred tax
balance will reflect the tax payable/ receivable on profits derived from the usage of the asset.
B. The asset is land (non-depreciable) measured in terms of IAS 16’s revaluation model.
IAS 12.51B states that we must presume that all non-depreciable assets measured at fair value in
terms of IAS 16 are to be sold.
Thus, the deferred tax balance must reflect the tax payable/ receivable on profits derived from the
sale of the asset, even though management intends to recover the carrying amount through usage.
C. The asset is an investment property measured in terms of IAS 40’s fair value model.
IAS 12.51C states that we should presume that investment properties measured under the fair
value model are to be sold. The presumption is rebuttable, however, if the asset is depreciable and
the investment property is held within a business model the objective of which is to consume
substantially all of the economic benefits embodied in the investment property over time, rather
than through sale. In this case, the property is a building and a building is depreciable (i.e. a
building would have been depreciated had the cost model applied to it).
Therefore, if the property is held within a business model the objective of which is to consume
substantially all of the economic benefits embodied in the investment property over time, rather
than through sale, both criteria for rebuttal would be met and the deferred tax balance should then
be measured based on the real intention which is to use the asset.
If the related business model does not involve consuming substantially all of the economic
benefits embodied in the investment property over time, then the deferred tax balance must reflect
the presumed intention to sell and thus the balance will reflect the tax that will be payable/
receivable on profits derived from the sale of the asset, even though management currently
intends to keep the asset and thus currently intends to recover the carrying amount through usage
D. The asset is an investment property measured in terms of IAS 40’s fair value model.
IAS 12.51C states that we should presume that investment properties measured under the fair
value model are to be sold. Although the presumption can be rebutted in the case of some
investment properties, the presumption in this case may not be rebutted since one of the
requirements for rebuttal is not met: the asset must be depreciable but yet land is not depreciable.
Thus, the deferred tax balance must reflect the presumed intention to sell: the balance will reflect
the tax payable/ receivable on profits derived from the sale of the asset, even though management
intends to recover the carrying amount through usage.
Chapter 6 289
5.4.3 Measuring deferred tax based on management’s expectations (IAS 12.51A-C)

As we can see, we must consider what management’s expectations are regarding how the
carrying amount of the asset is expected to be recovered. Sometimes we have to base our
deferred tax calculation on management’s actual expectations and sometimes we need to base
it on the presumed intention to sell the asset.
Management expectations can really only relate to one of the following three intentions.
Notice how the deferred tax calculation differs in each case:
Sell the asset: If the intention is to sell the asset, then measure the deferred tax liability or
asset to reflect the tax that would be due or receivable in terms of tax legislation if the
asset was sold. The tax that will be due in terms of tax legislation on the sale of the asset
would be recoupments/scrapping allowances and capital gains tax;
Keep the asset: If the intention is to keep the asset, then measure the deferred tax liability
or asset to reflect the tax that would be due or receivable in terms of tax legislation based
on the income that is expected to be made from the use of the asset. The tax that will be
due in terms of tax legislation from the use of the asset will be income tax on the
economic benefits that flow from the asset; and
Keep the asset for a period of time and then sell it: If the intention is to keep and then sell
the asset, then measure the deferred tax liability or asset to reflect the tax that would be
due or receivable in terms of tax legislation on the expected income from the use of the
asset plus the sale of the asset.
5.4.3.1 Intention to sell the asset (actual or presumed intention)
If the asset is measured at fair value and the intention is to sell the asset, the deferred tax on
the revaluation will be measured using the following logic:
The fair value is the expected selling price of the Are you looking for more
actual asset. examples on assets
revalued to FV where the
The tax deductions will not change simply because
intention is to sell?
the asset has been measured at fair value (i.e. the tax
authority will not increase or decrease the tax Then look no further than:
deductions allowed). Chapter 8: example 13: revaluation to a
The deferred tax caused by the asset must then be FV that does not exceed cost
measured based on the tax that would apply to the Chapter 8: example 16 – 18: revaluation
to a FV that exceeds cost.
sale of an asset at its carrying amount. This would
typically involve a:
Recoupment (or scrapping allowance), and a
*
Taxable capital gain: if the asset was revalued to a fair value that exceeded cost.
* If the asset is revalued to a fair value that does not exceed cost, the taxable profits
cannot involve a capital gain, because capital gains only arise on the proceeds above
cost, but could involve a recoupment or scrapping allowance.
5.4.3.2 Intention to keep the asset
If the asset is measured at fair value and the intention is to Are you looking for more
keep the asset, the deferred tax caused by this asset will examples on assets
be measured using the following logic: revalued to FV where
the intention is to keep?
The fair value is the expected future revenue from the
Then look no further than:
sale of items produced by the asset;
Chapter 8: example 13: revaluation to
The tax deductions will not change simply because a FV that does not exceed cost
the asset has been measured at fair value; Chapter 8: example 14 - 15:
The deferred tax caused by the asset must be revaluation to a FV that exceeds cost
measured based on the tax that applies if sales income were earned to the value of its
carrying amount.
Thus, any increase in the carrying amount when re-measuring an asset to fair value would
mean extra sales income is expected but no extra tax deductions would be expected.
290 Chapter 6
5.4.4 How to measure the deferred tax if the fair valued asset is also non-deductible
It can happen that the non-current asset that is measured at fair value is a non-deductible asset
(i.e. an asset the cost of which is not deductible from taxable profits).
any temporary difference arising from the initial recognition of such an asset (other than
an asset acquired through a business combination) is exempt from deferred tax; but
any further temporary difference arising from the revaluation of such an asset is not
exempt from deferred tax (see IAS 12.15 and section 5.3.2 for revision of the exemption).
The principle that the deferred tax balance should reflect the future tax based on the relevant
intention (to keep or sell) does not change. This is explained below.
If the asset is non-deductible and the intention is to keep the asset, the deferred tax:
on the carrying amount of the asset that relates to its cost would not be recognised (it
would be exempt from deferred tax in terms of the IAS 12.15 exemption);
on any increase in the carrying amount of the asset due to the re-measurement to fair
value would be measured by calculating the tax that would be due/ receivable assuming
the increase in carrying amount represented future sales (i.e. the deferred tax on this
increase would be measured at the income tax rates).
If the asset is non-deductible and the intention is to sell the asset, the deferred tax:
on the carrying amount of the asset that relates to its cost would not be recognised (it
would be exempt from deferred tax in terms of the IAS 12.15 exemption);
on any increase in the carrying amount of the asset due to the re-measurement to fair
value would be measured by calculating the tax that would be due/ receivable assuming
the asset were sold.
Thus:
If the asset’s fair value does not exceed cost, the deferred tax balance would be nil:
There would be no recoupment possible because there are no prior deductions to
recoup; and
There would be no taxable capital gain possible since the expected selling price is
less than cost.
If the asset’s fair value does exceed cost, the deferred tax balance will reflect tax on
the extent to which the fair value over cost is included in taxable profits:
There would be no recoupment possible because there are no prior deductions to
recoup; but
A taxable capital gain would be possible to the extent that the excess of the fair
value over cost is included in taxable profits.
Let us consider why we provide deferred tax on the revaluation by using, as an example, a
non-deductible asset that has been revalued upwards in terms of IAS 16’s revaluation model:
The taxable temporary difference that arose when the asset was initially acquired is
exempt from deferred tax in terms of IAS 12.15: the exemption applies to the initial
recognition of a non-deductible asset.
As this asset gets depreciated (or impaired) the carrying amount decreases and the
resulting decrease in the temporary difference is also exempt from deferred tax in terms of
IAS 12.15: the exemption applies to the initial recognition of a non-deductible asset,
which includes the gradual writing-off of this initial cost.
Chapter 6 291
Are you looking for more

When this asset is revalued upwards, we are adding examples on non-
an amount to the carrying amount: this debit is not deductible assets?
related to the initial recognition of an asset and thus
the exemption from deferred tax in IAS 12.15 does
not apply (IAS 12.15 only applies to the temporary Then look no further than:
difference that arises as a direct consequence of the Chapter 8: example 21: intention to
initial recognition of the asset – a revaluation has keep (depreciable);
nothing to do with the initial recognition but is Chapter 8: example 20: intention to sell
simply a re-measurement of the asset) (depreciable).
Example 13: Revaluation above cost: PPE: intention to keep

Non-deductible
Depreciable
An item of property, plant and equipment was purchased for C1 200 on 1 January 20X1.
Depreciation is calculated over a total useful life of 4 years to a nil residual value (straight-line)
The tax authorities do not grant any tax deductions on this asset
The asset was revalued to fair value of C1 440 on 31 December 20X2.
The profit before tax and before depreciation (fully taxable) is C1 720 in 20X4.
Required:
Assuming management has the intention to keep the asset:
A. Calculate the current income tax for 20X4.
B. Calculate the deferred tax balances and adjustments.
C. Disclose the tax expense note for 20X4. Comparatives are not required.
Solution 13: Intention to keep
Comment:
This is an asset that is revalued in terms of IAS 16’s revaluation model but since the asset is
depreciable, management’s real intention to keep the asset is not over-ridden by IAS 12.51B’s
presumed intention to sell. See example 15 where we ignore management’s intention to keep the
asset and presume the intention is to sell the asset instead.
This situation (a non-deductible, depreciable asset that is to be kept) is also covered in chapter 8’s
example 21, where example 21shows the revaluation journals and related deferred tax journals.
Solution 13A: Current tax

20X4
C
Profit before tax and before depreciation 1 720
Depreciation (C1 440 – 0) / 2 remaining years x 1 year (720)
Add back depreciation Per above: not deductible 720
Current income tax at 30% 516
292 Chapter 6
Solution 13B: Deferred tax
W1. DT on PPE - intention to keep

Non-deductible Carrying Tax Temporary Deferred
Depreciable amount base differences tax
(FV greater than CP)
Cost: 1/1/20X1 1 200 0 (1 200) 0 Exempt IAS12.15
Depreciation / Deductions (300) 0 300 0 Exempt IAS12.15
Carrying amount: 31/12/20X1 900 0 (900) 0 Exempt IAS12.15
600 0
RS: 31/12/20X2 (reval @ YE) 840 0 (840) (252) Cr DT; Dr RS
Carrying amount: 31/12/20X2 1 440 0 (1 440) (252) L (W2)
Depreciation / Deductions (historic) (300) 0 300 0 Exempt IAS12.15
Depreciation / Deductions (extra) (420) 0 420 126 Dr DT; Cr RS
Carrying amount: 31/12/20X3 720 0 (720) (126) L (W2)
Carrying amount: 31/12/20X4 0 0 0 0
W2. DT balances: Tax on future profits from operating profits

At 31/12/20X2: CA = 1 440 At 31/12/20X3: CA = 720
Taxable Tax Taxable Tax
profits at 30% profits at 30%
Extra future profits 840 420
31/12/X2: ACA (1 440) – HCA (600)
31/12/X3: ACA (720) – HCA (300)
Less extra future deductions 0 0
(1)
Extra future taxable profits/ tax 840 252 420 126
Notes:
(1) Measured at 30% of 840 since the revalued amount will be recovered through operating profits.
Entity name
20X4 20X3
Income taxation expense 516 xxx
Current 13A 516 xxx
Deferred 13B: W1 (the DT adj was credited to RS not TE) 0 xxx
Applicable tax rate 30% xxx
Tax effects of
Profit before tax 1 000 (13A) x 30% 300 xxx
Non-deductible depreciation 720 (13B: W1) x 30% 216 xxx
Tax expense on face of statement of comprehensive income 516 xxx
Effective tax rate 516 / 1 000 51,6% xxx
Chapter 6 293
Example 14: Revaluation above cost: PPE: intention to sell

Non-deductible
Depreciable
Depreciation is calculated at 25% pa to a nil RV (straight-line)
The tax authorities do not grant any tax deductions on this asset
The asset was revalued to fair value of 1 440 on 31 December 20X2.
The profit before tax and before depreciation (fully taxable) is C1 720 in 20X4.
Required:
Assuming management intends to sell the asset:
Solution 14: Intention to sell

Comment:
This situation (a non-deductible, depreciable asset that is to be sold) is covered in chapter 8’s example
20, where example 20 shows the revaluation journals and related deferred tax journals.
The answer is identical to the calculation shown in example 13A, repeated here for your convenience:
20X4
C
Profit before tax and before depreciation 1 720
Depreciation (C1 440 – 0) / 2 remaining years x 1 year (720)
Add back depreciation Per above: not deductible 720

W1: DT on PPE - intention to sell
Carrying Tax Temporary Deferred
Non-deductible amount base differences tax
Depreciable
Cost: 1/1/20X1 1 200 0 (1 200) 0 Exempt IAS12.15

Carrying amount: 31/12/20X1 900 0 (900) 0 Exempt IAS12.15
600 0
RS: 31/12/20X2 (reval @ YE) 840 0 (840) (36) Cr DT; Dr RS
Carrying amount: 31/12/20X2 1 440 0 (1 440) (36) L (W2: 0 + 36)
Carrying amount: 31/12/20X3 720 0 (720) 0 (W2: 0 + 0)
Depreciation / Deductions (extra) (420) 0 420 0
294 Chapter 6

W2. DT balances: expected sale of PPE At 31/12/X2: At 31/12/X3:
CA = 1 440 CA = 720
Taxable Tax at Taxable Tax at
W2.1 Tax on recoupment: profits 30% profits 30%
Selling price (1 440), limited to cost price (1 200) 1 200 720
Less tax base 0 0
Recoupment and related tax (1) 1 200 0 720 0
W2.2 Tax on taxable capital gain:

Selling price 1 440 720
Less base cost (assumed = cost) (1 200) (1 200)
Capital gain/ (loss) 240 (480)
Inclusion rate (given) 50% 50%
Taxable capital gain/ (loss) (2) 120 36 (240) 0
36 0
Notes:
1. There is no recoupment possible: since the asset was not deductible, there can be no recoupment of anything.
2. If we sold for C720 at end 20X3, a tax deductible capital loss of C240 would arise and may be available to
reduce any taxable capital gains in future. Capital losses (as opposed to capital gains) are ignored in this text.
Thus the possible deferred tax asset of C72, (being the possible future tax saving of 240 x 30%), is ignored.

Entity name
20X4 20X3
Current 14A 516 xxx
Deferred 14B: W1 (the DT adj was credited to RS not TE) 0 xxx
Tax effects of
Profit before tax 1 000 (13A) x 30% 300 xxx
Non-deductible depreciation 720 (13B: W1) x 30% 216 xxx
Effective tax rate 516 / 1 000 51,6% xxx
Example 15: Revaluation above cost: PPE: intention to keep

Non-deductible
Non-depreciable
The item is land and is not depreciated
The tax authorities do not grant any tax deductions on this asset. The base cost is C1 200.
The land was revalued to fair value of 2 040 on 31 December 20X2.
The land was sold for C1 800 during 20X4
The profit before tax and before the sale (fully taxable) is C1 000 in 20X4.
Required:
Assuming management’s intention is to keep the asset:
Chapter 6 295
Solution 15: Intention to keep

Comment:
This asset is revalued in terms of IAS 16’s revaluation model and since the asset is non-depreciable,
management’s real intention to keep the asset is over-ridden by IAS 12.51B’s presumed intention. The
deferred tax is thus measured on the presumed intention to sell the asset even though management’s real
intention is to keep the asset.
This situation is also covered in chapter 8’s example 22, where the focus is on the revaluation journals
and related deferred tax journals.

20X4
Profit before tax and before the sale 1 000
Loss on sale Proceeds: 1 800 – CA: 2 040 (FV) (240)
Profit before tax 760
Add back loss on sale 240
Add taxable capital gain (Proceeds: 1 800 – Base cost: 1 200) x 50% 300
W1. DT on PPE: intention to keep

Non-deductible Carrying Tax Temporary Deferred
Non-depreciable amount base differences tax
Cost: 1/1/20X1 1 200 0 (1 200) 0 Exempt IAS 12.15
Movement: 20X1 0 0 0 0 Exempt IAS 12.15
Carrying amount: 31/12/20X1 1 200 0 (1 200) 0 Exempt IAS 12.15
Movement: 20X2 0 0 0 0 Exempt IAS 12.15
1 200 0
RS – 31/12/20X2 840 0 (840) (126) Cr DT; Dr RS
Carrying amount: 31/12/20X2 2 040 0 (2 040) (126) L (W2: 0 + 126)
Movement: 20X3 0 0 0 0
Carrying amount: 31/12/20X3 2 040 0 (2 040) (126) L
Sold (CA) (2 040) 0 2 040 126 Dr DT; Cr RS
Carrying amount: 31/12/20X4 0 0 0 0 L
W2. DT balances: Tax on future profits from expected sale of land

At 31/12/20X2: CA = 2 040
W2.1 Tax on recoupment: Taxable profits Tax at 30%
Selling price (2 040), limited to Cost price (1 200) 1 200
Less tax base 0
Recoupment and related tax (1) 1 200 0
W2.2 Tax on taxable capital gain:

Selling price 2 040
Capital gain 840
Inclusion rate 50%
Taxable capital gain and related tax 420 126
Total deferred tax balance 126
Notes:
(1) There is no recoupment possible: since the asset was not deductible, there can be no recoupment of anything.
296 Chapter 6
Entity name
20X4 20X3
Current 15A 390 xxx
Deferred W1 (the DT adj. was credited to RS not TE) 0 xxx
Tax effects of
Profit before tax 15A: 760 x 30% 228 xxx
Exempt capital loss 15A: (Loss on sale: 240 + Taxable capital 162 xxx
gain: 300) x 30%
Effective tax rate Tax: 390 / Profit before tax: 760 51,3% xxx
5.5 Sale of a non-current asset

When a non-current asset is sold:
the accounting records could reflect either a:
profit (capital and/ or non-capital), or
loss; and
the tax records could reflect either a:
taxable profit (recoupment and/ or capital gain) or
a deductible loss (scrapping allowances and / or a capital loss).
Recoupments and scrapping allowances can only ever apply to an asset that is deductible.
Please note that capital losses are not covered in this text.
These differences are covered in detail in chapter 5. A summary of the calculations in the
accounting records and tax records follows.
IFRS and the accounting records Tax legislation and the tax records
Total profit or loss Total profit or loss
Proceeds xxx Proceeds xxx
Less carrying amount (xxx) Less tax base (xxx)
Profit or (loss) on sale xxx Profit or (loss) on sale xxx
Capital portion Taxable capital gain
Proceeds xxx Proceeds xxx
Less cost (xxx) Less base cost (xxx)
Capital profit xxx Capital gain xxx
Inclusion rate for companies @ 50%
Taxable capital gain xxx
Non-capital portion Recoupment / Scrapping allowance
Proceeds limited to cost xxx Proceeds limited to cost xxx
Less carrying amount (xxx) Less tax base (xxx)
Non-capital profit or (loss) xxx Recoupment/ (scrapping allowance) xxx
A recoupment is the reversal of tax deductions allowed in prior years whereas a scrapping
allowance is simply the granting of a further deduction where the asset is sold at a loss.
Chapter 6 297
The following two examples repeat the basic principles of a sale of an asset (covered in
chapter 5). The examples after these two examples introduce the deferred tax implications of
the sale of an asset.
Example 16: Non-current asset sold at a profit with a recoupment
A company purchases an asset for C1 200 on 1 January 20X1.
The company depreciates this asset over 3 years, straight-line to a nil residual value.
The tax authority allows this cost to be deducted over 4 years.
The company sells the asset for C900 on 1 January 20X3.
Required:
A. Calculate the depreciation expensed and the capital allowances granted to 31 December 20X2.
B. Calculate the net cost of the asset to the company after having sold it.
C. Calculate the profit on sale and the recoupment of allowances, if any.
Solution 16A: Depreciation versus capital allowances

W1. Depreciation and capital allowances Depreciation Capital allowances
20X1: [(C1 200 – 0) / 3 years]; and [C1 200 / 4 years] 400 300
31/12/20X2: Cumulative 800 600
Solution 16B: Cost to company

W2. Net cash outflow to company C
Cost of purchase 1 200
Cost recovered through sale (900)
Net cost to company 300
Solution 16C: Profit on sale versus recoupment on sale

W3. Profit/ (loss) on sale C
Proceeds 900
Less carrying amount (1 200 – 800) (400)
Profit on sale 500
W4. Recoupment/ (scrapping allowance) on sale
Proceeds (900) limited to cost (1 200) (cost is greater, so proceeds not limited) 900
Less tax base (1 200 cost – 600 allowances to date) (600)
Recoupment / (scrapping allowance) 300
Comment: The real net cost to the company is 300 (see example 16B). This is reflected by both:
A net tax deduction of 300: deductions granted of 600 – recoupment of deductions of 300
A net expense of 300: depreciation of 800 – profit on sale of 500
Example 17: Non-current asset sold at a loss with a scrapping allowance

A company purchases an asset for C1 200 on 1 January 20X1.
The company depreciates this asset over 3 years, straight-line to a nil residual value.
The tax authority allows this cost to be deducted over 4 years.
The company sells the asset for C300 on 1 January 20X3.
Required:
A. Calculate the depreciation expense and capital allowances granted to 31 December 20X2.
B. Calculate the net cost of the asset to the company after having sold it.
C. Calculate the loss on sale and the recoupment of allowances, if any.
298 Chapter 6
Solution 17A: Depreciation versus capital allowances

W1. Depreciation and capital allowances Depreciation Capital allowances
31/12/20X2: Cumulative 800 600
Solution 17B: Cost to company

W2. Net cash outflow to company C
Cost of purchase 1 200
Cost recovered through sale (300)
Net cost to company 900
Solution 17C: Loss on sale versus scrapping allowance

W3. Profit or loss on sale C
Proceeds 300
Less carrying amount (1 200 – 800) (400)
Loss on sale (100)
W4. Recoupment / (scrapping allowance) on sale
Proceeds (300) limited to cost (1 200) (cost is greater, so proceeds not limited) 300
Less tax base (1 200 – 600) (600)
Scrapping allowance (300)
Comment: The real net cost to the company is 900 (see solution 17B). This should be reflected by both:
A net tax deduction of 900: deductions granted: 600 + extra deduction (scrapping allowance): 300
A net expense of 900: depreciation expensed: 800 + extra expense (loss on sale): 100
Example 18: Sale of a deductible, depreciable asset (plant) at below cost with
deferred tax implications
A plant was purchased on 1 January 20X1 for C30 000 and sold on 1 January 20X2 for
C21 000.
The depreciation rate used by the accountant is 50% p.a. straight-line;
The rate of wear and tear allowed as a tax deduction is 33 1/3 % p.a. straight-line
The profit before tax is C20 000 in 20X1 and 20X2, according to both the accountant
and the tax authority, before taking into account the asset in any way.
The income tax rate is 30% and there are no components of other comprehensive income.
Required:
B. Calculate the current income tax for 20X2.
D. Disclose the above in as much detail as is possible for 20X2.

Plant: Carrying Tax Temporary Deferred DT
Deductible amount base difference tax at 30% balance/
Depreciable (per SOFP) (IAS 12) TD x 30% adjustment
Purchase 30 000 30 000 0 0
Depreciation/ deduction (15 000) (10 000) 5 000 1 500 Dr DT Cr TE
Closing balance – 20X1 15 000 20 000 5 000 1 500 Asset
Sale: write off CA and TB (15 000) (20 000) (5 000) (1 500) Cr DT Dr TE
Closing balance – 20X2 0 0 (1) 0 0
(1) The tax base of an asset represents the deductions still to be made for tax purposes: after the
asset is sold, there can be no further deductions.
Chapter 6 299

W2. Profit on sale – per accountant 20X2
Proceeds 21 000
Less carrying amount 15 000
Cost 30 000
Less accumulated depreciation (1 yr x 15 000) (15 000)
Profit on sale: non-capital profit 6 000
W3. Recoupment on sale – per tax authority

Proceeds (limited to cost): the cost is not a limiting factor in this example 21 000
Less tax base (20 000)
Cost 30 000
Less accumulated capital allowance (1 yr x 10 000) (10 000)
Recoupment on sale 1 000
W4. Current income tax - 20X2 Profits Tax at 30%

Profit before tax (accounting profits) (20 000 + 6 000) 26 000 7800
Movement in temporary differences: (5 000) (1 500)
- less profit on sale (W3) (6 000)
- add recoupment (W4) 1 000
Taxable profits and current income tax 21 000 6 300
Solution 18C: Ledger

20X1 20X1 Tax 3 000
CTP: NT 3 000 Deferred tax(W1) 1 500 20X2 Tax (W4) 6 300
Total 1 500 P&L 1 500
20X2 Balance 9 300
CTP: NT (W4) 6 300
Deferred tax (W1)1 500
Total 7 800 P&L 7 800

20X1 Tax 1 500 20X2 Tax 1 500
Comment:
Notice that the balance on the deferred tax reverses out: the net expenses since 20X1 to 20X2 total
C9 000 in terms of both the accountant and the tax authority:
Accountant: depreciation of 15 000 less profit of 6 000
Tax authority: capital allowance of 10 000 less recoupment of 1 000).
Company name
Note 20X2 20X1
C C
Profit before tax (20 000 + 6 000) (20 000 – 15 000) 26 000 5 000
Income tax expense 15. (7 800) (1 500)
300 Chapter 6
Solution 18D: Continued…

Company name
Note 20X2 20X1
ASSETS C C
Non-current assets
Property, plant and equipment (W1) 0 15 000
Deferred tax (W1) 6. 0 1 500
Company name
For the year ended 31 December
20X2 20X1
C C
Property, plant and equipment (W1) 0 1 500

Current (W4) 6 300 3 000
Deferred (W1) 1 500 (1 500)
Total tax expense per the statement of comprehensive income 7 800 1 500
Example 19: Sale of a deductible, depreciable asset (plant) at above cost

A plant was purchased on 1 January 20X1 for C30 000 and sold on 1 January 20X2 for
C35 000.
The depreciation rate used by the accountant is 50% p.a. straight-line;
The rate of wear and tear allowed as a tax deduction is 33 1/3 % p.a. straight-line.
The base cost for the purposes of calculating the taxable capital gain, is C31 000;
The profit before tax and before taking into account the sale, is C20 000 according to
both the accountant and the tax authority for 20X1 and 20X2;
The inclusion rate of the capital gain in taxable profits is 50%;
The income tax rate is 30% and there are no components of other comprehensive income
Required:
D. Disclose the above in the financial statements for the year ended 31 December 20X2.

The calculation of the deferred tax using the balance sheet approach is identical to the calculation under
example 18:
Whether the asset is sold at above or below original cost does not change its carrying amount or
tax base at the end of year 20X2.
Both are simply zero since the asset has been sold.
In other words, what the asset is sold for (selling proceeds), has no bearing on deferred tax.
The price the asset sells for only affects the current income tax calculation, in the form of
recoupment or scrapping allowances, and capital gains tax.
Chapter 6 301

W1. Recoupment on sale – per tax authority 20X2
Proceeds (35 000) limited to cost (30 000): (thus 30 000 is a limiting factor) 30 000
Less tax base (20 000)
Cost 30 000
Less accumulated capital allowance (1 yr x 10 000) (10 000)
Recoupment 10 000
W2. Taxable capital gain – per tax authority 20X2
Proceeds 35 000
4 000
Inclusion rate @ 50%
Proceeds 35 000
Cost 30 000
Less accumulated depreciation (1 yr x 15 000) (15 000)

- capital profit (35 000 – 30 000) 5 000
- non-capital profit (30 000 – 15 000) 15 000
W4. Taxable profits and current income tax - 20X2 Profits Tax at 30%
Profit before tax (accounting profits) (20 000 + profit on sale: 20 000) 40 000
Exempt income: exempt portion of capital profit
- Less capital profit W3 (5 000)
- Add taxable capital gain W2 2 000
Taxable accounting profits and tax expense 37 000
Movement in temporary differences: (5 000)
- Less non-capital profit on sale W3 (15 000)
- Add recoupment on sale W1 10 000
Solution 19C: Ledger

20X1 20X1: Tax exp 3 000
CTP: NT 3 000 Deferred tax 1 500 Balance c/f 3 000
P&L 1 500 3 000 3 000
3 000 3 000 20X1 Bal b/f 3 000
20X2 20X2: Tax exp 9 600
CTP: NT 9 600 Balance c/f 12 600
Deferred tax 1 500 P&L 11 100 12 600
Total 11 100 11 100 20X2 Bal b/f 12 600

20X1: Tax exp 1 500
20X1 Bal c/f 1 500
1 500 1 500
20X1 Bal b/f 1 500
20X1: Tax exp 1 500
1 500 1 500
20X2 Bal b/f 0
302 Chapter 6
Entity name
Note 20X2 20X1
C C
Profit before tax (20K + 20K) (20K – 15K) 40 000 5 000
Name
20X2 20X1
C C
Current (W4) 9 600 3 000
Deferred (W1 example 18) 1 500 (1 500)
Property, plant and equipment W1 (example 18) 0 1 500
Example 20: Sale of a non-deductible, non-depreciable asset at below cost

Entity Ltd purchased land for C30 000 on 1 January 20X1
The land was sold on 1 January 20X2 for C20 000.
The local tax authority taxes 50% of capital gains but does not allow the deduction of
capital losses
The profit before tax but before taking into account the sale is C20 000 according to
both the accountant and the tax authority and for both 20X2 and 20X1.
The income tax rate is 30%
Required:
C. Disclose this in the financial statements for the year ended 31 December 20X2.

Land: Carrying Tax Temporary Deferred DT
Non-deductible amount base difference tax at 30% balance/
Non-depreciable (per SOFP) (IAS 12) TD x 30% adjustment
Purchase 30 000 0 (30 000) 0 Exempt
Depreciation/ deductions (0) (0) 0 0 0
Closing balance – 20X1 30 000 0 (30 000) 0 Exempt
Sale: write off of CA & TB (30 000) (0) 30 000 (0) Exempt
Closing balance – 20X2 0 0 0 0
Chapter 6 303
W2. Recoupment/ scrapping allowance on sale – per tax authority 20X2

Proceeds (20 000) limited to cost (30 000): (therefore 30 000 is not a limiting factor) 20 000
Less tax base (no deductions of cost allowed for this land) (0)
Recoupment 20 000
Recoupment is not possible (since no deductions were allowed, there can be nothing (20 000)
to recoup!)
Recoupment * 0
Comment:
There appeared to be a recoupment because the tax base is nil, but, we must remember that the tax base
is nil because the asset was non-deductible and not because all the tax deductions had been granted.
W3. Profit/ (loss) on sale – per accountant 20X2

Proceeds 20 000
Cost 30 000
Less accumulated depreciation (this land is not depreciated) (0)
Loss on sale (10 000)
W4. Taxable profits and current income tax - 20X2 Profits Tax at 30%
Profit before tax (accounting profits) (20 000 – 10 000) 10 000
Movement in temporary differences: exempt (IAS 12.15) 10 000
Add back loss on sale of land W3 10 000
Add recoupment: not applicable W2 (not deductible) 0
Movement in temporary differences: normal 0
Entity Ltd
Note 20X2 20X1
C C
Profit (loss) before tax (20 000 – 10 000) (20 000 + - 0) 10 000 20 000
Taxation expense 5. (6 000) (6 000)
Entity Ltd
Note 20X2 20X1
C C
ASSETS
Non-current assets
Property, plant and equipment W1 0 30 000
Deferred tax: income tax W1 6 0 0
304 Chapter 6
Entity Ltd
20X2 20X1
current W4 6 000 6 000
deferred W1 0 0
Tax Rate Reconciliation

Tax effects of:
Profit before tax (10 000 x 30%); (20 000 x 30%) 3 000 6 000
Exempt temporary differences (add loss: 10 000 x 30%) 3 000 0
Tax expense charge per statement of comprehensive income 6 000 6 000
Effective tax rate (6 000/ 10 000) (6 000 / 20 000) 60% 30%
Example 21: Sale of non-deductible, non-depreciable asset at above cost

Daisy Limited purchased land for C30 000 on 1 January 20X1. This land:
was then sold on 1 January 20X3 for C40 000;
was not depreciated and no deductions had been allowed for tax purposes;
had a base cost, for the purposes of calculating the taxable capital gain, of C31 000 and
the inclusion rate of the capital gain in taxable profits was 50%.
The profit before tax and before taking into account the sale, is C20 000 according to both
the accountant and the tax authority for 20X2 (and 20X1).
Required:

Comment: The calculation of deferred tax using the balance sheet approach is identical to the
calculation under example 20 since the amount that the asset is sold for does not affect the deferred tax
calculation in any way. The deferred tax calculation focuses only on the calculation of the carrying
amount and tax base. The fact that this asset was sold at above original cost does not affect its carrying
amount or tax base: both are simply reduced to zero when the asset is sold since the asset no longer
belongs to the company.

Taxable profits and current income tax – 20X1:

Proceeds (40 000) limited to cost (30 000): (therefore 30 000 is a limiting factor) 30 000
Less tax base (no deductions against cost allowed) (0)
Recoupment 30 000
Exemption (since no deductions were allowed, there can be no recoupment) (30 000)
Recoupment after exemption 0
Chapter 6 305

Proceeds 40 000
9 000
Inclusion rate 50%

Proceeds 40 000
Cost 30 000
Less accumulated depreciation (no depreciation on this land) (0)
- capital profit (selling price: 40 000 – cost price: 30 000) 10 000
- non-capital profit (cost price: 30 000 – carrying amount: 30 000) 0
W4. Taxable profits and current income tax - 20X2 C

Profit before tax (accounting profits) (20 000+ profit on sale: 10 000) 30 000
- Exempt income: exempt portion of capital profit (5 500)
Less capital profit W3 (10 000)
Add taxable capital gain W2 4 500
- Exempt temporary difference: (IAS 12.15) 0
Less non-capital profit W3 (0)
Add recoupment W1 (exempted in terms of IAS 12.15) 0
- Movement in temporary differences: W1 (example 20) 0
Taxable profits and current income tax 24 500
Current income tax at 30% 7 350

Entity name
Note 20X2 20X1
C C
Profit (loss) before tax (20 000 + 10 000) (20 000 + - 0) 30 000 20 000
Entity name
Note 20X2 20X1
ASSETS C C
Non-current assets
Property, plant and equipment W1 (example 20) 0 30 000
Deferred tax: income tax W1 (example 20) 6 0 0
306 Chapter 6
Entity Name
20X2 20X1

Current W4 7 350 6 000
Deferred W1 (example 20) 0 0

Tax effects of:
Profit before tax (30 000 x 30%) (20 000 x 30%) 9 000 6 000
Exempt capital profit (10 000 – 4 500) x 30% (1 650) 0
Tax expense per statement of comprehensive income 7 350 6 000
Effective rate of tax (7 350/ 30 000) (6 000 / 20 000) 24.5% 30%
Example 22: Sale of non-deductible, depreciable asset at below cost

A building was purchased for C30 000 on 1 January 20X1.
This was sold on 1 January 20X2 for C28 000.
Depreciation was provided at 10% p.a. on cost.
No deductions were allowed by the tax authorities.
The profit before tax and before taking into account the sale according to both the accountant and the
tax authority, is as follows:
20X1: C50 000
20X2: C20 000
Required:
Building: Carrying Tax Temporary Deferred DT

Non-deductible amount base difference tax at 30% balance/
Depreciable (per SOFP) (IAS 12) TD x 30% adjustment

Purchase 30 000 0 (30 000) 0 Exempt
Depreciation/ deductions (3 000) (0) 3 000 0 Exempt
Closing balance – 20X1 27 000 0 (27 000) 0 Exempt
Sale: write off of CA and TB (27 000) (0) 27 000 (0) Exempt
Chapter 6 307

Proceeds (28 000) limited to cost (30 000): (therefore 30 000 is not a limiting factor) 28 000
Less tax base (no deductions of cost allowed for this land) (0)
Recoupment 28 000
IAS 12.15 exemption (since no deductions were allowed, there can be no recoupment) (28 000)
Recoupment after exemption 0

Proceeds 28 000
Cost 30 000
Less accumulated depreciation (30 000 x 10%) (3 000)
Profit on sale (all a ‘ non-capital profit’ since selling price was below original cost) 1 000
W4. Calculation of current income tax 20X2 20X1

Profit before tax (accounting profits) (20 000 + profit on sale: 1 000) 21 000 47 000
(50 000 – depreciation: 3 000)
Movement in temporary differences: IAS 12.15 exemption (1 000) 3 000

- Add depreciation 30 000 x 10% 0 3 000
- Less profit on sale W3 (1 000) 0
Movement in temporary differences: normal 0 0
Taxable profits 20 000 50 000
Current income tax at 30% 6 000 15 000

Entity name
Note 20X2 20X1
C C
Profit (loss) before tax (20K + 1K) (50K – 3K) 21 000 47 000
Entity name
20X2 20X1
ASSETS C C
Non-current assets
Property, plant and equipment W1 0 27 000
Deferred tax: income tax W1 0 0
308 Chapter 6
Solution 22C: Continued…

Name
20X2 20X1
Current W4 6 000 15 000
Deferred W1 0 0

Tax effects of:
Profit before tax (21 000 x 30%) (47 000 x 30%) 6 300 14 100
Exempt temporary differences (less profit on sale: 1 000 x 30%) (300) 900
(add depreciation: 3 000 x 30%)
Effective tax rate (6 000/ 21 000) (15 000 / 47 000) 28.6% 31.9%
Example 23: Sale of non-deductible, depreciable asset at above cost

A building purchased for C30 000 on 1 January 20X1 was sold on 1 January 20X2 for
C40 000.
Depreciation of 10% per annum was provided (residual value: nil).
No deductions were allowed by the tax authorities.
Its base cost, for the purposes of calculating the taxable capital gain, is C31 000 and the
inclusion rate of the capital gain in taxable profits is 50%.
The profit before tax and before taking into account the sale, is C20 000 according to both
the accountant and the tax authority for 20X2 and 20X1.
Required:

The deferred tax calculation is identical to the calculation in example 22: the fact that the asset is sold
at above cost does not change its CA or TB: both become zero once sold.

W1 Recoupment on sale – per tax authority 20X2
Proceeds (40 000) limited to cost (30 000): (therefore 30 000 is a limiting factor) 30 000
Less tax base no deductions allowed on this building (0)
Recoupment 30 000
IAS 12.15 exemption (30 000)
Recoupment after exemption (1) 0

Proceeds 40 000
Capital gain 9 000
Inclusion rate 50%
Chapter 6 309

Proceeds 40 000
Cost 30 000
Less accumulated depreciation (30 000 x 10%) (3 000)

- capital profit (proceeds: 40 000 – cost: 30 000) 10 000
- non-capital profit (cost: 30 000 – carrying amount: 27 000) 3 000
W4. Calculation of current income tax - 20X2 20X2 20X1

Profit before tax (accounting profits) (20 000 + 13 000) 33 000 17 000
(20 000 – 3 000)
Exempt income: exempt portion of capital profit (5 500) 0
Less capital profit W3 (10 000) 0
Add taxable capital gain W2 4 500 0
Movement in temporary differences: exempt (IAS 12.15): (3 000) 3 000

Add depreciation 0 3 000
Less non-capital profit W3 (3 000) 0
Add recoupment (1) W1 0 0
Movement in temporary differences: normal 0 0
Taxable profits 24 500 20 000

Entity name
Note 20X2 20X1
C C
Profit before tax (20 000 + 13 000) (20 000 - 3 000) 33 000 17 000
Entity name
Note 20X2 20X1
ASSETS C C
Non-current assets
Property, plant and equipment W1: example 22 0 27 000
Deferred tax: income tax W1: example 22 6 0 0
Notes
(1)
That there is no recoupment, because no deductions have been allowed previously, due to the
exemption in IAS12.15
310 Chapter 6

Entity name
20X2 20X1
current W4 7 350 6 000
deferred W1: example 22 0 0
Tax effects of:
Profit before tax (33 000 x 30%) 9 900 5 100
(17 000 x 30%)
Non-deductible depreciation (3 000 x 30%) 0 900
Exempt capital profit less non-taxable capital profit: 5 500 x 30% (1 650) 0
IAS 12.15 exempt temporary difference: non-capital profit (900) 0
less exempt non-capital profit: 3 000 x 30%
Effective tax rate (7 350/ 33 000) (6 000 / 17 000) 22.3% 35.3%
6. Exemption From Deferred Tax (IAS 12.15 and IAS 12.24)
IAS 12 offers two exemptions from the requirement to recognise deferred tax:
IAS 12.15 provides us an exemption from recognising deferred tax liabilities; and
IAS 12.24 provides us an exemption from recognising deferred tax assets.
The exemption from recognising deferred tax liabilities is covered in depth in section 5.3.2.
This section summarises the exemption relating to both deferred tax liabilities and deferred
tax assets.
A deferred tax liability is normally recognised on taxable temporary differences, but if the
taxable temporary difference meets the criteria in IAS 12.15, it is exempt from deferred tax.
The following is a summary of the relevant IAS 12 paragraph (IAS 12.15):

a deferred tax liability shall be recognised for all taxable temporary differences,
except where the deferred tax liability arises from:
goodwill; or
the initial recognition of an asset or liability, which
did not arise through a business combination, and which
at the time of the transaction, affects neither accounting profit nor taxable profit.
Similarly, a deferred tax asset is normally recognised on deductible temporary differences,

but if this difference meets the criteria in IAS 12.24, it may be exempt from deferred tax.
The following is an extract of the relevant IAS 12 paragraph (IAS 12.24):

a deferred tax asset shall be recognised for all deductible temporary differences,
except where the deferred tax asset arises from the:
- initial recognition of an asset or liability, which
- did not arise through a business combination, and
- at the time of the transaction, affects neither accounting profit nor taxable profit
Chapter 6 311
In other words, no deferred tax would be recognised on Important! The exemptions

the temporary differences that arise on the initial from deferred tax
recognition of an asset or liability where the initial (IAS 12.15 and IAS 12.24):
recognition affects neither accounting profit nor taxable
profit, and where the asset or liability is not acquired as only apply to the initial recognition
part of a business combination. (e.g. the cost of purchase);
applies to any asset (not just non-
We covered some examples that showed the exemption current assets) or liability;
from recognising a deferred tax liability on the taxable
temporary difference arising on the acquisition of non- do not apply to acquisitions arising
through business combinations.
current assets (see section 5.3.2).
Since the exemption principles apply equally to the exemption from recognising a deferred
tax asset on deductible temporary differences, this text does not include any further examples.
7. Rate Changes and Deferred Tax
A deferred tax balance is simply an estimate of the tax owing to the tax authority in the long-
term or the tax savings expected from the tax authority in the long-term. The estimate is made
based on the temporary differences multiplied by the applicable tax rate. If this tax rate
changes, so does the estimate of the amount of tax owing by or owing to the tax authority in
the future. Therefore, if a company has a deferred tax balance at the beginning of a year
during which the rate of tax changes, the opening balance of the deferred tax account will
need to be re-estimated.
This is effectively a change in accounting estimate, the adjustment for which is processed in
the current year’s accounting records.
Since the tax expense account in the current year will include an adjustment to the deferred
tax balance from a prior year, the effective rate of tax in the current year will not equal the
applicable tax rate. The difference between the effective and the applicable rate of tax results
in the need for a tax rate reconciliation in the tax note.
The date on which a rate change is announced by the Minister of Finance is generally referred
to as the date of substantive enactment (assuming that there were no other significant changes
to other tax rates that were also announced). The deferred tax balance is always adjusted for
the new rate unless the date of substantive enactment occurs after year end. The current tax
payable balance is only adjusted if the effective date of the change occurs before year end.
Example 24: Rate changes: journals
The closing balance of deferred tax at the end of 20X1 is C60 000.
Required:
Show the journal entries relating to the rate change in 20X2 assuming that:
A. the balance in 20X1 is an asset and that the rate was 30% in 20X1 and 40% in 20X2;
B. the balance in 20X1 is a liability and that the rate was 30% in 20X1 and is 40% in 20X2;
C. the balance in 20X1 is an asset and that the rate was 40% in 20X1 and is 30% in 20X2;
D. the balance in 20X1 is a liability and that the rate was 40% in 20X1 and is 30% in 20X2.
Solution 24: Journals

1 January 20X2 Calculations Debit/ Debit/ Debit/ Debit/
(Credit) (Credit) (Credit) (Credit)
Deferred tax: income tax (A/L) (a); (b); (c); (d) 20 000 (20 000) (15 000) 15 000
Income tax expense (20 000) 20 000 15 000 (15 000)
Rate change: adjustment to DT opening balance
Notes
312 Chapter 6
(a) Tax rate increased by 10%: DTA: 60 000 / 30 % x (40% – 30%) = 20 000 (DT asset increases)
(b) Tax rate increased by 10%: DTL: 60 000 / 30 % x (40% – 30%) = 20 000 (DT liability increases)
(c) Tax rate decreased by 10%: DTA: 60 000 / 40 % x (40% – 30%) = 15 000 (DT asset decreases)
(d) Tax rate decreased by 10%: DTL: 60 000 / 40 % x (40% – 30%) = 15 000 (DT liability decreases)
Example 25: Rate changes: journals and disclosure

The opening balance of deferred tax at the beginning of 20X2 is C45 000, (credit balance).
Deferred tax is due purely to temporary differences caused by capital allowances on the
The tax rate in 20X1 was 45% but changed to 35% in 20X2.
The profit before tax in 20X2 is C200 000, all of which is taxable in 20X2.
No balance was owing to or from the tax authority at 31 December 20X1 and no
payments were made to or from the tax authority during 20X2.
There are no other temporary differences,
There is no exempt income and no non-deductible expenses,
Required:
A. Calculate the effect of the rate change.
B. Show the calculation of deferred income tax using the balance sheet approach.
C. Calculate the current income tax for 20X2.
D. Post the related journal in the ledger accounts.
E. Disclose the above in the financial statements for the year ended 31 December 20X2.
Solution 25A: Rate change

The opening balance in 20X2 (closing balance in 20X1) was calculated by multiplying the total
temporary differences at the end of 20X1 by 45%.
Therefore, the temporary differences (TD) provided for at the end of 20X1 (opening deferred tax
balance in 20X2) are as follows:
Old deferred tax balance = Temporary difference x applicable tax rate

.: C45 000 = Temporary difference x 45%
.: Temporary difference = C45 000/ 45%
.: Temporary difference = C100 000
The credit balance means that the company is expecting the tax authority to charge them tax in the
future on the temporary difference of C100 000.
If the tax rate is now 35%, the estimated future tax on this temporary difference of C100 000 needs to
be changed to:
Revised deferred tax balance = Temporary difference x applicable tax rate

.: New deferred tax balance = C100 000 x 35%
.: New deferred tax balance = C35 000
An adjustment to the opening deferred tax balance in 20X2 must be processed:
Dr/ (Cr)
Deferred tax balance was (45 000) Balance: credit
Deferred tax balance should now be (35 000) Balance: credit
Adjustment needed 10 000 Adjustment: debit deferred tax, credit tax expense
Chapter 6 313

Non-current assets: Carrying Tax Temporary Deferred Deferred tax
Depreciable (per FP) (IAS 12) TD x % adjustment
Opening balance @ 45% xxx xxx (100 000) (45 000) Liability
Rate change (100 000 x 10%) 10 000 Dr DT Cr TE
Opening balance @ 35% (100 000) (35 000)
Movement (1) 0 0 0 0
Closing balance – 20X2 xxx xxx (100 000) (35 000) Liability
Notes:
(1)
The question stated that there were no other temporary differences other than the balance of
temporary differences at 31 December 20X1.
Solution 25C: Current tax

Taxable profits and current income tax - 20X2 Profits Tax at 35%
Profit before tax (accounting profits) (given) 200 000

Exempt income and non-deductible expenses: (given) 0
Movement in temporary differences: (given) 0 0
Solution 25D: Ledger accounts

The credit balance of the deferred tax account must be reduced, thus requiring this account to be
debited. The contra entry will go to the tax expense account, since this is where the contra entry was
originally posted when the 45 000 was originally accounted for as a deferred tax liability.
Income tax (E) Deferred tax (L)

CTP: NT 70 000 Deferred tax(1) 10 000 Tax(1) 10 000 Balance b/d 45 000
Total c/f 60 000 Balance c/d 35 000
70 000 70 000 45 000 45 000
Total b/f 60 000 Balance b/d 35 000
P&L 60 000
60 000 60 000
Current tax payable: income tax (L)

Tax 70 000
Solution 25E: Disclosure
Entity name
Note 20X2 20X1
C C
Profit before tax (given) 200 000 xxx
Income tax expense 3 (60 000) xxx
Profit for the year 140 000 xxx
Total comprehensive income 140 000 xxx
314 Chapter 6
Solution 25E: Continued ...

Entity name
Note 20X2 20X1
LIABILITIES C C
Deferred tax: income tax 25A or 25B 4 35 000 45 000
Current liabilities
Current tax payable: income tax 25C 70 000 0
Entity name
3. Income tax expense 20X2

C
Income taxation 60 000
Current 200 000 x 35% 70 000
Deferred
- Current year 25B: (no temporary differences) 0
- Rate change 25A or 25B (10 000)
Tax expense per the statement of comprehensive income 60 000
Tax effects of:

Profit before tax (200 000 x 35%) 70 000
Rate change 25A or 25B (10 000)
Tax expense charge per statement of comprehensive income 60 000
Effective tax rate (60 000/ 200 000) 30%
Please note: there was insufficient information to be able to provide the comparatives for the tax note.
4. Deferred tax liability 20X2 20X1

C C
8. Deferred Tax Assets (IAS 12.34)
8.1 What causes a deferred tax asset?

Since an asset is defined in the Conceptual Framework as representing future economic
benefits, deferred tax assets would therefore represent future tax savings. A deferred tax asset
can arise on any one or more of the following categories:
Deductible temporary differences (DTDs)
For example: in the case of a plant, the tax base is greater than its carrying amount,
or, put another way: the future wear and tear that will be deducted (tax base) is greater
than the future economic benefits (carrying amount): this net tax deduction will
reduce future taxable profits and thus reduce the future tax expense charge;
Chapter 6 315
Unused tax credits (UTCs)

For example: in some countries, entities are able to reduce their future tax expense by
carrying forward tax credits calculated in terms of legislation;
Unused tax losses (assessed losses) (UTLs)
For example: if an entity makes a tax loss in the current year, it may be allowed to
carry this loss forward to future years in which it makes a profit, this loss thus
reducing the amount of profits upon which taxes are levied. This thus represents a
future tax saving (i.e. an unused tax loss will reduce future income tax).
Deductible temporary differences, unused tax credits and unused tax losses are generally able
to be carried forward from one year to the next until they are able to be used to reduce the
future taxable amounts on which tax would be levied. Therefore, all three categories represent
future tax savings. A future tax saving is obviously an asset to the entity, but it can obviously
be recognised only if it is probable that future taxable profits will be big enough to allow the
tax saving from these items to be utilised (i.e. realised).
8.2 Deferred tax assets: Recognition in terms of the Conceptual Framework

Whilst a deferred tax asset may exist, whether to recognise it in the accounting records or not
depends on the requirements of both the Conceptual Framework and IAS 12.
The Conceptual Framework requires that before an asset To recognise or not to

may be recognised, the recognition criteria must be met: recognise… that is the
It must be reliably measurable; and question!
The inflow of future economic benefits must be
A deferred tax asset may only be
probable. recognised if the recognition criteria
are met.
After reading this chapter, you should hopefully have no
difficulty in measuring these assets reliably (tax rate Deferred tax assets on unutilised tax
multiplied by the temporary difference: TB – CA) but the losses represent a tax savings against
future profits;
inflow of future economic benefits is not always
probable. If you are able to reliably measure the asset but However the existence of an
the related inflow of future economic benefits is not assessed loss in the first place may
probable, the asset may not be recognised. indicate the entity will never earn
profits to utilise the tax loss!
Each of the three deferred tax assets (DTDs, UTCs, and UTLs) would only be able to be
recognised if both recognition criteria were met. The deferred tax on an unutilised tax loss is,
however, the deferred tax asset that is generally the most difficult to recognise.
The reason why it is more difficult to recognise deferred tax assets on tax losses than on
unused tax credits or deductible temporary differences is simply that if we make a tax loss, it
may mean that we are already in financial difficulty, in which case it is possible that we may
never make future profits big enough to be able to deduct the tax loss and realise a tax saving.
Worked Example: Tax losses may or may not represent future tax savings
Consider the two scenarios below:
Scenario 1:
We make a tax loss in 20X1 of C100 000 and expect to make a taxable profit in 20X2 of
C300 000 (before carrying forward the tax loss from 20X1).
The tax rate is 30% and we are allowed to carry tax losses forward.
Scenario 2:
We make a tax loss in 20X1 of C100 000 and expect to make another tax loss in 20X2 of
C300 000 (before carrying forward the tax loss from 20X1)
The tax rate is 30% and we are allowed to carry tax losses forward after which we expect to
have to close the business.
316 Chapter 6
Solution to Worked Example: Tax losses may or may not represent future tax savings
Scenario 1:
Calculation of current income tax: 20X2 20X1

C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ 300 000 (100 000)
forward
Tax loss brought forward (100 000) 0
Taxable profit/ (tax loss) 200 000 (100 000)
Current income tax at 30% 60 000 0
Since the company expects to make taxable profits of C300 000 before adjusting for tax losses
brought forward, the tax loss of C100 000 will be able to be used to reduce the future tax from
C90 000 (C300 000 x 30%) to C60 000 (calculation above). This is clearly a tax saving of C30 000.
Conclusion:
This predicted saving is therefore a deferred tax asset of C30 000 at the end of 20X1 which
should be recognised if the future taxable profits are probable.
Scenario 2:
Calculation of estimated current income tax: 20X2 20X1

C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ (300 000) (100 000)
forward
Taxable profit/ (tax loss) (400 000) (100 000)
Conclusion:
We would not recognise the deferred tax asset at the end of 20X1 since, at this date, it was not
considered probable that we would make sufficient taxable profits in the future.
If, however, our forecast for the years beyond 20X2 had indicated that sufficient profits were
expected to be made thus enabling us to utilise the C100 000 tax loss, then we would be able to
recognise the deferred tax asset of C30 000 at 31 December 20X1 (assuming that the tax loss
does not expire in terms of tax legislation before the company becomes sufficiently profitable to
be able to utilise it).
Example 26: Recognition of deferred tax assets: tax loss expected to expire:
discussion
Human Limited made a tax loss of C100 000 in 20X1.
There was no tax loss brought forward from 20X0.
Required: Explain whether or not a deferred tax asset should be recognised at the end of 20X1 if the
entity’s final management-reviewed forecast shows a tax loss of C50 000 in 20X2 (before considering
the tax loss from 20X1) and where the tax legislation provides that the 20X1 tax loss will expire on
31 December 20X2: refer to both the Framework and IAS 12.
Solution 26: Recognition of DTA: tax loss expected to expire:

Definition of an asset (Conceptual Framework):
Resource controlled by the entity: a tax loss of C100 000 in the name of the entity
From a past event: the trading that resulted in the tax loss
Future economic benefits expected to flow in: since the entity has predicted a further tax loss in
20X2 after which the 20X1 tax loss will expire, the entity does not expect to be able to make use of
the C30 000 tax saving that is attached to the C100 000 tax loss.
Chapter 6 317

Recognition criteria (Conceptual Framework):
The potential tax saving must be reliably measurable: tax loss of C100 000 x 30% = C30 000;
The inflow of future economic benefits must be probable: management has budgeted a future tax
loss of C50 000, in 20X2 and because the 20X1 tax loss expires on 31 December 20X2 if not used,
this tax loss will simply expire and never result in a tax saving – there are therefore no future
economic benefits expected.
Recognition criteria (IAS 12.34):
Our tax loss is C100 000 and since we expect to make a further tax loss of C50 000, we are not
expecting to be able to deduct the C100 000 tax loss at all in the calculation of the future current
tax payable and are therefore not expecting to ever receive the tax saving on the tax loss, since the
C100 000 tax loss will have expired by the end of 20X2.
Since this expectation is drawn from a final forecast that has already been reviewed by
management this expectation is probable: there is insufficient profit before the tax loss expires.
Therefore, in other words, it is not probable that there will be sufficient future taxable profit to be
available against which the unused tax losses can be utilised.
Conclusion:
The asset definition and both sets of recognition criteria are not met and thus a deferred tax asset may
not be recognised.
The following calculation proves that the saving would not happen:
20X2 20X1
W1. Calculation of current income tax: C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ forward (50 000) (100 000)
Reverse 20X1 unutilised tax loss expiring 31/12/20X2 100 000
Taxable profit/ (tax loss) (50 000) (100 000)
8.3 Deferred tax assets: Recognition in terms of IAS 12
In addition to the recognition criteria given in the Framework, the question of whether or not
to recognise a deferred tax asset is also affected by IAS 12. The two most important
paragraphs in IAS 12 guiding us as to whether or not to recognise the deferred tax asset are:
IAS 12.34: A deferred tax asset shall be recognised for: Recognition

- the carry forward of unused tax losses (also called Notice that the recognition
assessed losses) and unused tax credits criteria in IAS 12 are similar
- to the extent that it is probable that future taxable to that of the conceptual framework.
profit will be available against which the unused tax losses and unused tax credits can
be utilised. IAS 12.34
IAS 12.24: A deferred tax asset shall be recognised for :
- all deductible temporary differences
- to the extent that it is probable that taxable profit will be available against which the
deductible temporary difference can be utilised (except if the temporary difference is
exempted). IAS 12.24
It should be clear from the above that the decision as to whether or not to recognise the
deferred tax asset is the same in all three cases: there must be sufficient future taxable profits
in order to be able utilise the future deduction, unused tax credit or unused tax loss.
Taxable profits are considered to be available if the entity currently has more taxable
temporary differences than deductible differences. If this is the case, the deferred tax assets on
the deductible temporary differences will be recognised in full since the deferred tax liabilities
on the taxable temporary differences are greater, and thus the entity’s net deferred tax balance
will be a liability. IAS 12.28
318 Chapter 6
If the entity does not have sufficient taxable temporary differences against which the
deductible temporary differences can be off-set (i.e. the net deferred tax balance will be an
asset), then the deferred tax asset may only be recognised if it is probable that there will be
sufficient future taxable profits against which the deductible temporary differences may be
off-set. When estimating the probable future profits, we must obviously ignore taxable profits
arising from future (further) deductible temporary differences. See IAS 12.29
Example 27: Recognition of deferred tax asset: deductible temporary
differences
Animal Limited owned a computer which it purchased on 1 January 20X1 for C100 000.
The tax authorities allow a deduction of 20% in 20X1, 30% in 20X2 and 30% in 20X3.
The computer is depreciated on the straight-line basis over 2 years to a nil residual
value.
There are no items of exempt income or non-deductible expenses.
There are no temporary differences other than those arising from the above.
Required:
Calculate and prove what portion of the deferred tax asset balance should be recognised at
31 December 20X1 assuming that the entity’s final management-reviewed forecast shows:
A. minimum profits before tax of C240 000.
B. a profit before tax of C10 000 in 20X2 after which the company is expecting to close down.
C. a total loss before tax of C240 000 (C120 000 in 20X2 and 20X3) and due to an economic
meltdown in the country, the company is planning to possibly close down before the end of 20X3.
Solution 27 (A, B and C): Recognition of DTA: deductible temporary difference
W1. DT on computer: Carrying Tax Temporary Deferred DT

Depreciable (per SOFP) (IAS 12) TD x 30% adj.
Purchase 100 000 100 000 0 0
Depreciation/ deductions (50 000) (20 000) 30 000 9 000 Dr DT Cr TE
Closing balance – 20X1 50 000 80 000 30 000 9 000 Asset
Future depr/ deductions: X2 & X3 (50 000) (80 000) 30 000 (9 000) Cr DT Dr TE
Scenario A Scenario B Scenario C

W2. Calculation of future income tax payable C C C
Future profit before tax 240 000 10 000 (240 000)
Future exempt income and non-deductible expenses 0 0 0
Future profit before tax that is taxable 240 000 10 000 (240 000)
Future movement in temporary differences: (30 000) (30 000) (30 000)
- Add future depreciation CA: 50 000 – RV: 0 50 000 50 000 50 000
- Less future tax deduction TB: 80 000 - 0 (80 000) (80 000) (80 000)
Future income tax payable at 30% 63 000 0 0
W3. Calculation of future tax savings

Tax that would be due on ‘future A: 240 000 x 30% 72 000 3 000 0
profit before tax that is taxable’ B: 10 000 x 30%
C: loss = 0 tax
Future income tax payable at 30% W2 above 63 000 0 0
Future tax saving due to deduction of temporary differences 9 000 3 000 0
Chapter 6 319

Conclusion: By looking at the tax that would have been due and payable had there been no deductible
temporary differences and comparing it to the tax that is due and payable after taking into account these
differences, one can assess the extent to which the future deductible temporary differences will result in
tax savings and therefore whether the company should recognise a deferred tax asset, and if so at what
amount. The deferred tax asset at 31 December 20X1 should therefore be measured at:
C C C
Deferred tax asset balance to be recognised: 9 000 3 000 0
8.4 Deferred tax assets: measurement
The deferred tax asset balance is simply measured as the tax on the deductible temporary
difference using the usual balance sheet approach. This is the same principle we have been
using to measure the deferred tax balances in previous examples. The only difference is that,
with deferred tax assets, we could be limited to the amount that should be recognised (as
evident in scenario B in the prior example). As a result, a variety of situations could arise:
deferred tax assets could arise in the current year that you are not able to recognise:
Traditionally no entry is processed for these deferred tax assets although it would not
be incorrect to process 2 journal entries that effectively contra each other out (the latter
approach is useful for audit trail purposes and will help with your disclosure):
debit DT asset, credit tax expense (recognising the deferred tax asset); and
credit DT asset, debit tax expense (immediately reversing the deferred tax asset).
This text follows the first approach, where no deferred tax journal is processed.
deferred tax assets that arose in a prior year and which you did not recognise as an asset in
a prior year but which you are now recognising in the current year due to the recognition
requirements now being met:
debit DT asset, credit tax expense;
deferred tax assets that were recognised in a prior
Unrecognised deferred
year but which you now need to partially or fully
tax assets
write-off (i.e. write-down) as they no longer meet the
recognition requirements: The journals that contra each other
credit DT asset, debit tax expense; out shown here, can also be used in an
exam situation to show that you
deferred tax assets that were recognised and then
decided that a deferred tax asset
either partially or fully written-down in prior years, should not be recognised.
but which are now being partially or fully reinstated
(i.e. a write-back): Check with your lecturer about how
debit DT asset, credit tax expense. marks will be awarded.
8.5 Deferred tax assets: disclosure
There are numerous disclosure requirements relating to deferred tax assets. These are
comprehensively discussed in section 10.3, but the following is a brief summary:
The tax expense note should include the amount of:

current year deferred tax assets that are not recognised;
prior year deferred tax assets that are now recognised in the current year;
prior year deferred tax assets that were recognised but are now written-down
the write-back of previously written-down deferred tax assets.
The deferred tax asset/ liability note requires disclosure of:

the amount of the temporary differences that were not recognised as deferred tax assets;
the expiry date relating to these unrecognised deferred tax assets, if applicable.
320 Chapter 6
Example 28: Tax losses: deferred tax asset recognised in full

Wear and tear on vehicle (allowed by the tax authorities) 2 years straight-line
Income tax rate 30%
Profit or loss before tax (after deducting any depreciation on the vehicle) for the year ended:
31 December 20X1 Loss: C40 000
31 December 20X3 Profit: C400 000
Other information:
There are no temporary differences other than those evident from the information provided.
The company recognised deferred tax assets in full:
it had always expected to make sufficient future taxable profits and
therefore expected to realise the related tax savings.
Required:
A. Calculate the taxable profits and current tax per the tax legislation for 20X1 to 20X3.
B. Calculate the deferred income tax balances for 20X1 to 20X3.
C. Show all tax-related journals that would be processed in 20X1, 20X2 and 20X3.
D. Disclose the above tax-related information in the financial statements for 20X3.
Solution 28A: Calculation of current income tax

W1 Calculation of current income tax 20X3 20X2 20X1
Profit before tax 400 000 (20 000) (40 000)
Add back depreciation (120 000 / 4 years) 30 000 30 000 30 000
Less capital allowance (120 000 / 2 years) 0 (60 000) (60 000)
Taxable profit/ (tax loss) created in current year 430 000 (50 000) (70 000)
Tax loss brought forward (120 000) (70 000) 0
Solution 28B: Calculation of deferred income tax

W2 Calculated of deferred income tax
Carrying Tax base Temporary Deferred tax DT balance/
amount difference at 30% adjustment
W2.1 Vehicle (SOFP) (IAS 12) (b) – (a) (c) x 30%
Balance: 1 Jan 20X1 0 0 0 0
Purchase of asset 120 000 120 000 0 0
Depreciation (30 000) (60 000) (30 000) (9 000)
Balance: 31 Dec 20X1 90 000 60 000 (30 000) (9 000) Liability
Depreciation (30 000) (60 000) (30 000) (9 000)
Balance: 31 Dec 20X2 60 000 0 (60 000) (18 000) Liability
Depreciation (30 000) 0 30 000 9 000
Balance: 31 Dec 20X3 30 000 0 (30 000) (9 000) Liability
W2.2 Tax loss

Movement 0 70 000 70 000 21 000
Balance: 31 Dec 20X1 0 70 000 70 000 21 000 Asset
Movement 0 50 000 50 000 15 000
Balance: 31 Dec 20X2 0 120 000 120 000 36 000 Asset
Movement 0 (120 000) (120 000) (36 000)
Balance: 31 Dec 20X3 0 0 0 0
Chapter 6 321
Solution 28C: Journals
Journals 20X1 Debit Credit
Income tax expense (E) W2.1 9 000

Deferred tax: income tax (L) 9 000
Origination: DT adjustment due to temporary differences: vehicle (20X1)
Deferred tax: income tax (A) W2.2 21 000

Income tax expense (E) 21 000
Origination: DT adjustment due to tax loss being created (20X1)
Journals 20X2

Origination: DT adjustment due to temporary differences: vehicle (20X2)

Origination: DT adjustment due to tax loss being created (20X2)
Journals 20X3
Deferred tax: income tax (L) W2.1 9 000
Reversal: DT adjustment due to temporary differences: vehicle (20X3)

Deferred tax: income tax (A) 36 000
Reversal: DT adjustment due to tax loss being used (20X3)
Income tax expense (E) W1 (part) 93 000

Current tax payable: income tax (L) 93 000
Current tax estimated based on current taxable profits (20X3)
Entity name
Note 20X3 20X2
Entity name
Note 20X3 20X2
C C
Profit before tax 400 000 (20 000)
Income tax income/ (expense) 12 (120 000) 6 000
Profit for the period 280 000 (14 000)
Total comprehensive income 280 000 (14 000)
322 Chapter 6
Solution 28D: Continued ...

Entity name
20X3 20X2
The deferred tax balance comprises tax on the following types of temporary differences:
Property, plant and equipment W2.1 (9 000) (18 000)
Tax losses W2.2 0 36 000
(9 000) 18 000
Income taxation expense
Current Journals 93 000 0
Deferred Journals: 20X3: 9 000 cr – 36 000 dr 27 000 (6 000)
20X2: 9 000 dr – 15 000 cr
120 000 (6 000)
Effective tax rate 20X3: 120 000 / 400 000; 20X2: 6 000 / 20 000 30% 30%
Example 29: Tax losses: deferred tax asset recognised in full then written-down
Repeat example 28 assuming that:
deferred tax assets had been recognised in full in 20X1 but
in 20X2 sufficient future taxable profits were no longer probable, with the result that
deferred tax assets could only be recognised to the extent that taxable temporary
differences were available.
The information from example 28 is repeated here for your convenience:
Capital allowance on vehicle allowed by the tax authorities 2 years straight-line
Income tax rate 30%
Profit or loss before tax (after deducting any depreciation on the vehicle) for the year ended:
31 December 20X3 Profit: C400 000
Other information:
There are no temporary differences other than those evident from the question.
Required:
Show the deferred tax asset/ liability note and the tax expense note for 20X2.
Solution 29: Tax losses: deferred tax asset recognised in full then written-down
Although W2.1 and W2.2 are the same as in example 28, a further working (W2.3 below), showing the
prior year DTA written-down and the current year DTA that is now not recognised, is useful.
W2.3 Vehicle: Tax loss:
Summary of def tax: W2.1 W2.2
Recognised Total Recognised Unrecognised
Movement (9 000) 21 000 21 000 0
Balance: 31 Dec 20X1 (9 000) 21 000 21 000 0
Movement: (9 000) 15 000
Prior year DTA written-down (21 – 9) (12 000) 12 000
Current year DTA not recognised (15 – 9) 9 000 6 000
Balance: 31 Dec 20X2 (18 000) 36 000 18 000 18 000
Chapter 6 323

Comment:
Since future taxable profits are no longer probable from 20X2, from 20X2 the total deferred tax balance
must not go into debit (i.e. must not become a deferred tax asset). The unrecognised portion is simply
the balancing amount.
Entity name
20X2 20X1
Property, plant and equipment W2.1 (Ex 28) (18 000) (9 000)
Tax losses W2.2 (Ex 28) 18 000 21 000
0 12 000
A deferred tax asset of C18 000 relating to a tax loss of C60 000 has not been recognised (20X1
unrecognised deferred tax asset: nil). The tax loss has no expiry date.

Income taxation
Current W1 (Ex 28) 0 0
Deferred
Current year movement in temp differences Calc (1) (below) (6 000) (12 000)
Prior year DTA written down W2.3 12 000 0
Current year DTA not recognised W2.3 6 000 0
Tax expense per the statement of comprehensive income 12 000 (12 000)
Tax rate reconciliation

Tax effects of:
Profit before tax (20 000 loss x 30%)(40 000 loss x 30%) (6 000) (12 000)
Prior year DTA now written down Per above 12 000 0
Current year DTA not recognised Per above 6 000 0
Tax expense per the statement of comprehensive income 12 000 (12 000)
Effective tax rate (12 000 exp / 20 000 loss) (12 000 inc / 40 000 loss) (60%) 30%
(1) Calculation of DT on current year movement in TDs: 20X1: 9 000 dr + 21 000 cr = 12 000 credit
(amounts extracted from W2.1 and W2.2) 20X2: 9 000 dr + 15 000 cr = 6 000 credit
Example 30: Tax losses: deferred tax asset recognised partially

Repeat example 28 (example 28’s information was repeated in example 29) assuming that:
the company has never been able to recognise deferred tax assets in excess of its taxable
temporary differences
Required: Show how your answer to example 28 would change.
Solution 30A: Calculation of current income tax

There would be no change to the calculation of current income tax
Solution 30B: Calculation of deferred income tax

There would be no change to the calculation of deferred tax with the exception of a further calculation
(W2.3 on the next page) to show the amount of the deferred tax asset and liability that will be
recognised for the temporary difference arising from the vehicle and from the tax loss (relating to
income tax).
324 Chapter 6

W2.3 Vehicle: Tax loss:
Summary of def tax: W2.1 W2.2
Recognised Total Recognised Unrecognised
Movement (9 000) 21 000 9 000 12 000
Balance: 31 Dec 20X1 (9 000) 21 000 9 000 12 000
Movement (9 000) 15 000 9 000 6 000
Balance: 31 Dec 20X2 (18 000) 36 000 18 000 18 000
Movement: 9 000
a) Portion of DTA used (36 000) (36 000)
b) Prior year unrecog. DTA now recognised 18 000 (18 000)
Balance: 31 Dec 20X3 (9 000) 0 0 0
Comment:
The effect of this approach is that the total deferred tax balance cannot go into debit. The unrecognised
portion is simply the balancing amount. Since in 20X3 the tax loss is utilised and resulted in a tax
saving of C36 000, it is fair to say that the asset has been used up. Since 18 000 of this asset has not
been recognised yet, this portion must now be recognised.
Solution 30C: Journals

Journals 20X1 Debit Credit
Deferred tax (L) 9 000
Originating: DT adjustment due to temporary differences: vehicle (20X1)
Deferred tax (A) W2.2/ W2.3 9 000
Originating: Deferred tax asset recognised for deductible temporary
differences relating to the tax loss, limited to the amount of the deferred tax
liability at year end (c/b 21 000 limited to 9 000 - DTA o/b 0)
Journals 20X2
Originating: DT adjustment due to temporary differences: vehicle (20X2)
Deferred tax: income tax (A) W2.2/ W2.3 9 000
Originating: Deferred tax asset recognised for deductible temporary
differences relating to the tax loss, limited to the amount of the deferred
tax liability at year end (c/b 36 000 limited to 18 000 – DTA o/b 9 000)
Journals 20X3
Deferred tax: income tax (L) W2.1 9 000
Reversing: DT adjustment due to temporary differences: vehicle (20X3)
Income tax expense (E) W2.2/ W2.3 36 000
Deferred tax (A) 36 000
Reversing: DT adjustment due to tax loss being used (20X3)
Prior year unrecognised DTA on the tax loss now recognised: this portion
of the DTA had never been recognised and yet it has now been used
Income tax expense (E) W1: Part A (a) 93 000
Current tax payable: income tax 93 000
Current tax charge in 20X3
Chapter 6 325

Entity name
20X3 20X2 20X1
5. Deferred tax asset/ (liability) C C C
Property, plant and equipment (9 000) (18 000) (9 000)
Tax loss 0 18 000 9 000
(9 000) 0 0
Unprovided deferred tax assets 0 18 000 12 000
The 20X2 unprovided deferred tax asset was due to a tax loss of C60 000 (20X1 a tax loss of C40 000).

Income taxation
Current 28A: W1 93 000 0 0
Deferred
Current year movement in temp diff’s Calc (1) 27 000 (6 000) (12 000)
Current year DTA not recognised W2.3 0 6 000 12 000
Prior year unrecognised DTA now
recognised W2.3/jnl (18 000)
Tax expense in the statement of compr. income 102 000 0 0
Tax rate reconciliation
Applicable tax rate 30% 30% 30%
Tax effects of:
Profit before tax (400Kx 30%) (20K loss x 30%) 120 000 (6 000) (12 000)
(40K loss x 30%)
Current year DTA not recognised Above 0 6 000 12 000
Prior yr unrecognised DTA now recognised Above (18 000) 0 0
Tax expense per the statement of compr. income 102 000 0 0
Effective tax rate (102 000 / 400 000) (0/loss) (0/loss) 25.5% N/A N/A
(1) DT adj to tax expense due to temporary differences: vehicle (9 000) cr 9 000 dr 9 000 dr
DT adj to tax expense due to temporary differences: tax loss 36 000 dr (15 000) cr (21 000) cr
(adjustments extracted from W2.1 and W2.2 in solution 28A)
27 000 dr (6 000) cr (12 000) cr
Entity name
As at ……..20X3
Note 20X3 20X2 20X1
Non-current liabilities C C C
Deferred tax: income tax W2.3 5 9 000 0 0
Entity name
For the year ended …..20X3
Note 20X3 20X2 20X1
C C C
Profit before tax 400 000 (20 000) (40 000)
Income tax expense 15 (102 000) 0 0
Profit for the period 298 000 (20 000) (40 000)
Other comprehensive income 0 0 0
Total comprehensive income 298 000 (20 000) (40 000)
326 Chapter 6
9. Deferred Tax Implications: Secondary Tax on Companies and Dividends Tax
9.1 Overview
Many countries levy a tax on dividends. South Africa used Did you know?
to levy secondary tax on companies (STC). STC was
levied on a dividend declared by a company. From 1 April One of the reasons South
Africa changed from STC to dividends
2012, however, South Africa replaced STC with dividends tax was to align with international
tax. Dividends tax is a tax levied on the dividends received standards and thus encourage foreign
by the shareholder and is a tax on the shareholder. investment
Since STC was a tax levied on the entity declaring the dividends, it was considered to be a tax
on the entity’s profits (being the portion of the profits that were declared as dividends). Thus
it was recognised and disclosed as part of the entity’s tax expense in the statement of other
comprehensive income.
Although secondary tax on companies is no longer levied in South Africa, an entity may still
have previously recognised deferred tax assets on unutilised STC credits. These are explained
in section 9.2
9.2 Deferred tax on STC credits
Under South Africa’s previous STC legislation, an ‘unutilised tax credit’ could arise. This
represented a tax credit that could be carried forward and used to reduce the following year’s
STC charge. Bearing in mind that STC was a tax expense levied on the entity’s profits, this
meant that any unutilised STC credit that arose at year-end would represent a future tax
saving to the entity. This would generally have resulted in the recognition of a deferred tax
asset (debit deferred tax asset and credit tax expense).
When this credit was successfully used to reduce the STC charge in a subsequent year, this
deferred tax asset would be utilised (credit deferred tax asset and debit tax expense).
Since the introduction of dividends tax in South Africa, Deferred tax assets on
any unutilised STC credit that existed on 1 April 2012 STC credits
may no longer be used to reduce future STC (because
there is no future STC). However, for the next three STC credits can still be used to
years, these unutilised STC credits may be used to reduce reduce dividends tax, but
the amount of dividends tax to be calculated and withheld The deferred tax on these credits
from dividend payments made to shareholders. In other must be derecognised because
words, the unutilised STC credits are no longer able to STC credits do not represent a
reduce the entity’s future tax expense, but they are now future tax saving for the entity, as
available for use by the shareholder in reducing his/her dividends tax is a tax on the
dividends tax expense. shareholder.
Thus, although unutilised STC credits do represent a future saving of dividends tax (from the
shareholder’s perspective), these credits no longer represent a deferred tax asset to the entity,
because they no longer represent a future tax saving for the entity, as dividends tax is a tax on
the shareholder. As a result, when dividends tax was introduced (1 April 2012), any deferred
tax assets on STC credits that existed on that date had to be derecognised immediately.
When writing off these deferred tax assets, the debit entry must be expensed in profit or loss
(i.e. credit deferred tax asset and debit tax expense).
When calculating the dividends tax owed by its shareholders, unutilised STC credits must be
allocated pro-rata amongst all shareholders within the same class that are entitled to
dividends, irrespective of whether or not the shareholder/s are exempt from dividends tax.
Any credits that have not yet been used within 3 years of the effective date will expire.
Chapter 6 327
10. Disclosure of Income Tax (IAS 12.79 – 12.88)
10.1 Overview
IAS 1 and IAS 12 require certain tax disclosure in the statement of comprehensive income,
statement of financial position and related notes to the financial statements.
Where the tax is caused by profits or losses, this tax:
is presented as part of the tax expense in the profit or loss section of the statement of
comprehensive income; and
is supported by a note (the tax expense note).
Where the tax is caused by gains or losses recognised directly in equity (other comprehensive
income), this tax is:
shown as a separate line item in the other
comprehensive income section of the statement of Comprehensive basis
comprehensive income; or
deducted from each component thereof; and the term used to describe the
supported by a note (the tax on other comprehensive method whereby
income note): this note shows the tax effect of each the tax effects of all temporary
differences are recognised
component of other comprehensive income.
10.2 Accounting policy note
Although not specifically required, it is important for foreign investors to know how a local
company measures line items in its financial statements. In this regard, a brief explanation of
the method of calculation is considered appropriate.
A suggested policy note appears below.
Entity name
20X2 20X1
1. Accounting policies C C
1.1 Deferred tax
Deferred tax is provided on the comprehensive basis. Deferred tax assets are provided
where there is reason to believe that these will be utilised in the future.
10.3 Statement of financial position disclosure
10.3.1 Face of the statement of financial position
10.3.1.1 Non-current asset or liability (IAS 1.56)
The deferred tax asset or liability is always classified as a non-current asset or liability. Even
if an entity believes that some of its deferred tax balance will reverse in the next year, the
amount may never be classified as current. See IAS 1.56
10.3.1.2 Show deferred tax per category of tax
Although not specifically mentioned in IAS 12, it makes sense to disclose the deferred tax for
each type of tax as separate line items. For example, if there was another tax in addition to
income tax, the deferred tax for each type would be disclosed separately. Since STC was
replaced with dividends tax, there is no tax on profits in South Africa other than income tax.
328 Chapter 6
10.3.1.3 Setting-off of deferred tax assets and liabilities (IAS 12.74)
If there is a deferred tax asset and a deferred tax liability, these should be disclosed as
separate line-items on the face of the statement of financial position (i.e. they should not be
set-off against one another) unless IAS 12.74:
Current tax assets and liabilities are legally allowed to be set-off against each other when
making tax payments; and
The deferred tax assets and liabilities relate to taxes levied by the same tax authority on:
the same entity; or on
different entities in a group who will settle their taxes on a net basis or at the same time.
Example layout of tax balances in the statement of financial position is shown below:
Entity name
As at ……..20X2
20X2 20X1
Non-current assets/ Non-current liabilities C C
- Deferred tax: income tax 5. xxx xxx
Current assets/ Current liabilities
- Current tax payable: income tax xxx xxx
- Current tax payable: value added tax xxx xxx
Example 31: Set-off of deferred tax assets and liabilities

At 31 December 20X2 there is
a deferred tax asset relating to a tax levied by a local tax authority: C20 000; and
a deferred tax liability relating to income tax levied by a national tax authority: C80 000.
Required:
Disclose the deferred tax asset and liability in the statement of financial position assuming:
A. the local and national tax authorities are considered to be part of one central tax authority and this
central tax authority allows each of these taxes to be settled on a net basis;
B. the local and national tax authorities are considered to be part of one central tax authority but this
central tax authority does not allow each of these taxes to be settled on a net basis is.
Solution 31A: Settlement on a net basis is allowed

Entity name
As at ……..20X2
20X2 20X1
Non-current liabilities C C
- Deferred tax (80 000-20 000) 4. 60 000 xxx
Solution 31B: Settlement on a net basis is not allowed

Entity name
As at ……..20X2
Note 20X2 20X1
ASSETS C C
Non-current assets
- Deferred tax: local tax 5. 20 000 xxx
LIABILITIES
- Deferred tax: income tax 4. 80 000 xxx
Chapter 6 329
10.3.2 Deferred tax note (asset or liability)

10.3.2.1 The basic structure of the deferred tax note (IAS 12.81 (g)(i))
The deferred tax balance may reflect an asset or liability balance and therefore it makes sense
to explain, in the heading of the note, whether the balance is an asset or liability (if, for
example, you reflect liabilities in brackets, then the heading would be: asset/ (liability)). In
practice, it is also common to disclose on the face of the statement of financial position
whether the deferred tax is as asset or liability.
You must disclose the amount of the deferred tax asset and liability recognised for each:
type of temporary difference (e.g. property, plant and equipment, prepayments and
provisions);
unused tax losses; and
unused tax credits. IAS 12.81 (g) (i)
Example of the layout of a deferred tax asset/ liability note:
Entity name
For the year ended continued …
20X2 20X1
5. Deferred income tax asset / (liability) C C
Provisions xxx xxx
Year-end accruals xxx xxx
Property, plant and equipment (xxx) xxx
Unused tax loss xxx (xxx)
(xxx) (xxx)
Tip
Be careful not to confuse the breakdown of the deferred tax movement (i.e. the statement of
comprehensive income effect) with the deferred tax closing balance (i.e. the statement of financial
position effect) when compiling this note. In an exam situation, you can find the closing balance easily
in your deferred tax balance sheet approach working (see section 2.3)
10.3.2.2 A deferred tax reconciliation may be required (IAS 12.81 (g) (ii))
For each type of temporary difference, unused tax loss and unused tax credit, the amount of
the deferred tax adjustment recognised in profit or loss must be disclosed.
This separate disclosure could be provided in the tax expense note. Alternatively, one may be
able to identify the deferred tax adjustment that was recognised in profit or loss by simply
comparing the opening and closing balances per type of temporary difference (e.g. property,
plant and equipment).
On occasion, however, it is not possible to identify each deferred tax adjustment per type of
temporary difference that was recognised in profit or loss by simply comparing the opening
and closing balances per type of temporary difference.
This could happen, for example, when the difference between the opening and closing
balance of deferred tax resulting from the temporary differences on property, plant and
equipment may have involved other comprehensive income (e.g. a revaluation surplus), in
which case, the deferred tax movement would be due to:
a deferred tax adjustment recognised in other comprehensive income, and
a deferred tax adjustment recognised in profit or loss (i.e. tax expense),
In such cases, a reconciliation between the opening and closing balance of deferred tax per
type of temporary difference would be required.
330 Chapter 6
Example of the layout of the reconciliation that may be needed in the deferred tax asset/ liability note:
Entity name
20X2 20X1
5. Deferred income tax asset / (liability) continued ...
C C
… Continued from note 5 above:
Reconciliation:
Opening deferred tax balance relating to PPE (xxx) xxx
Deferred tax recognised in other comprehensive income:
- revaluation surplus xxx xxx
Deferred tax recognised in profit or loss 6. xxx (xxx)
Closing deferred tax balance relating to PPE (xxx) (xxx)
10.3.2.3 Extra detail needed on unrecognised deferred tax assets (IAS 12.81 (e))
In respect of any unrecognised deferred tax assets, disclosure must be made of:
the amount of the deductible temporary difference, unused tax loss and unused tax credit;
the expiry date of the tax loss/ tax credit, if any. IAS 12.81 (e)
The following is an example of what might then be included in the above deferred tax note:
Example of the detail regarding unrecognised deferred tax assets in the deferred tax asset/ liability note:
Entity name
20X2 20X1
5. Deferred income tax asset / (liability) continued ... C C
… Continued from note 5 above:
A potential tax saving on a tax loss of C1 000 was not recognised as a deferred tax asset.
This tax loss will not expire.
10.3.2.4 Extra detail needed on recognised deferred tax assets
An entity shall disclose the amount of a deferred tax asset and the nature of the evidence
supporting its recognition, when:
the entity has suffered a loss in either the current or preceding period in the tax
jurisdiction to which the deferred tax asset relates; and
the utilisation of the deferred tax asset is dependent on future taxable profits in excess of
the profits arising from the reversal of existing taxable temporary differences. IAS 12.82
10.3.2.5 Extra detail needed on unrecognised deferred tax liabilities (IAS 12.81 (i))
The standard requires disclosure of the amount of income tax relating to dividends that were
proposed or declared before the financial statements were authorised for issue, but are not
recognised as a liability.
10.4 Statement of comprehensive income disclosure
10.4.1 Face of the statement of comprehensive income
Income tax and any other forms of tax considered to be a tax levied on the entity’s profits are
combined to reflect the income tax expense in the statement of comprehensive income
(sometimes referred to as tax expense). The tax expense must be reflected as a separate line
item in the statement of comprehensive income (required by IAS 1, chapter 3).
Chapter 6 331
The tax effect of other comprehensive income may be shown on the face of the statement of
comprehensive income or in the notes. The following example adopts the option of
presenting tax on other comprehensive income in the notes. IAS 1.90
Example of the disclosure of tax expense on the face of the statement of comprehensive income:
Entity name
20X2 20X1
C C
Income tax expense 6. xxx xxx
Profit for the period xxx xxx
Other comprehensive income xxx xxx
Items that may be reclassified to profit or loss
Cash flow hedge, net of reclassification adjustments and tax 23 xxx xxx
Items that may never be reclassified to profit or loss
Revaluation surplus, net of tax 24 xxx xxx
10.4.2 Tax on profit or loss – the income tax expense note

10.4.2.1 Basic structure of the income tax expense note (IAS 12.79 - .80)
The tax expense line item in the statement of comprehensive income should be referenced to a
supporting note.
The supporting note gives details of the adjustments made in the tax expense account.
Step 1
Separate the tax note into the two main types of tax levied on company profits: income tax
and any other tax that may be levied on the entity’s profits.
Step 2
Separate the two types of tax into the two types of tax adjustments: the current adjustment and
the deferred adjustment. IAS 12.80 (a) & (c)
In respect of current tax, show the:
Current tax for the current year; IAS 12.80 (a)
Any under/ (over) provision of current tax in a prior year/s. IAS12.80(b)
In respect of deferred tax:
The adjustment on the current year movement in temporary differences IAS 12.80 (c)
The effects of rate changes on prior year deferred tax balances. IAS 12.80 (d)
Step 3
Include a reconciliation explaining why the effective rate of tax differs from the applicable
rate of tax (where these rates differ, of course!). IAS 12.81(c)
The reconciliation can be provided in either or both of the following forms:
a reconciliation between tax expense (income) and the product of accounting profit
multiplied by the applicable tax rate(s); or
a reconciliation between the average effective tax rate and the applicable tax rate.
The reconciliation should also include:
The basis on which the applicable tax rate(s) was computed (if a computation was
required); IAS 12.81 (c)
An explanation regarding any changes in the applicable tax rate(s) compared to the
previous accounting period. IAS 12.81(d)
332 Chapter 6
Example of the layout of a basic income tax expense note:
Entity name
20X2 20X1
C C
Income tax xxx xxx
current income tax

current year provision xxx xxx
prior year under/ (over) provision xxx xxx
deferred income tax 5.
current year deferred tax: xxx xxx
prior year deferred tax: rate change xxx (xxx)
Other taxes levied on company profits xxx xxx

current xxx xxx
deferred xxx xxx
Tax expense per the statement of comprehensive income xxx xxx
Applicable tax rate (ATR) Income tax rate: 30% x% x%
Tax effects of:

Current tax under/ (over) provision Per above xxx (xxx)
Deferred tax rate change Per above xxx xxx
Add other taxes on co. profits Per above: current + deferred xxx xxx
10.4.2.2 Effect of deferred tax assets on the income tax expense note (IAS 12.80 (e) - (g))
The following must be disclosed relative to the deferred tax expense:
Reductions in the deferred tax expense caused by recognising a previously unrecognised
deferred tax asset. IAS 12.80 (f)
Increases in the deferred tax expense if you recognised a deferred tax asset in a prior year
and this deferred tax asset subsequently needs to be written-down IAS 12.80 (g)
Decreases in the deferred tax expense if a previous write-down of a deferred tax expense
now needs to be reversed IAS 12.80 (g)
The following must be disclosed relative to the current tax expense:
Decreases in current tax expense where a deferred tax asset that has not been recognised
has now been utilised (i.e. the tax expense has now been effectively reduced). IAS 12.80 (e)
Chapter 6 333
Example of the layout of a detailed income tax expense note:
Entity name
For the year ended ...
20X2 20X1
C C
Income tax xxx xxx
current income tax

current year provision 80(a) xxx xxx
prior year under/ (over) provision 80(b) xxx xxx
deferred income tax 5.

current year movement in temporary differences 80(c)
prior year def tax balance: rate change adjustment 80(d) xxx (xxx)
current year def tax asset: not recognised xxx xxx
prior year recognised def tax asset: write-down/ (back) 80(g) xxx (xxx)
prior year unrecognised def tax asset: recognised: 80(f) 0 (xxx)
Other taxes levied on company profits xxx xxx

current xxx xxx
deferred xxx xxx
Applicable tax rate (ATR) Income tax rate: 30% x% x%
Tax effects of:

Prior year under/ (over) provision Per above xxx xxx
Prior year deferred tax balance: rate change Per above xxx (xxx)
Current year deferred tax asset not recognised Per above xxx xxx
Prior year recognised def tax asset written-down/ Per above xxx (xxx)
(written-back)
Prior year unrecog def tax asset now recognised Per above 0 (xxx)
Other tax on companies Per above xxx xxx
10.4.2.3 Tax relating to changes in accounting policies and correction of errors (IAS 12.80 (h))
The tax on an adjustment caused by either:
a change in accounting policy or
correction of error
that had to be made in the current year because it was impracticable to process in the relevant
prior year must be shown separately from other tax.
This can be done in aggregate (i.e. current plus deferred tax). IAS 12.80 (h)
334 Chapter 6
10.4.2.4 Extra detail required with regard to discontinuing operations (IAS 12.81 (h))
In respect of discontinued operations, the tax expense relating to:
the gain or loss on discontinuance; and
the profit or loss from the ordinary activities of the discontinued operation for the period,
together with the corresponding amounts for each prior period presented.
10.4.3 Tax on other comprehensive income (IAS 12.81 (a) and (ae))
The statement of comprehensive income shows the following separately from one another:
Profit or loss; and
Other comprehensive income (OCI, being part of equity).
Tax on profit or loss is shown in the ‘income tax expense’ line item and details thereof are
disclosed in the ‘income tax expense’ note. Tax on other comprehensive income (OCI), on
the other hand, is not recognised as an expense. Instead it is recognised by netting it off in the
relevant OCI ledger account. Although this netting off occurs, the tax effect (current plus
deferred tax) must still be separately disclosed. The tax effect must be separately disclosed
for each item of OCI that exists.
Chapter 3 explained that each item of other comprehensive income, classified by nature:
must be presented as separate line items on the face of the statement of comprehensive
income, and
must be grouped under the relevant category heading of either:
- items that may be reclassified to profit or loss; and
- items that will never be reclassified to profit or loss. IAS 1.82A
An item of other comprehensive income may have been affected by a tax adjustment and may
also have been affected by a reclassification adjustment (where applicable) during the period.
For each such item of other comprehensive income:
any reclassification adjustment that may have occurred must be separately disclosed;
the tax adjustment that may have occurred must be separately disclosed, and where there
was a reclassification adjustment, then the tax effect on this reclassification adjustments
must also be separately disclosed;
The abovementioned reclassification adjustments and tax effects may be presented on either
the face of the statement of comprehensive income, or in the notes. IAS 1.90
This textbook adopts the approach of presenting each item of other comprehensive income net
of any reclassification and tax adjustments on the face of the statement and presenting the
reclassification adjustments (where applicable) and tax effects in the notes.
Example of the layout of OCI notes showing the disclosure of the tax effects
Entity name
20X2 20X1
23. Other comprehensive income: cash flow hedge C C
Cash flow hedge gain/ (loss) xxx (xxx)
Tax on gain/ loss (xxx) xxx
Reclassification of cash flow gain (xxx) (xxx)
Tax on reclassification of cash flow gain/ (loss) xxx xxx
Cash flow hedge gain/ (loss), net of reclassifications and tax xxx (xxx)
24. Other comprehensive income: revaluation surplus
Revaluation surplus increase/ (decrease) xxx (xxx)
Tax on increase/ (decrease) (xxx) xxx
Revaluation surplus increase/ (decrease), net of tax xxx (xxx)
Chapter 6 335
11. Summary
Income tax expense line item

in the statement of comprehensive income
includes:
Income tax: current tax plus deferred tax
Current income tax

Current year estimate
taxable profits x tax rate
Prior year estimate under/ (over) provided

assessment for the prior year – current tax recognised in prior year
Deferred income tax

current year adjustment =
movement in temporary differences x tax rate
or
temporary differences at end of year x tax rate - temporary differences at beginning of year x
tax rate
prior year adjustment due to rate change = opening deferred tax balance / old rate x
difference in tax rate
deferred tax on OCI adjustments are NOT included in the income tax expense line item of the
P/L section: they are included with the OCI line-items in the OCI section
Secondary tax on companies

Replaced by dividend tax on 01/04/12
Was a tax levied on the entity and was measured at 10% of net dividend declared
STC charge was included in the tax expense line item since it was considered to be a tax on
the entity’s profits
Deferred tax assets would arise on unutilised STC credits
These unutilised STC credits are no longer beneficial to the entity and any related deferred
tax assets must be derecognised immediately
Unutilised STC credits may be used to reduce the dividends tax owed by the shareholder for
the next 3 years following the introduction of dividends tax (01/04/2012), after which these
credits will expire
Dividends tax
Dividend tax replaced STC with effect from 1 April 2012
Dividend tax is levied on the shareholder at 15% of the dividend received
Unutilised STC credits may be used to reduce the dividends tax owed by the shareholder
Dividend tax is not a tax on the entity and is thus not included in the entity’s tax expense and
similarly, there are no deferred tax consequences
Deferred tax is
Recognised on certain
Temporary differences:
Calculations: Examples of items that cause

temporary differences
Balance sheet approach Accruals:
new IAS 12 income received in advance
Income statement approach expenses prepaid
old IAS 12 Provisions
See next page for the calculations Non-current assets
336 Chapter 6
Deferred tax @ 30 % Equals

Timing Taxable profits
adjustment for
difference per RoR
the year
Versus
Income
Taxable profits
statement
per accountant
approach
Methods of
calculation
Carrying value of
Balance sheet
Assets &
approach
Libilities
Versus
Deferred tax @ 30 % Equals Tax Base of

Temporary
balance at end of Assets &
difference
year Liabilities
The portion that The portion that

will be deducted or will not be taxed
in the future in the future
Tax base
The portion that The portion that

will not be deducted or will be taxed
in the future in the future
Chapter 6 337
Measurement of tax:
Use enacted; or
Substantively enacted tax rates
If a new rate is announced before reporting date:
Use prof judgement to decide whether it has been substantively enacted
In SA, it is generally considered substantively enacted
o If the new rate is not linked to other tax laws:
On the date announced by the Minister of Finance
o If the new rate is inextricably linked to changes to other tax laws, when:
announced by the Minister of Finance; and
President has approved the change.
Measuring current tax Measuring deferred tax

The amount expected to be paid to The amt calculated using tax rates that are
(recovered from) the taxation authorities expected to apply to the period when the
IAS 12.46
asset is realised or the liability is settled
IAS 12.47
Affected by management intentions
Management intentions (IAS 12.51 A-C)

Keep: income tax rates x TD (unless it is land in which case always use rates/
calculations applicable to the portion that is a taxable capital gain)
Sell: use rates/ calculations applicable to the portion that is a taxable capital gain
Keep then sell: combination of rates/ calculations
Presumed intentions: we presume the intention is to sell if the asset is:
a non-depreciable PPE (land) measured in terms of IAS 16’s revaluation model
an investment property measured in terms of IAS 40’s fair value model (this is
rebuttable if the property is depreciable and is held within a business model that
intends to earn substantially all the benefits over time rather than through a sale)
Recognition of Deferred tax (DT):

Deferred tax arises from temporary differences (TD)
If it is a taxable TD If it is a deductible TD If it is an exempt TD

Recognise a DTL Recognise a DTA Do not recognise DTA/L
Exempt Temporary differences

The exemption applies only to initial recognition (i.e. the initial cost and anything stemming
from that cost e.g. depreciation or impairments or impairments reversed).
The exemption thus does not apply to revaluation surpluses and anything stemming from that
revaluation surplus (i.e. the extra depreciation caused by the revaluation surplus)
338 Chapter 6
Temporary differences
due to Non-current assets
Deductible Not deductible Not deductible

Depreciable Depreciable Not depreciable
TB = portion that will be TB = portion that will be TB = portion that will be
deducted in the future deducted in the future deducted in the future
= Cost – cumulative =0 =0
allowances already deducted
Deferred tax balance = (TB – Deferred tax balance =

CA) x tax rate Temporary differences (TB – CA) are exempt from DT IAS 12.15
Therefore no DT unless it is revalued to fair value and then
only that portion of the carrying amount relating to the
revaluation results in deferred tax
Non-deductible assets cause reconciling items in the tax rate

reconciliation:
Depreciation (if depreciable)
Impairments
Profit or loss on sale
Chapter 6 339
Gripping GAAP Property, plant and equipment: the cost model
Chapter 7
Property, Plant and Equipment: The Cost Model
Reference:
IAS 16, IAS 36, IAS 12, IAS 20, IFRIC 1, IFRS 13 (incl. any amendments to 10 December 2014)
Contents: Page
1. Introduction 342
2. Recognition 342
2.1 Overview 342
2.2 Meeting the definition 343
2.3 Meeting the recognition criteria 343
2.4 When the definitions and recognition criteria are met for significant parts 343
Example 1: Significant parts 343
3. Initial measurement 344
3.1 Overview 344
3.2 Cost and the effect of the method of acquisition 344
3.2.1 Cash, credit or beyond normal credit terms 344
Example 2: Cash payment within normal credit terms 345
Example 3: Cash payment beyond normal credit terms 345
3.2.2 Fair value 345
3.2.2.1 Asset exchange 345
Example 4: Exchange of assets; both fair values are known 346
Example 5: Exchange of assets with no commercial substance 347
Example 6: Exchange of assets involving cash and cash
equivalents 347
3.2.2.2 Government grants 348
Example 7: Government grant asset: fair value or nominal amount 348
Example 8: Government grant to acquire an asset 349
3.3 Initial costs 349
3.3.1 Overview 349
3.3.2 Purchase price 350
Example 9: Initial costs: purchase price 350
3.3.3 Directly attributable costs 350
Example 10: Initial costs: purchase price and directly attributable costs 351
Example 11: Initial costs: purchase price, directly attributable costs and
significant parts 352
3.3.4 Future costs: dismantling, removal and restoration costs 352
3.3.4.1. Future costs: overview 352
3.3.4.2. Future costs: existing on acquisition 353
Example 12: Initial cost involving future costs 353
3.3.4.3 Future costs: caused/increases over time 354
Example 13: Subsequent costs involving future costs 354
3.3.4.4 Future costs: caused/increases over time – more detail 355
3.4 Subsequent costs 356
3.4.1 Day-to-day servicing 356
Example 14: Repainting of vehicle 356
Example 15: Purchase of engine 356
Example 16: Engine overhaul – extending the useful life 357
Example 17: Servicing an engine 357
3.4.2 Replacement of parts and derecognition of assets 357
3.4.2.1 Derecognition of the old part 357
3.4.2.2 Capitalisation of a new part 358
340 Chapter 7

Example 18: Replacement of a part 358
Example 19: Replacement of a part that was not previously identified 359
3.4.3 Major inspections 359
Example 20: Major inspection performed 359
Example 21: Major inspection purchased as part of the asset 360
Example 22: Major inspection derecognised 361
4. Subsequent measurement 362
4.1 Overview 362
4.2 Cost model 362
4.3 Depreciation 362
4.3.1 Overview 362
4.3.2 Residual value and the depreciable amount 363
4.3.3 Method of depreciation 363
4.3.4 Useful life 364
4.3.5 Depreciating the whole asset or the parts thereof 364
4.3.6 Depreciation journal 365
Example 23: Depreciation calculation with many dates 365
Example 24: Depreciable amount and straight-line depreciation 365
Example 25: Depreciation using diminishing balance 366
Example 26: Depreciation using sum-of-the-units 366
Example 27: Depreciation involved with a self-constructed asset 367
4.3.7 Change in estimate 367
Example 28: Sum-of-the-units with a change in total expected production 368
4.4 Impairments 368
4.1 Overview 368
4.2 Recoverable amount 369
4.3 Comparing the carrying amount with the recoverable amount 369
4.4 Depreciation in periods following an impairment 369
Example 29: Cost model – impairment loss 371
Example 30: Cost model – reversal of impairment loss 371
Example 31: Cost model – a summary example (the asset is not depreciated) 373
Example 32: Cost model – a summary example (the asset is depreciated) 374
5. Derecognition 375
6. Deferred Tax Consequences 376
6.1 Overview 376
6.2 Comparing the carrying amount and tax base 376
Example 33: Deferred tax caused by the purchase, depreciation and sale of PPE 377
Example 34: Deferred tax involving the impairment of PPE 379
6.3 Deferred tax exemptions 380
Example 35: Deferred tax involving exempt temporary differences 380
7. Disclosure 381
7.1 Overview 382
7.2 Accounting policies and estimates 382
7.5 Further encouraged disclosure 383
7.6 Disclosure regarding fair value measurements 383
7.7 Sample disclosure involving property, plant and equipment 384
Example 36: Cost model disclosure – no impairment 385
Example 37: Cost model disclosure – with impairments 386
8. Summary 390
Chapter 7 341
1. Introduction
This chapter deals with a vital component of most businesses: the physical (tangible) assets
that are used to make profits. There are many different types of property, plant and equipment,
each of which shares one important characteristic: they are used by the business over more
than one year in order to generate income. They are thus non-current in nature.
Property, plant and equipment may be measured using

either the cost model or revaluation model. This chapter Examples of items of PPE
include:
explains the use of the cost model. The revaluation
model is explained in the following chapter. land;
buildings;
We will learn a variety of things in this chapter: plant;
how to recognise and measure the asset on initial equipment (factory);
acquisition; equipment (office);
how to recognise and measure subsequent costs; furniture; and
how to subsequently measure the asset using the cost vehicles.
model, where this involves:
depreciation; and
impairments (and reversals thereof); and
how to disclose property, plant and equipment.
The cost model first measures the asset at cost. The asset The carrying amount is
is subsequently measured to reflect the effects of usage reflected by three
and damage. accounts:
Depreciation is processed to reflect the effect of the usage Cost account: this shows how much it
of the asset and impairments are processed to reflect any was initially measured at (see sect 3).
damage to the asset (please note that the damage for Accumulated depreciation account:
purposes of impairments including all kinds of events, this shows the cumulative effect of
such as physical damage or even a downturn in the the usage of the asset.
economy etc). Accumulated impairment loss
account: this shows the cumulative
Thus the carrying amount is reflected by the following effect of damage (any kind – not just
three accounts: physical) to the asset.
cost account
less accumulated depreciation account, and
less accumulated impairment losses account.
2. Recognition (IAS 16.7 and 16.43)
2.1 Overview
Before we can recognise an item as ‘property, plant and equipment’, it must meet:
the definition of property, plant and equipment; and
PPE is defined as: Recognition criteria

tangible items, held : the inflow of future economic
- for use in the production or supply of benefits to the entity is probable; and
goods or services,
- for rental to others or the asset’s cost can be reliably
- for administration purposes; and measured. Reworded IAS 16.7
are expected to be used during more
than one period. IAS 16.6
342 Chapter 7
2.2 Meeting the definition

Before one can recognise an asset as property, plant and equipment the definition thereof must
be met. This definition (see pop-up on the previous page) requires that the item be tangible.
This means that it must have a physical form (e.g. a machine has physical form but a patent
does not). The next issue is that we must plan to use the item for more than one period. An
asset that will be used for a year or less is a current asset (property, plant and equipment is a
non-current asset). We could use it in one of three ways – we could use it to produce or supply
goods or services (e.g a machine that we use to make inventory or a machine that we use to
resurface roads), to rent to third parties (e.g. a building that we rent out to someone) or for
administration purposes (e.g. a building that we use as our head office).
2.3 Meeting the recognition criteria
If the definition is met, the next step is to check if the recognition criteria are also met (see
pop-up on prior page). The recognition criteria in IAS 16 are the same as the basic recognition
criteria given in the Conceptual Framework and are simply that the expected inflow of future
economic benefits from the use of the asset must be probable and the asset must have a cost
that is reliably measurable.
2.4 When the definition and recognition criteria are met for significant parts
In order to facilitate more accurate calculation of the future depreciation of the asset, the cost
of each significant part should be recognised in a separate asset account. See IAS 16.44
A part is considered to be significant if its cost is significant in relation to the total cost of the
asset. The idea behind recognising each part separately is that we will then be able to
depreciate each part separately (significant parts often have different useful lives and residual
values to the remainder of the item of property, plant and equipment).
Example 1: Significant parts
Whoosh Limited bought a ship for C1 000 000 cash on 30 June 20X1. It has three parts:
Engine: C300 000 (a significant part)
Hull: C500 000 (a significant part)
Various other moving and non-moving parts: C200 000 (individually insignificant).
On 30 June 20X1, the total other property, plant and equipment had a carrying amount of C3 000 000.
Required:
a) Show the journal entry to record the purchase of the ship.
b) Present the ship in the detailed statement of financial position on the date of acquisition.

Ship: engine: cost (asset) 300 000
Ship: hull: cost (asset) 500 000
Ship: other insignificant parts: cost (asset) 200 000
Bank 1 000 000
Purchase of ship
Solution 1B: Disclosure

Whoosh Limited
As at 30 June 20X1
20X1
Non-current assets C
Property, plant and equipment Other: 3 000 000 + Ship: 1 000 000 4 000 000
Comment: When disclosing the ship in the SOFP, did you notice how a single line item for total
property, plant and equipment is shown:
the separate parts are not disclosed separately, and
the ship is not disclosed separately.
Chapter 7 343
3. Initial Measurement (IAS 16.15 – 16.28)
3.1 Overview
Once we have established that an item must be recognised

PPE is initially measured
as an item of property, plant and equipment (i.e. it meets at:
the definitions and recognition criteria), it must be
measured at cost. its cost IAS 16.15
The cost of the asset on the date it is recognised is referred to as the initial cost (see 3.3). Costs
that should be included in this cost include:
its purchase price (see 3.3.1);
directly attributable costs (see 3.3.2); and
Initial costs include:
certain future costs (see 3.3.3). See IAS 16.16
purchase price
Later on in the asset’s life, further costs may be incurred directly attributable costs
in relation to the asset, which we refer to as subsequent certain future costs See IAS 16.16
costs (see 3.4). These subsequent costs include, for
example:
Day-to-day servicing (i.e. repairs and maintenance);
Replacement of parts; and
Major inspections.
The method of acquisition can affect the measurement of cost (see 3.2).
3.2 Cost and the effect of the method of acquisition
The initial cost of acquisition may be paid for:

Cost is defined as
using cash (or a cash equivalent), where the payment
is immediate, or within normal credit terms or the amount of cash or cash equivalents
beyond normal credit terms; paid; or
using an asset other than cash (referred to as an asset the fair value of the consideration
exchange); or given (if it is not cash); or
the amount attributed to that asset in
using a government grant (i.e. the cost of purchase terms of other standards
could have been subsidised). at the time of acquisition or
construction. Reworded IAS 16.6
If the transaction is paid for in cash, the measurement of
cost is based on the cash amount. If, however, the asset is acquired by giving up a non-cash
asset (e.g. machine), or if the government gave the asset to the entity (i.e. a government grant),
a fair value may be needed.
3.2.1 Cash, credit or beyond normal credit terms (IAS 16.23)
If the acquisition is paid for in cash, either immediately If we defer payment for
or within normal credit terms, then the asset is simply the asset, its cost is
recorded at the cash amount (i.e. nominal amount). measured at:
Present value (i.e. amount we would
If a cash payment is deferred beyond normal credit terms, have paid in cash on purchase date )
then the amount paid (nominal amount) must be present Note: resent value (i.e. amount we would
valued to the equivalent cash amount due on date of have paid in cash on purchase date )
recognition. Note:
Total amount we’ll pay
The difference between the present value and the actual Less present value (cost)
amount that will be paid is recognised as an interest = Interest expense recognised over the
expense (unless this interest expense is capitalised to the payment period
asset in terms of IAS 23 Borrowing costs).
344 Chapter 7
Example 2: Cash payment within normal credit terms

Washy Limited purchased a machine for C100 000. There were no individually significant
parts. The purchase price is payable within normal credit terms.
Required:
Show the journal entries relating to the purchase and payment of the machine.
Solution 2: Cash payment within normal credit terms

Debit Credit
Machine: cost (asset) 100 000
Trade accounts payable (liability) 100 000
Purchase of machine on normal credit terms
Bank 100 000
Payment made to supplier of machine
Example 3: Cash payment beyond normal credit terms

A company purchased a machine for C100 000:
There were no individually significant parts.
The purchase price is payable after one year (being longer than normal credit terms).
The present value of this amount, calculated using an appropriate interest rate of 10%,
is C90 909.
Required:
Show the journal entries relating to the purchase and payment of the machine.
Solution 3: Cash payment beyond normal credit terms

Debit Credit
Machine: cost (asset) 90 909
Finance costs (expense) 9 091
Purchase of machine for C100 000 but payment on normal credit terms
is C90 909 (i.e. C100 000 present valued at a 10% discount rate of
10%). The difference is recognised as interest (C90 909 x 10%)
Bank 100 000
Payment made to supplier of machine
3.2.2 Fair value (IAS 16.24 – 16.26)
If the asset is not paid for in cash, or is not entirely paid Fair value is defined as:
for in cash, the fair value of the purchase consideration
must be measured. This happens when the asset is the price that would be received to sell an
asset (or paid to transfer a liability)
acquired via:
in an orderly transaction
an asset exchange; or
a government grant (i.e. where we are either given between market participants
the asset entirely for free or may be required to at the measurement date IFRS 13.9
pay a very small amount, referred to as a nominal amount).
3.2.2.1 Asset exchange
When recording an asset acquired through an exchange of assets, the cost of the new asset will
be the fair value of the asset/s given up. However, the fair value of the asset received must be
used instead if:
the fair value of the asset given up is not available; or
the fair value of the asset received is ‘more clearly evident’. See IAS 16.26
Chapter 7 345
The standard does not explain what it means by ‘more clearly evident’ but it is submitted that
if the asset given up has a fair value of C100 but the fair value of the asset received is C250,
then one would probably argue that the C250 should be used since it seems more relevant to
use C250 as its fair value than to use the C100.
In the event that the exchange of assets is deemed to have no commercial substance (e.g. two
vehicles are exchanged, of the same vintage, with the same mileage and in the same condition),
the cost of the asset acquired is the carrying amount of the asset given up.
An exchange is considered to have no commercial substance if the exchange of assets:

will not change the future cash flows in any way (risk, timing or amount);
will not change the value of the operation that is to use the asset; or
any expected change in cash flows or value is insignificant relative to the fair value of the
assets exchanged. (IAS 16.25)
An exchange of similar assets generally leads to an exchange having no commercial substance,
but an exchange of dissimilar assets could also have no commercial substance.
The following diagram may help to simplify the treatment of exchanges of assets:
Exchange of assets
Use fair value Use carrying amount of asset given up

of the asset/s given up; or if the exchange lacks commercial
of the asset received – if this is more substance; or
clearly evident. See IAS 16.26 if the FV’s of both assets were unable to
Only use FV if it is reliably measurable! be reliably measurable. See IAS 16.24
Example 4: Exchange of assets; both fair values are known

Don Limited gave up a machine for a vehicle (acquired):

Machine: Carrying amount (cost was C18 000) 10 000 10 000 10 000
Fair value 11 000 11 000 unknown
Vehicle: Fair value 12 000(1) 15 000(2) 12 000
(1) The difference in fair values is considered to be immaterial.
(2) The difference in fair values is considered to be material and the fair value of the vehicle is more clearly
evident than the fair value of the machine.
Required: For each scenario, show how you would journalise the exchange and explain your answer.
Solution 4: Exchange of assets; both fair values are known

Ex 4A Ex 4B Ex 4C
Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Vehicle: cost 11 000 15 000 12 000
Machine: Cost (18 000) (18 000) (18 000)
Machine: accumulated depreciation (-A) 8 000 8 000 8 000
Profit on exchange of assets (P/L) (balancing) (1 000) (5 000) (2 000)
Exchange of machine (given up) for vehicle (acquired)
Comment:
Example 4A: Explanation: The vehicle is measured at the FV of the machine (FV of asset given up).
The asset sold is removed from the books (derecognised) and the new asset is recognised at the fair
value of the asset given up because the fair value of the asset given up (machine) is readily available.
Note: Where the fair value of the asset given up and fair value of the asset received is materially
different, the fair value of the asset received may be considered ‘more clearly evident’. In this example,
however, we were told that the difference between the two fair values (C1 000) is immaterial.
346 Chapter 7
Example 4B: Explanation: The vehicle is measured at the FV of the vehicle (FV of asset received).
The asset given up must be derecognised and the newly acquired asset must be recognised at the fair
value of the acquired asset.
This fair value is used because the difference in the fair values is material, and thus the fair value of the
asset acquired is assumed to be ‘more clearly evident’ than the fair value of the asset given up.
Example 4C: Explanation: The vehicle is measured at the FV of the vehicle (FV of asset received).
The asset given up is derecognised and the newly acquired asset is recognised at the fair value of the
acquired asset. The reason is that the fair value of the asset given up is not available.
Example 5: Exchange of assets with no commercial substance

Machine A is exchanged for machine B. The exchange is considered to have no commercial
substance.
Machine A: Cost 50 000
Accumulated depreciation 5 000
Fair value 30 000
Machine B: Fair value 20 000
Required:
Explain how this should be recorded in the general ledger, if at all.
Solution 5: Exchange of assets with no commercial substance

Since the asset exchange has no commercial substance, the acquired asset is not measured at fair value
at all, but rather at the carrying amount of the asset given up.
The following journal would be required:
Debit Credit
Machine A: accumulated depreciation 5 000
Machine A: cost 50 000
Machine B: cost 45 000
Exchange of assets: machine given up in return for a plant
Comment:
If the fair value of the asset received is much lower than the value of the asset given up, it may be
an indication that the asset given up was impaired. In this case, before journalising the exchange,
we must first calculate the recoverable amount of the asset given up.
The recoverable amount of an asset is the highest amount one could expect from either the use or
sale of the asset (i.e. the highest future economic benefits possible).
If the recoverable amount is lower than its carrying amount, the asset is considered to be impaired
and thus the carrying amount must be reduced before accounting for the exchange.
More information relating to impairments (damage) can be found in chapter 11.
Example 6: Exchange of assets involving cash and cash equivalents

A company gave up a vehicle and cash in exchange for a machine. Consider the
following two scenarios: Situation A Situation B
Vehicle: Carrying amount (cost was C18 000) 10 000 10 000

Fair value 10 000 unknown
Cash: 1 000 1 000
Machine: Fair value unknown 12 000
Required:
For situation A and B, show the related journal entry for the asset exchange.
Chapter 7 347
Solution 6: Exchange of assets involving cash and cash equivalents

Ex 6A Ex 6B
Dr/ (Cr) Dr/ (Cr)
Vehicle: accumulated depreciation and impairment loss (-A) 8 000 8 000
Vehicle: cost (18 000) (18 000)
Bank (1 000) (1 000)
Machine: cost See explanations below 11 000 12 000
Profit on exchange of assets (P/L) See explanations below N/A (1 000)
Vehicle and cash exchanged for a machine
Comment:
Example 6A: Explanation: The old asset is removed (derecognised) and the new asset (machine) is
recognised at the fair value of both assets given up (i.e. the vehicle and the cash).
Example 6B: Explanation: Although the fair value of cash is known, the fair value of the vehicle that
was given up is not available and therefore the fair value of the acquired machine must be used instead.
This resulted in a profit on exchange.
3.2.2.2 Government grants (IAS 20)

Government often provides grants to assist businesses in Government grants relating
starting up. This clearly benefits the business, but also to PPE affect measurement
of cost:
benefits government through creation of jobs and thus
If we receive cash to buy PPE:
more taxpayers! - Cost is credited with this cash.
If we receive PPE for free:
Government grants can be analysed into two basic - Cost is measured at FV of the PPE;
categories. Either the company is given: If we receive PPE & had to pay a
the actual non-monetary asset (e.g. a building); or nominal amount, choose between:
cash. - Cost measured at FV of the PPE; &
- Cost measured at nominal amount.
If the company is given the actual non-monetary asset (e.g. a building or land), the company
will measure the transaction at the asset’s fair value and:
debit the asset; and
credit a deferred income (equity) account.
If a company is given the actual non-monetary asset (e.g. a building or land), but is required to
pay a small sum of cash (a nominal amount), it may choose to measure the asset at:
its fair value; or
the nominal amount to be paid. See IAS 20.23
If the entity chooses to measure the asset at its fair value, even though a small amount is paid
for the grant, the journal is similar to the one above:
debit the asset (fair value);
credit bank (nominal amount); and
credit a deferred income (equity) account (fair value – nominal amount).
If the entity chooses to measure the asset at the nominal amount to be paid for the grant, the
journal is as follows (notice how the value of the grant is ignored in its measurement!):
debit the asset (at its nominal cost); and
credit bank.
Example 7: Government grant asset: fair value or nominal amount
The South African government gives Beanies Limited a building to be used to train
accountants:
The fair value of the building is C50 000 and
The company is required to pay a relatively small sum of C1 000 for the building.
Required: Show the journal entries assuming:
A. The company chooses to measure the licence at its fair value.
B. The company chooses to measure the licence at its nominal amount.
348 Chapter 7
Solution 7: Government grant asset: fair value or nominal amount

Ex 7A Ex 7B
Dr/ (Cr) Dr/ (Cr)
Building: cost (asset) A: FV of 50 000 B: Nom Amt: 1 000 50 000 1 000
Deferred income (OCI) A: 50 000 – 1 000 B: N/A (49 000) N/A
Bank Given (1 000) (1 000)
Recognising the licence granted by the government
If the grant is cash to be used in the acquisition of another asset (as opposed to cash to be used
to fund expenses or provided simply as financial assistance), the company will:
debit bank with the grant (or debit another asset account if the grant is not cash); and
credit the cost of the asset being subsidised (or credit a deferred income account). See IAS 20.23
Example 8: Government grant to acquire an asset

The government grants Hothead Limited C50 000 in cash:
The cash must be used to buy a nuclear plant.
The company subsequently purchases the nuclear plant for C80 000.
Required: Show the journals relating to the grant and the subsequent purchase of the nuclear plant.
Solution 8: Government grant to acquire an asset

Debit Credit
Bank 50 000
Deferred grant income 50 000
Receipt of government grant to acquire a nuclear plant
Nuclear plant: cost 80 000
Bank 80 000
Purchase of nuclear plant
Nuclear plant: cost 50 000
Government grant recognised as a reduction in the cost of the plant
Comment:
Notice that the nuclear plant has a cost of only C30 000 instead of C80 000 because the cost of its
acquisition was subsidised by the government.
Deferred grant income does not need to be set-off against the cost of the asset. It can remain as
deferred grant income (an asset) that is recognised in profit/loss over the useful life of the asset.
The effect on the Statement of comprehensive income is the same regardless of whether the grant
is set-off against the cost of the asset or recognised as deferred grant income – it will still affect
profit or loss at the same rate, being the rate at which the asset is used up (i.e. depreciated).
3.3 Initial costs (IAS 16.16 -16.21)

3.3.1 Overview
Costs that should be included in the initial cost of an asset

are those that are necessary to bring the asset to a location Elements of cost:
and condition suitable for its intended use. The cost of an
item of property, plant and equipment comprises the purchase price;
directly attributable costs; and
purchase price, any directly attributable costs, and the initial estimates of future costs
initial estimate of the costs of dismantling and removing (if the entity has the obligation).
See IAS 16.16
the item and restoring the site on which it is located if the
entity has the obligation to incur these costs. See IAS 16.16
3.3.2 Purchase price (IAS 16.16)
The term purchase price includes import duties and non-refundable taxes. The purchase price
is reduced by trade discounts and rebates received. Where the purchase price includes a tax
Chapter 7 349
that will be claimed back from the tax authorities (such as VAT), this tax is excluded from the
purchase price.
Example 9: Initial costs: purchase price

Nabs Limited bought a machine. The invoice showed the following:
Marked price: C100 000
Less discount (offered to long-standing customers only): C15 000
Less volume rebate: C5 000
Less cash discount: C2 000
VAT is added at 14% on the final amount (assume Nabs Limited is a registered VAT
vendor).
Required:
Show the journal entry for the acquisition of this machine.
Solution 9: Initial costs: purchase price

Dr/ (Cr)
Machine: cost 100 000 – discounts and rebates: (15 000 + 5 000 + 2 000) 78 000
Current tax receivable: VAT (100 000 – 15 000 – 5 000 – 2 000) x 14% 10 920
Bank (100 000 – 15 000 – 5 000 – 2 000) x 114% (88 920)
Purchase of machine
Comment: Notice that the machine’s cost:

is net of all discounts and rebates and
does not include VAT: since we are registered VAT vendors, we can claim this back (i.e. it is a
refundable tax) and thus the VAT is debited to a separate asset account: current tax receivable.
3.3.3 Directly attributable costs (IAS 16.16 , 16.17 & 16.19 – 16.21)
We must include in the cost of an asset directly

Directly attributable
attributable costs. costs are those
The term directly attributable costs is used to refer to that were necessary;
those costs that we believe were necessary to get the asset to get the asset to a location and
condition;
into a location and condition that enabled it to be used as
that enabled it to be used as
management intended it to be used. intended by management.
Reworded IAS 16.16(b)
If costs incurred to get an asset to the required location

and condition are directly attributable costs, then it means that costs incurred after the date on
which the asset is finally in this required location and condition cannot be referred to as
directly attributable costs. Thus, costs that are incurred after the date on which the asset is in
the location and condition that enables it to be used as management intended, may not be
capitalised (i.e. capitalisation ceases at that point).
Examples of directly attributable costs include:

cost of preparing the site;
initial delivery and handling costs;
installation and assembly costs;
employee benefits (salaries, wages etc) relating directly to its construction or acquisition;
professional fees; and
cost of testing that the asset is functioning correctly (net of any proceeds earned from the
sale of items produced during testing). See IAS 16.17
Any cost that is not a directly attributable cost is not included in the cost of the asset.
The following are examples of costs that are not considered to be directly attributable costs:
administration and other general overheads;
350 Chapter 7
advertising and other costs relating to introducing a new product or service; conducting
business in a new location or with a new type of customer;
cost of training staff, for example, on how to use the newly acquired asset. See IAS 16.19
Costs that were not necessary in bringing the asset to a location and condition that enables it to
be used as intended by management are not included in the cost of the asset, for example:
income and expenses that result from incidental operations occurring before or during
construction of an asset (e.g. using a building site as a car park until construction starts);
abnormal wastage. See IAS 16.21 and .22
Costs that are incurred after the asset is brought to a location and condition that enables it to be
used as intended by management are not included in the cost of the asset, for example:
staff training and costs of opening new facilities;
initial operating losses made while demand for an asset’s output increases;
costs of moving the asset to another location; and
costs incurred while an asset, which is now capable of being used, remains idle or is being
utilised at below intended capacity. See IAS 16.19 and .20
Example 10: Initial costs: purchase price and directly attributable costs
A Limited purchased a special factory plant on 1 January 20X1, details of which follow:
C
Purchase price (including VAT of 14%) 570 000
Import duties - non-refundable 100 000
Installation costs 30 000
Fuel (incurred while transporting the plant to the factory) 45 000
Administration costs 10 000
Staff party to celebrate the acquisition of the new plant 14 000
Staff training 12 000
Testing to ensure plant fully operational before start of production 42 123
Proceeds from sale of samples and by-products that were produced during testing 13 000
Advertising of the ‘amazing widgets’ to be produced by the new plant 50 000
Initial operating loss 35 000
The initial operating loss was incurred as a result of having to dump unsold ‘widgets’ at sea since the
advertising had not yet created sufficient demand. The company is a registered ‘VAT vendor’.
Required:
Calculate the initial costs to be capitalised to the plant account.
Solution 10: Initial costs: purchase price and directly attributable costs
C
Purchase price (excluding VAT: 570 000 x 100/114) (note 1) 500 000
Import duties - non-refundable 100 000
Installation costs 30 000
Fuel 45 000
Administration costs (note 2) 0
Staff party (note 2) 0
Staff training (note 2) 0
Testing 42 123
Proceeds from sale of samples and by-products (13 000)
Advertising 0
Initial operating losses (note 3) 0
Debit to the asset account 704 123
Chapter 7 351

Note 1: The VAT paid is not capitalised because the company is registered as a VAT vendor and thus
this VAT is refundable.
Note 2: Staff training is not capitalised because they are not costs directly associated with bringing the
asset to a location and condition necessary for it to be used as intended by management.
Note 3: These costs are excluded because they are incurred after the asset was brought to a location and
condition that enabled it to be used as intended by management.
Example 11: Initial costs: purchase price, directly attributable costs & significant parts
B Air bought an aircraft on 1 January 20X2, incurring all the following related costs in January 20X2:
Purchase price: C’000
Outer-body component 50 000
Engine component 70 000
Internal fittings component 20 000
Other costs:
Delivery costs* 500
Legal costs associated with purchase rights* 200
Costs of safety certificate 1 000
*These costs are incurred in proportion to the purchase price across the 3 components.
Under local aviation authority regulations, all passenger aircraft must be granted a safety
certificate by the aviation authority, which must be renewed every 2 years.
All components have a nil residual value. The estimated useful lives of these parts are as follows:
Outer-body 30 years
Engines 10 years
Internal fittings 5 years
Required: Determine the carrying amount of the separate components at 31 December 20X2.
Solution 11: Initial costs: purchase price, directly attributable costs & significant parts
Outer-body Engine Interior fittings Safety certificate
C’000 C’000 C’000 C’000
Initial cost 50 000 70 000 20 000 0
Safety certificate 1 000
Delivery costs 50/140 x 500 179 250 71 0
70/140 x 500
20/140 x 500
Legal costs 50/140 x 200 71 100 29 0
70/140 x 200
20/140 x 200
50 250 70 350 20 100 1 000
Less: depreciation 50 250/30 years (1 675) (7 035) (4 020) (500)
70 350/10 years
20 100/ 5 years
1 000/ 2 years
Carrying amount: 31/12/20X2 48 575 63 315 16 080 500
3.3.4 Future costs: dismantling, removal and restoration costs (IAS 16.16 & 16.18 & IFRIC 1)
3.3.4.1 Future costs: overview
The ownership of an asset may come with obligations to Future costs could
dismantle the asset, remove it and/or restore the site on arise:
which it is located at some stage in the future. This Simply due to the acquisition; or
obligation may arise: Due to the usage of the asset.
IAS 16.6(c)
On acquisition: in other words, simply by having
They are capitalised to PPE unless
purchased the asset; or the PPE is used to make inventories.
Over time: in other words, through having used the asset.
352 Chapter 7
If the property, plant and equipment is used to make inventories, then future costs are not
capitalised to the cost of property, plant and equipment but to inventories instead! See IAS 16.16 (c)
3.3.4.2 Future costs: existing on acquisition (IAS 16.16 & 16.18)
If an obligation arises through simply having purchased

Future costs arising on
the asset (i.e. by having acquired ownership), then the acquisition are:
estimated future costs must be included in the initial cost
of the asset. The time value of money, if material, must be capitalised as an initial cost;
taken into account in calculating the initial amount to be measured at a PV if “FV – PV = a
recognised in terms of future dismantling, removal and material amount’.
restoration costs.
Example 12: Initial cost involving future costs

A Limited bought a factory plant on 1 January 20X1 for a cash outlay of C704 123, which
included the purchase price and other directly attributable costs. The purchase agreement
included the acceptance of an obligation to rehabilitate a nearby river, detailed below:
Estimated future amount, payable on 31 December 20X2 C70 031
Present value of future amount (discounted at rate of 10%) C57 877
The plant has an estimated useful life of 10 years and a nil residual value.
Required:
Calculate the initial cost of the plant and show all journals for 20X1 and 20X2.
Solution 12: Initial cost involving future costs

Working 1: Calculation of initial cost to be capitalised
Purchase price and other directly attributable costs 704 123
Future costs (obligation due to ownership): measured at present value 57 877
Debit to the asset account 762 000
Working 2: Effective interest rate table for the provision

Interest @ 10% Payment Balance
1 January 20X1 57 877
31 December 20X1 5 788 0 63 665
31 December 20X2 6 366 (70 031) 0
12 154 (70 031)
1 January 20X1 Dr/ (Cr)

Plant: cost Two separate cost accounts are created for the 704 123
Plant: rehabilitation: cost 2 significant parts – since the useful lives differ 57 877
Bank Given (704 123)
Provision for rehabilitation Present value of future amount: given (57 877)
Purchase of plant – including a related obligation acquired on purchase date
31 December 20X1
Depreciation (P/L) 99 351
Plant: accum depreciation (-A) (704 123 – 0) / 10 years x 1 year (70 412)
Plant: rehab: accum deprec. (-A) 57 877 / 2 years x 1 year (28 939)
Depreciation on plant (2 significant parts)
Interest expense 57 877 x 10% or W2 5 788
Provision for rehabilitation (5 788)
Unwinding of the discount – recognised as an expense (always an expense!)
Chapter 7 353
Solution 12: Continued… Dr/(Cr)

31 December 20X2 99 351
Plant: accum depreciation (-A) (704 123 – 0) / 10 years x 1 year (70 412)
Plant: rehab: accum deprec. (-A) 57 877 / 2 years x 1 year (28 939)
Depreciation on plant (2 significant parts)
Interest expense (57 877 + 5 788) x 10% or W2 6 366
Provision for rehabilitation (6 366)
Unwinding of the discount – recognised as an expense (always an expense!)
Provision for rehabilitation 70 031
Bank (70 031)
Payment of amount due in terms of the rehabilitation (payment assumed)
Plant: rehab: accum deprec. 57 877
Plant: rehabilitation: cost (57 877)
Derecognition of the cost of the plant’s part being the related obligation to
rehabilitate the river (now fully depreciated)
3.3.4.3 Future costs: caused/increases over time (IAS 16.16 & 16.18)
If the obligation for future costs arises as a result of the asset being used (rather than simply an
obligation that already exists on the date of purchase), the present value of the obligation that
arises as the asset is used must also be capitalised to the cost of the asset (i.e. added as a
subsequent cost).
This means that the cost of the asset will change every time the usage of the asset leads to an
additional obligation.
This will obviously affect the calculation of depreciation

Future costs arising due
because the depreciable amount that gets depreciated over to usage:
the remaining useful life of the asset is constantly
changing (i.e. the depreciable amount will be the revised are capitalised as a subsequent cost;
cost less accumulated depreciation). unless the asset has reached the end
of its UL in which case the future
costs are recognised in P/L;
If the asset has reached the end of its useful life (i.e. it has
been fully depreciated), then any changes to the liability are measured at PV if “FV – PV = a
material amount
from that point on, would have to be recognised directly
in profit or loss.
Example 13: Subsequent costs involving future costs

A coal plant was purchased for C600 000 on 1 January 20X1, at which point its useful life
was considered to be 6 years and its residual value was nil (both unchanged).
An environmental rehabilitation obligation arose on 31 December 20X4 when a new
law was introduced that affected all companies who were operating coal plants as at
31 December 20X4 (i.e. the law does not affect companies who operated coal plants
before 31 December 20X4 but have ceased to operate such plants).
The law requires that those affected companies pay for environmental rehabilitation at
the end of the asset’s useful life based on the damage caused by such plants, assessed
from the effective date of 1 January 20X4 (i.e. although the law only affects companies
that were still operating coal plants at 31 December 20X4, these companies would be
required to pay for rehabilitation costs relating to any damage that may have occurred
from an earlier effective date of 1 January 20X4).
The expected cost of the rehabilitation on 31 December 20X6 due to damage caused
from 1 January 20X4 to 31 December 20X4 was assessed by environmental experts to
be C70 031 (the present value of this amount at 31 December 20X4, using a discount
rate of 10% was C57 877). No additional damage was caused during 20X5.
354 Chapter 7
The plant had always been used solely to manufacture products for sale to customers,
but from 20X4, some of these products were used to manufacture a machine:
Plant usage/year
The plant was used in the manufacture of products: 20X4 20X5
that would be sold to customers 70% 70%
that would be used to manufacture a machine (classified 30% 30%
as property, plant and equipment)
Required: Show the related journals for the years ended 20X4 and 20X5.
Solution 13: Subsequent costs involving future costs

Depreciation (P/L) (600 000 – 0) / 6 x 1 year 100 000
Plant: accumulated depreciation (-A) 100 000
Depreciation on plant for 20X4
Inventory (A) 100 000 x 70% 70 000
Machine: cost (A) 100 000 x 30% 30 000
Depreciation on plant capitalised to inventory and machinery
Inventory (A) Present value: 57 877 x 70% 40 514
Plant: cost (A) Present value: 57 877 x 30% 17 363
Provision for environmental restoration: plant 57 877
Recognition of new environmental rehabilitation obligation, measured at
present value, capitalised to inventory & plant
31 December 20X5
Plant: accumulated depreciation (-A) (CA: 217 3631 – RV 0) / 22 x 1 year 108 682
Depreciation on plant for 20X5
Inventory (A) 108 682 x 70% 76 077
Machine: cost (A) 108 682 x 30% 32 605
Depreciation on plant capitalised to inventory and machinery
Interest (E) 57 877 x 10% 5 788
Provision for environmental restoration: plant (L) 5 788
Unwinding of the discount – recognised as an expense
1: Carrying amount on 1 January 20X5: Cost: (600 000 + 17 363) – Acc Depr: (100 000 x 4 years) = 217 363
2: Remaining useful life on 1 January 20X5: 6 years – 4 years = 2 years left
Comment: Notice how the provision for rehabilitation has been added to the plant cost and inventory
cost and was not shown in a separate ‘plant rehabilitation account’ (as was the case in the previous
example). This is because both these asset accounts and the liability account will affect the profit or loss
at roughly the same rates.
3.3.4.4 Future costs: caused/increases over time – more detail (IFRIC 1)
The provision for future costs may require adjustment over time, resulting from:
The unwinding of discount as one gets closer to the date of the future cost (e.g. getting
closer to the date on which the asset has to be decommissioned);
A change in the expected future cash outflow (or future economic benefits); and
A change in the estimated current market discount rate.
The unwinding of the discount is expensed in profit or loss as a finance costs. Capitalisation of
these finance costs under IAS 23 Borrowing Costs is not permitted. IFRIC 1.8
However, a change in the expected future cash outflows or a change in the estimated current
market discount rate would affect the asset’s carrying amount.
Chapter 7 355
The journal adjustments to account for changes in future cash flows or changes in discount
rates are detailed in IFRIC 1 and depend on whether property, plant and equipment is measured
using the cost model or revaluation model.
Since IFRIC 1 requires an understanding of both the cost model (explained in this chapter) and
the revaluation model (explained in chapter 8) and also requires an understanding of provisions
(explained in chapter 18), these journals are not covered in this chapter or the chapter on the
revaluation model, but in the chapter relating to provisions (chapter 18).
3.4 Subsequent costs (IAS 16.12 – 16.14)
Subsequent costs are
As mentioned earlier, further costs are frequently incurred only capitalised if:
in connection with an asset well after the acquisition or
construction thereof. These costs can be categorised as: The recognition criteria are met (if
Day to day servicing; not, cost must be expensed)
Replacement of parts; Replacement of parts and repeat major
Major inspections. inspections:
derecognise old carrying amount
3.4.1 Day-to-day servicing (IAS 16.12) capitalise new cost (generally as a
separate part).
It is to be expected that an asset requires certain
maintenance. Although maintenance costs may be material in amount, these should always be
expensed. Typically, day-to-day servicing costs include labour, consumables and small parts.
Example 14: Repainting of vehicle

A delivery vehicle acquired for C100 000, is repainted one month after acquisition. The
cost of repainting is C3 000. The vehicle is to be used as a delivery vehicle.
Required: Briefly explain whether or not the C3 000 must be capitalised to the vehicle and provide the
relevant journal entries.
Solution 14: Repainting of vehicle

The painting in itself does not lead to future economic benefits. It does not increase the useful life of
the vehicle and does not increase the performance thereof. The painting was probably done for
advertising or maintenance purposes, and should be expensed as such.
Debit Credit
Advertising/ maintenance expense 3 000
Bank/ creditors 3 000
Painting of vehicle
Example 15: Purchase of engine

Assume that the delivery vehicle acquired in example 14 is acquired without an engine.
Subsequent to the original acquisition of the vehicle, a new engine is purchased at a cost of
C8 000.
Required: Briefly explain whether this cost may be capitalised to the vehicle and provide the journals.
Solution 15: Purchase of engine

The vehicle is to be used as a delivery vehicle, from which no future economic benefits would be
possible without an engine. The installation of the engine makes future economic benefits possible and
thus the cost of the engine should be capitalised as part of the cost that was required in order to bring
the asset to a location and condition necessary to enable it to be used as intended by management. If
the cost of this engine is significant to the company and, if the engine has a materially different useful
life to that of the vehicle, then it must be capitalised as a separate part of the vehicle.
Debit Credit
Vehicle: cost (or: Vehicle: engine: cost) 8 000
Purchase of engine for the vehicle
356 Chapter 7
Example 16: Engine overhaul - extending the useful life

Assume that the delivery vehicle acquired in example 15 has its engine overhauled a few
days after acquisition. This overhaul, costing C2 000, is performed in order to extend the
useful life of the engine.
Required: Briefly explain if this cost must be capitalised and provide the relevant journal entries.
Solution 16: Engine overhaul - extending the useful life

For any cost to be capitalised, the asset definition and recognition criteria must be met:
The engine is a resource controlled by the entity (log books and physical security) as a result of a
past event (the purchase of the vehicle). Since the overhaul results in an increased life and
therefore an expected increase in future economic benefits, this aspect of the definition is also met.
The cost is reliably measured at 2 000 and thus if the expected future economic benefits are also
probable, the recognition criteria will also met and the overhaul would be capitalised:
Debit Credit
Vehicle: cost 2 000
Payment for engine overhaul
If the overhaul is a significant cost and results in the engine having a materially longer useful life than
the vehicle shell, then the carrying amount of the engine (together with the cost of the overhaul) should
be removed from the ‘vehicle shell’ account and recorded as a separate part of the vehicle as follows:
Debit Credit
Vehicle engine: cost 8 000
Vehicle (without engine): cost 100 000
Vehicle: cost 100 000 + 8 000 108 000
Separation of the components: engine and vehicle shell
Payment for engine overhaul
The engine (cost: 8 000 + 2 000 = 10 000) is depreciated separately from the vehicle (cost: 100 000).
Example 17: Servicing an engine

Assume that the engine acquired in example 16 has its engine serviced 6 months after
acquisition.
Required: Briefly explain whether this cost must be capitalised.
Solution 17: Servicing an engine

For costs to be capitalised, the asset definition and recognition criteria must be met. Although
servicing costs are incurred in the pursuit of future benefits, servicing is needed continuously and thus
we cannot argue that an inflow of future benefits from these servicing costs is probable. Thus the
recognition criteria are not met and thus the cost of servicing is expensed as day-to-day servicing.
3.4.2 Replacement of parts and derecognition of assets (IAS 16.13)
3.4.2.1 Derecognition of the old part
Some items of property, plant and equipment have parts that regularly require replacements
(e.g. an aircraft may require its seats to be replaced every 3 years). Conversely, a part may
unexpectedly need replacement (e.g. a part may need to be replaced because it was damaged).
Where a part of an asset is replaced, the carrying amount of the old part must be removed from
the asset accounts by expensing its carrying amount in profit or loss (i.e. credit cost, debit
accumulated depreciation and debit/ credit the profit or loss with the carrying amount).
Chapter 7 357
The derecognition is easy if the replaced part had been recognised and depreciated as a
separate part of the asset, but if the replaced part was not originally recognised separately, its
carrying amount will need to be estimated (see example 19).
If the part needed replacing because it was damaged (as opposed to needing replacing simply
because the part has reached the end of its useful life), we must first check for impairments
before we derecognise its carrying amount.
If this damage caused the value of the part (its recoverable amount) to drop below its carrying
amount, the carrying amount must be reduced to reflect this impairment (i.e. debit impairment
loss expense and credit accumulated impairment losses), after which it may be derecognised
(i.e. credit cost, debit accumulated depreciation, debit accumulated impairment losses and the
contra entry to these three entries would be a single debit to the profit or loss reflecting the
carrying amount that is being expensed). Impairments are explained in section 5.
3.4.2.2 Capitalisation of a new part
Assuming that the definitions and recognition criteria are met, the cost of the replacement part
must be recognised as an asset. If the cost of this new part is significant in relation to the value
of the asset as a whole and has a useful life and method of depreciation that is different to the
rest of the asset, then this new part must be recorded in a separate asset account. However, all
immaterial replacement parts should be expensed as day-to-day servicing.
Example 18: Replacement of a part

Bigboy Limited owned a car that had a carrying amount of C30 000 on 1 January 20X1.
Details of this car, recorded as two significant parts, were as follows on 1 January 20X1:
Car structure: C20 000, with a remaining useful life of 10 years and a nil residual value
Car engine: C10 000, with a remaining useful life of 2 years and a nil residual value
This old engine (original cost: C12 000) was scrapped and replaced during 20X1 due to the car having
been driven without oil. The engine was replaced on 1 October 20X1 at a cost of C15 000. The new
engine has a useful life of 3 years and a nil residual value. The straight line method is used.
Required: Show the journal entries relating to the purchase of the new engine in 20X1.
Solution 18: Replacement of a part

1 October 20X1 Debit Credit
Depreciation – vehicle (P/L) (10 000 – 0) / 2 years x 9/12 3 750
Vehicle engine: acc. depreciation (-A) 3 750
Depreciation of the vehicle’s engine to date of replacement: structure:
Impairment loss – vehicle (P/L) Engine: 10 000 – 3 750 6 250
Vehicle engine: acc. impairment loss (-A) 6 250
Impairment: vehicle’s engine to date of replacement & derecognition
Vehicle engine: acc. depreciation (-A) 12 000 – 10 000 + 3 750 5 750
Vehicle engine: acc. impairment loss (-A) 6 250
Vehicle engine: cost Given 12 000
Derecognition of old engine
Purchase of new engine
31 December 20X1
Depreciation – vehicle (P/L) 3 250
Vehicle engine: acc. depreciation (-A) (15 000 – 0) / 3 years x 3/12 1 250
Vehicle structure: acc. depreciation (-A) (20 000 – 0) / 10 years x 12/12 2 000
Depreciation of the vehicle at year end: (old structure & new engine)
Comment: The impairment loss was recorded before the old engine was derecognised to reflect the fact
that the old engine had been scrapped.
358 Chapter 7
Example 19: Replacement of a part that was not previously identified

A plant was bought on 1 January 20X1:
The purchase price was C1 000, paid in cash, (no significant parts were identified).
The estimated useful life of the plant is estimated to be 10 years on this date.
The engine of this plant seized up, was scrapped and had to be replaced on 1 January 20X2:
A new engine was installed (on the same day) at a cost of C500 cash.
The estimated useful life of the new engine is 5 years.
The cost of the old engine, when originally purchased as part of the plant, is estimated to be C300.
Required: Show the journals in 20X2.
Solution 19: Replacement of a part that was not previously identified

Calculations: Original Original Asset without
asset engine engine
Cost: 1 January 20X1 1 000 300 700
Accum. depreciation: (1 000/ 10 x 1) and (300/ 10 x 1) (100) (30) (70)
st
Carrying amount: 31 December 20X1 900 270 630

Impairment of plant (P/L) 270
Plant: accumulated impairment losses (-A) 270
Impairment of carrying amount of previous engine – part of the plant
Plant: accumulated depreciation (-A) 30
Plant: accumulated impairment losses (-A) 270
Plant: cost 300
Derecognition of engine (engine write-off) – part of the plant
Plant: engine: cost 500
Bank 500
Purchase of new engine (part of plant but separately recognised now)
31 December 20X2
Depreciation (P/L) 170
Plant: engine: accumulated depreciation (-A) C500/ 5 years 100
Plant: without engine: acc. depreciation (-A) C700/ 10 years * 70
Depreciation of plant: two separate parts (* or C630/ 9 remaining years)
3.4.3 Major inspections (IAS 16.14)
When an asset requires ‘regular major inspections as a condition to its continued use’, (a good
example, given in the IAS 16.14, being an aircraft), then the cost thereof, (or an estimate
thereof), must be capitalised as soon as the cost is incurred or an obligation arises. This
inspection will be recognised as an asset.
This ‘major inspection’ asset is then depreciated over the period until the date of the next
inspection. If the cost of the inspection is significant and the rate and method of depreciation
of the inspection differs from that applied to the other parts of the related asset, then the cost of
the inspection must be recognised as a separate part.
Example 20: Major inspection performed

New legislation was promulgated on 1 September 20X1 whereby all public transport buses
are required to undergo regular major inspections every 2 years.
Vroom Limited owns a bus that has a carrying amount of C80 000 as at 1 January 20X1.
A major inspection of this bus was performed on 1 October 20X1 at a cost of C20 000.
This bus is depreciated on the straight-line method to a nil residual value over its remaining useful
life of 10 years, calculated from 1 January 20X1.
Required:
A Show the journal entry relating to the major inspection.
B Present the bus in Vroom Limited’s statement of financial position at 31 December 20X1.
Chapter 7 359

Bus major inspection: cost 20 000
Bank 20 000
Major inspection performed on 1 October 20X1
31 December 20X1
Depreciation – bus (P/L) 10 500
Bus: acc. depreciation (-A) (80 000 – 0) / 10 years x 1 year 8 000
Bus major inspection: acc. depr. (-A) 20 000 / 2 years x 3 / 12 2 500
Depreciation of bus: physical bus and major inspection of the bus
Comment:
The inspection is recognised on 1 October 20X1 and not on 1 September 20X1: the pure enactment
of the new law does not create an obligation for Vroom Limited since it can choose to simply not
drive the bus publicly. The obligation thus arises when the inspection is performed.
The major inspection has a different useful life to that of the physical bus. Its useful life is 2 years
after which a new inspection will have to be performed. The inspection occurred 3 months before
year-end and therefore the inspection was depreciated over these 3 months.
Solution 20B: Disclosure

Vroom Limited
ASSETS 20X1
Non-current Assets C
Bus 80 000 + 20 000 – 8 000 – 2 500 89 500
If an entity buys an asset that, on the date of purchase, has already been inspected and thus
does not require another inspection for a period of time, the cost must be separated into:
the cost that relates to the physical asset (or its separate significant parts), and
the cost that relates to the balance of the previous major inspection purchased.
The cost of the inspection need not be separately identified on the sale documentation i.e. an
estimate of the cost can be made based on the expected cost of future similar inspections.
Example 21: Major inspection purchased as part of the asset

A ship is purchased for C1,3 million cash on 1 January 20X1:
when its economic useful life was estimated to be 10 years.
This ship may only be used if it is inspected for faults every 3 years.
The 20X0 inspection was done on 31 December 20X0 and is included in the purchase price
(although the exact cost thereof is not known).
The next inspection is due on 31 December 20X3. The expected cost of this future inspection is
C400 000 and the present value thereof is C300 000 (discounted to 1 January 20X1).
Required:
Show how this should be journalised in 20X1.
Solution 21: Major inspection purchased as part of the asset

Ship structure: cost (asset) 1 300 000 – 300 000 1 000 000
Ship major inspection: cost (asset) PV of 20X3 inspection cost 300 000
Bank Given 1 300 000
Purchase of ship: 20X0 inspection costs estim. using PV of 20X3 cost
360 Chapter 7

31 December 20X1
Depreciation – ship (P/L) 200 000
Ship structure: accum. depr. (-A) (1 000 000 – 0)/ 10 years 100 000
Ship major inspection: accum. depr. (-A) 300 000/ 3 years 100 000
Depreciation of ship: structure and major inspection
Comment:
The 20X3 inspection was not recognised as at 31 December 20X1 as no obligation exists for it in 20X1
(no ‘past event’ has occurred yet!). However, we use the expected 20X3 inspection cost to estimate the
value of the 20X0 inspection that had already been performed.
Example 22: Major inspection derecognised

Use the same information as that provided in example 21 and the following additional
information:
On 31 December 20X3 the first major inspection is performed at a cost of C400 000.
New legislation now requires that major inspections be performed every 2 years starting
from 31 December 20X3.
The next major inspection is estimated to cost C600 000.
Required: Show the journals in 20X2, 20X3 and 20X4.
Solution 22: Major inspection derecognised

Depreciation – ship (P/L) 200 000
Ship structure: acc. depreciation (A) 1 000 000/ 10 years 100 000
Ship major inspection: acc. depreciation (-A) 300 000/ 3 years 100 000
Depreciation of ship and depreciation of major inspection
31 December 20X3
Ship structure: accum. depreciation (-A) 1 000 000/ 10 years 100 000
Ship major inspection: accumulated depreciation (-A) (20X0) 300 000
Ship major inspection: cost (20X0) 300 000
Derecognition of carrying amount of 20X0 inspection
Ship major inspection: cost (20X3) 400 000
Bank 400 000
Payment: 20X3 major inspection
31 December 20X4
Ship structure: acc. depreciation (-A) 1 000 000/ 10 years 100 000
Comment:
The estimated cost of the first (20X0) major inspection that was included in the purchase price is
fully depreciated by 31 December 20X3.
The actual cost of the second major inspection, performed on 31 December 20X3, is capitalised
when incurred.
The cost of the third major inspection, due on 31 December 20X5, may not be provided for (until
it is performed on 31 December 20X5) since there is no present obligation (the ship may be sold
before this date, in which case, the cost of the major inspection would be avoided).
Chapter 7 361
4. Subsequent Measurement (IAS 16.43 – 16.63 and IAS 36)
4.1 Overview
The measurement of an item of property, plant and equipment is reflected in its carrying
amount and is constituted by its initial measurement and subsequent measurement.
Initial measurement of property, plant and equipment is always at cost and thus the
measurement of its carrying amount will initially simply reflect cost.
Subsequent measurement involves:

Carrying amount is
using the cost model or revaluation model; defined as:
depreciation: this reflects the usage of the asset; and
impairments: this reflects any damage to the asset. the cost (or fair value)
less accumulated depreciation
Thus the subsequent measurement of its carrying amount is less accumulated impairment
reflected by ledger accounts that not only show its cost but losses (if applicable) IAS 16.6 reworded
also its subsequent accumulated depreciation and accumulated impairments.
4.2 Cost model
We focus only on the cost model in this chapter (the revaluation model is explained in the next
chapter). Using the cost model simply means that the cost account will reflect the costs of the
asset (using the revaluation model, the asset is revalued to a fair value and so the cost account
is adjusted to reflect the fair value instead). These costs have been explained already
as being the total of:
The cost model
the initial cost (see section 3.3); and measures PPE as:
any subsequent costs (see section 3.4).
the cost (initial + subsequent)
The subsequent depreciation and impairment losses are less accumulated depreciation
calculated based on this cost. Let us know look at how to less accumulated impairment
measure depreciation and impairment losses. losses (if applicable)
4.3 Depreciation
4.3.1 Overview
Depreciation is defined
Depreciation reflects the extent to which the asset’s carrying as:
amount has dropped because of having used up the asset. systematic allocation of the
All items of property, plant and equipment, with the depreciable amount of an asset
exception of land in most cases, must be depreciated. Land
over its useful life. IAS 16.6
is generally not depreciated in the belief that land cannot be
used up: it always remains there, ready to be used, again and again. However, land that is
used, for example, as a quarry or landfill site, would obviously mean that the land would have
a limited useful life and thus would need to be depreciated.
In measuring depreciation, we simply expense:
the portion of the cost that will be lost due to usage (called its depreciable amount);
over its useful life
using a method that matches with the pattern in which we expect to use the asset.
The portion of a cost that we believe will not be lost through usage is referred to as its residual
value. We thus exclude the residual value when calculating the depreciation. It is thus the
depreciable amount (cost less residual value) that is depreciated.
Depreciation is usually recognised as an expense in profit or loss. On occasion, however, the
asset may be used to produce another asset, in which case the depreciation would be capitalised
to that other asset.
362 Chapter 7
Property, plant and equipment is depreciated on a significant parts basis. This means that, if an
asset has different parts each with a significant cost, we must separate this asset into these
different parts and depreciate each part separately if each of these parts has:
a different useful life; or
a different pattern of future economic benefits. See IAS 16.43 - .47
The measurement of depreciation involves estimating three The 3 variables of
variables: residual value (used to calculate the depreciable depreciation:
amount), useful life and method of depreciation. The Residual value
estimation of each of which will require professional Useful life
judgement (which can only come through experience). Method.
4.3.2 Residual value and the depreciable amount (IAS 16.51 – 16.54)
The depreciable amount is the portion of the asset’s cost
that we believe will be ‘lost’ through usage whereas the Depreciable amount is
defined as
residual value is the portion that will not be lost. This
residual value is simply an estimate and thus we need to the cost of the asset (or other
reassess our estimated residual value at the end of each amount, for example its fair value)
financial year to be sure that it has not changed. See IAS 16.51 less its residual value. IAS 16.6
The residual value is calculated as follows:

Expected proceeds on disposal: Residual value is defined
This is the amount for which the entity would be able as:
to sell the asset assuming it had already reached the the estimated amount that an
end of its useful life entity would currently obtain
from disposal of the asset,
Less the expected costs of disposal: after deducting the estimated
These are the costs that would be incurred today to costs of disposal,
dispose of the asset if the asset were already of the
age and in the condition expected
t the end of its useful life IAS 16.6
It can happen that the residual value is actually higher than
the asset’s current carrying amount. When this happens, we simply stop depreciating the asset.
Depreciation resumes (starts up again) if and when the residual value drops below carrying
amount. See IAS 16.54
4.3.3 Method of depreciation (IAS 16.60 – 16.62)
A variety of methods of depreciation are possible, including:
the straight-line method (resulting in a stable depreciation expense over the asset’s life);
the diminishing balance method (resulting in a decreasing depreciation expense over the
asset’s life); and
the sum-of-the-units method, now also known as the units of production method, (this
results in a fluctuating depreciation expense over the useful life of the asset). See IAS 16.62
The method chosen should match the way in which we
The depreciation method
expect to earn the future economic benefits through use of should reflect:
the asset. See IAS 16.60
the pattern in which,
However, it must be emphasised that the depreciation the FEB from the asset,
method should reflect the pattern of the consumption of the are expected to be consumed.
IAS 16.60 reworded
asset’s expected future economic benefits rather than
reflect the revenue generated by the asset. The reason for this is that, revenue that is generated
by an activity that includes the use of an asset is affected by numerous factors that may have no
relation to how the asset is being used up. For example, the revenue generated from the use of
an asset would be affected by factors such as inflation and pricing that is manipulated for
marketing purposes. It would also be affected by sales volumes where the volumes sold would
be affected by, for example, marketing drives and economic slumps.
Chapter 7 363
Worked example: Depreciation

An asset is expected to produce 100 000 units in year 1 and 80 000 units in year 2.
The total expected output of 180 000 units is expected to be sold evenly over a 3 year period (i.e. 60 000
units pa).
The sales department plans to market the units at C10 per unit in year 1, C12 per unit in year 2 and C15 per
unit in year 3. Thus budgeted sales are: C600 000 in year 1, C720 000 in year 2 and C900 000 in year 3.
Discussion of the example:
Depreciation on the straight-line method over the 3 years, based on unit sales of 60 000 units pa for 3
years, would not be appropriate. This is because the unit sales do not reflect the pattern of consumption
of the asset’s future economic benefits (depreciation based on 100 000 units in the first year and 80 000
units in the second year as a percentage of the total expected output of 180 000 units is a more
appropriate reflection of how the asset’s future economic benefits are expected to be consumed – in other
words, how the asset is expected to be used up).
Similarly, basing the depreciation on the sales in currency terms would also not be appropriate because this
would not reflect how the asset was actually being used up. The sales in currency terms is clearly affected
by the entity’s pricing strategy rather than the pattern in which the asset is being used up.
The asset is used up after 2 years and its carrying amount should obviously reflect this fact. See IAS 16.62A
Since the depreciation method is based on an expected pattern of future benefits, it is simply an
estimate and must be reviewed at the end of each financial year. See IAS 16.61
4.3.4 Useful life (IAS 16.51 & 16.55 -16.59)
Depreciation begins when an asset is available for use

(not when it was brought into use). Useful life is defined as:
Depreciation ceases at the earlier of date that the asset is the period over which an asset is
classified as held for sale in accordance with IFRS 5 and expected to be available for use by
the date that the asset is derecognised. This means that an an entity; or
asset that does not meet the criteria for classification as the number of production or similar
held for sale but is no longer being used and is simply units expected to be obtained from
awaiting disposal continues to be depreciated! the asset by an entity IAS 16.6
Depreciation does not cease if an asset is idle (unless the sum of the units method is used to
calculate the depreciation). See IAS 16.55
Determining the useful life involves a careful consideration of many factors including:
‘the expected usage of the asset’ (for example, the total number of units expected to be
manufactured by a plant);
‘the expected physical wear and tear’ on the asset (for instance, this would be less in a
company that has a repair and maintenance programme than in another company that does
not have such a programme);
‘technical or commercial obsolescence’, which may shorten the asset’s useful life. We
should also be on the look-out for an expected reduction in the selling price of the output
produced by the asset because this may suggest imminent ‘technical or commercial
obsolescence’ of the asset and thus may indicate a potential decrease in the asset’s
expected future economic benefits (and therefore a reduced useful life); and
other limits on the asset’s useful life, including legal limits (with the result that the useful
life to the company may be shorter than the asset’s actual useful life). IAS 16.56 reworded
See IAS 16.51
The useful life of an asset must be reviewed at the end of each financial year.
4.3.5 Depreciating the whole asset or the parts thereof (IAS 16.43- 16.47)
In order for depreciation to be more accurately measured, we may need to recognise and
depreciate each part of an asset separately, rather than as a whole, single asset. This is
necessary if the various parts each have a significant cost and have differing variables of
depreciation (useful life, residual value or method).
364 Chapter 7
For example: a vehicle may have an engine and a body where these two parts have different
useful lives. Similarly, the depreciation method could differ: the engine may need to be
depreciated over the number of kilometres travelled whereas the body may need to be
depreciated over a certain number of years.
4.3.6 Depreciation journal
Depreciation is usually expensed:

Debit Credit
Depreciation (E) xxx
Asset name: Accumulated depreciation (-A) xxx
Depreciation of PPE is expensed
If an entity uses an existing asset to construct another asset, the depreciation charge must be
capitalised to the cost of the newly constructed asset: (IAS 16.48 - .49)
Debit Credit
Constructed Asset: cost (A) xxx
Depreciation (E) xxx
Capitalisation of depreciation to the cost of the constructed asset
Example 23: Depreciation calculation with many dates

Braaimaster Limited bought an asset for C100 000 on 1 January 20X1.
It was available for use on 1 February 20X1 and brought into use on 1 March 20X1.
It was temporarily idle for the month of April 20X1.
Depreciation is estimated using the straight-line method, a 5-year useful life and a nil
residual value.
The asset was derecognised on 31 October 20X1.
Required: Calculate the depreciation on this asset for the year ended 31 December 20X1.
Solution 23: Depreciation calculation with many dates

The asset is depreciated from the time that it is available for use, being 1 February 20X1.
Depreciation must not cease while the asset is temporarily idle in April 20X1.
Depreciation ceases, however, on 31 October 20X1, when the asset is derecognised.
Depreciation in 20X1 is therefore = (100 000 – 0) / 5 years x 9 / 12 = 15 000
Example 24: Depreciable amount and straight-line depreciation

An asset is purchased at a cost of C110 000 on 1 January 20X1.
The asset has a total useful life of 10 years.
The company expects to sell the asset after 5 years for an estimated C30 000 (present
value), before taking into consideration the present value of the expected costs of
disposal of C20 000.
The straight-line method of depreciation is to be used for this asset.
Required: Calculate the depreciation for the year ended 31 December 20X1.
Solution 24: Depreciable amount and straight line depreciation

Residual value: C10 000
Expected proceeds on disposal (in current terms) 30 000
Less expected costs of disposal (in current terms) (20 000)
Depreciable amount: C100 000
Cost 110 000
Less residual value (10 000)
Useful life: 5 years
The shorter of:
Total useful life of the asset 10 years
The useful life to the business 5 years
Chapter 7 365

Depreciation 20X1: C20 000
Depreciable amount, divided by C100 000
Useful life 5 years
Comment: Since the asset is depreciated using the straight-line method, the depreciation will remain constant at
C20 000 per annum for each of the remaining 4 years of its useful life.
Example 25: Depreciation using diminishing balance

Koos Limited purchased an asset on 1 April 20X1 for C800 000.
The rate of depreciation to be used is 20% and the residual value is C327 680.
The depreciation method appropriate to the use of this asset is the diminishing balance.
Required: Calculate the depreciation expense recognised in each affected year assuming that:
A: the year end is 31 March.
B: the year end is 30 June.
Solution 25: Generic table

Depreciation calculated per year of Opening Depreciation Closing Calculations
its useful life (UL): balance at 20% balance
1st yr of its UL ending 31/03/X2 12 800 000 160 000 640 000 800 000 x 20% x 12/12
2nd yr of its UL ending 31/03/X3 12 640 000 128 000 512 000 640 000 x 20% x 12/12
3rd yr of its UL ending 31/03/X4 12 512 000 102 400 409 600 512 000 x 20% x 12/12
4th yr of its UL ending 31/03/X5 12 409 600 81 920 327 680 409 600 x 20% x 12/12
Accumulated depreciation: 472 320
Solution 25B: Apportionment of depreciation:

acquisition date coincides with year-end
Apportionment of depreciation to the financial years:
Depreciation calculated per year of its useful life apportioned to each financial year affected
to the financial year ended 30 Mar X1 (01/04/X1 – 30/03/X2): 160 000 x 1212 160 000
to the financial year ended 30 Mar X2 (01/07/X1 – 30/03/X3): 128 000 x 12/12 128 000
472 320
Solution 25B: Apportionment of depreciation:

acquisition date does not coincide with year-end
Apportionment of depreciation to the financial years:
Depreciation calculated per year of its useful life apportioned to each financial year affected
to the financial year ended 30 June X1 (01/04/X1 – 30/06/X1): 160 000 x 3/12 40 000
to the financial year ended 30 June X2 (01/07/X1 – 30/06/X2): 160 000 x 9/12 + 128 000 x 3/12 152 000
to the financial year ended 30 June X5 (01/07/X4 – 31/03/X5): 81 920 x 9/12 61 440
472 320
Example 26: Depreciation using sum-of-the-units

A company intends to depreciate its plant using the sum-of-the-units method:
The cost of the plant is C100 000 (purchased on 1 January 20X1).
The asset is expected to be able to produce 100 000 units in its lifetime.
Production in the year ended 31 December: 20X1 was 10 000 units and in 20X2 was
15 000 units.
Required: Calculate depreciation for the 20X1 and 20X2 year using the sum-of-the-units method.
Solution 26: Depreciation using sum-of-the-units

Depreciable amount: Given: 100 000
Depreciation: 31 December 20X1: C100 000 / 100 000 units x 10 000 units = C10 000
Depreciation: 31 December 20X2: C100 000 / 100 000 units x 15 000 units = C15 000
366 Chapter 7
Example 27: Depreciation involved with a self-constructed asset

Terrace Limited was constructing an asset for use in its factory.
The labour and material costs of construction totalled C100 000 in cash during 20X1.
Terrace Limited used one of its machines in the process of constructing this asset. The
machine was used for a period of six months in 20X1 on the construction of this asset.
The depreciation of this machine was C20 000 for the year ending 31 December 20X1.
Required: Show the journals for the year ended 31 December 20X1 relating to the asset assuming:
A. The constructed asset is a plant that became available for use on 1 October 20X1 and was depreciated
for 5 years to a nil residual value.
B. The constructed asset is inventory, half of which was sold on 1 October 20X1.
Solution 27A: Depreciation involved with a self-constructed plant

Debit Credit
Plant: cost 100 000
Bank 100 000
Payment for construction costs: labour and material
Depreciation – machine (P/L) 20 000
Machine: accumulated depreciation (-A) 20 000
Depreciation of machine (given)
Plant: cost 10 000
Allocation of depreciation of machine to plant in respect of 6 month usage
thereon: 20 000 / 12 x 6
Depreciation – plant (P/L) 5 500
Depreciation of plant: (100 000 + 10 000 – 0) / 5 years x 3/12
Solution 27B: Depreciation involved with manufacture of inventory
Debit Credit
Inventory 100 000
Bank 100 000
Payment for construction costs: labour and material
Depreciation of machine (given)
Inventory 10 000
Allocation of depreciation of machine to inventory in respect of 6 month
usage thereon: 20 000 / 12 x 6
Inventory 55 000
Sale of half of the inventory: (100 000 + 10 000 – 0) x 50%
4.3.7 Change in estimate (IAS 16.51 and IAS 16.61)
If a company decides that any one of the three variables of Changes in accounting
depreciation (residual value, useful life or method of estimates occur if any
depreciation) needs to be changed, this must be adjusted for of the following are
as a change in accounting estimate (in terms of changed:
IAS 8 Accounting policies, errors and estimates). estimated useful life
method of depreciation
Over and above the possible changes to the estimated the residual value
variables of depreciation, we may change our estimate of the estimated costs of dismantling,
present value of the future costs of dismantling, removing removing or restoring items of PPE.
or restoring items of property, plant and equipment. This is explained in section 3.3.4 and in
more depth in the chapter on provisions (chapter 18).
Chapter 7 367
There are two methods that may then be used to calculate the revised depreciation when there
is a change in estimate:
the reallocation method; and the
cumulative catch-up method.
These two methods are covered in detail in chapter 24 where further examples are provided
(together with disclosure requirements when there is a change in estimate). The journals for a
change in estimate are really simple and are best explained by way of the following example.
Example 28: Sum-of-the-units depreciation with a change in total expected
production
A company intends to depreciate its plant using the sum-of-the-units method:
The cost of the plant is C100 000 (purchased on 1 January 20X1).
Production in the year ended 31 December 20X1 was 10 000 units and in 20X2 it was 15 000 units.
Originally it was expected that the asset would be able to produce 100 000 units in its lifetime, but
in 20X2, this estimated total production was changed to 90 000 units.
Required: Calculate the depreciation for 20X2 assuming the change in estimate is accounted for by:
A Adjusting the carrying amount for the cumulative effect on depreciation to date; and
B Reallocating the carrying amount over the remaining useful life.
Solution 28A: Change in estimate – cumulative catch-up method

Accum. depreciation to 31/12/20X2: C100 000 x (10 000u + 15 000u) / 90 000 units = C27 777
Depreciation in 20X2: acc. depr. 20X2 – acc. depr. 20X1 = C27 777 – C10 000 = C17 777
Solution 28B: Change in estimate – reallocation method

Carrying amount 1 January 20X2: C100 000 – C10 000 = C90 000
Depreciation in 20X2: C90 000/ (90 000 – 10 000 units) x 15 000 = C16 875
4.4 Impairments (IAS 16.63 and IAS 36)
4.4.1 Overview
An impairment loss is
Items of property, plant and equipment must be tested for defined as:
indications of impairments at the end of every reporting the excess of
period. Impairment testing is governed by IAS 36 and is the carrying amount
explained in detail in chapter 11. over the recoverable
amount IAS 16.6 reworded
In a nutshell, an impairment indicator test is one that
tests an asset for evidence of damage of some kind or other.
Please note that damage is not referring exclusively to physical damage. We look for any kind
of damage that reduces the value of the asset (e.g. an economic downturn may reduce demand
for an asset’s output, in which case the asset becomes less valuable to the entity).
Thus, the impairment testing process is essentially a check to ensure that the asset’s carrying
amount is not overvalued. If we think the carrying amount may be too high, it may simply be
because we have not processed enough depreciation (i.e. the variables of depreciation may
need to be re-estimated):
If we believe that we have not processed enough depreciation, extra depreciation is then
processed (and accounted for as a change in estimate according to IAS 8); but
If we believe that the depreciation processed to date is a true reflection of past usage, and
yet we are worried that the carrying amount may be too high, we must calculate the
recoverable amount and compare it with the asset’s carrying amount.
Please notice the difference:

a drop in carrying amount caused by ‘normal usage’ is called depreciation; whereas
a drop in carrying amount caused by any kind of ‘damage’ is called an impairment loss.
368 Chapter 7
4.4.2 The recoverable amount

The recoverable amount is simply an estimate of the The recoverable amount
highest possible future economic benefits that you expect is defined as:
to be able to get from the asset – this may be through using
the asset (value in use) or selling the asset (fair value less The higher of
costs to sell). an asset’s fair value less costs of
disposal; &
The detail regarding how to calculate the value in use and its value in use. IAS 16.6
fair value less costs to sell is set out in IAS 36 Impairment

of assets and is explained in depth in the chapter dedicated to impairments (chapter 11).
4.4.3 Comparing the carrying amount with the recoverable amount
If the indicator test suggests that the asset is impaired (i.e. that the accumulated depreciation is
a fair reflection of the usage of the asset and thus a shortage of depreciation is not the reason
for the carrying amount being too high) the carrying amount must be compared with the asset’s
recoverable amount.
If the carrying amount is greater than this recoverable amount, the carrying amount is reduced
by processing an impairment loss expense.
If circumstances change and the recoverable amount

increases in a future year, the carrying amount may be Impairment loss reversed
increased to this recoverable amount. The increase is
recognised in profit or loss as an impairment loss reversal If at a subsequent date the RA
(income). increases above CA,
increase the CA,
However, if the recoverable amount increases to such an but only to the extent that the CA
extent that the carrying amount is now less than the does not exceed the depreciated
recoverable amount, we must be careful if using the cost (historical CA).
cost model, because the carrying amount may not exceed the depreciated cost (think of this as
a ‘magical’ historical carrying amount line).
In summary, when using the cost model, the carrying amount of an asset may be decreased
below its depreciated cost but may never be increased above depreciated cost (cost less
accumulated depreciation, ignoring any prior impairment losses).
Historical carrying amount Actual carrying amount (when using
(depreciated historic cost): the cost model):
original cost original cost
less accumulated depreciation (based on less accumulated depreciation and
the original cost) less accumulated impairment losses
4.4.4 Depreciation in periods following an impairment

The depreciation in future years will be based on the reduced carrying amount. In other words,
the depreciation in the year after the impairment will be calculated by depreciating the asset’s
new revised carrying amount over its remaining useful life to the residual value.
The following diagrams may help you to visualise the effects of the cost model:
Diagram 1: Cost model summarised
Recoverable amount
greater than HCA No adjustments allowed
HCA
Recoverable amount Recognised in P/L
less than HCA
HCA: historical carrying amount (depreciated cost)
Chapter 7 369
Diagram 2: Example adjustments using the cost model – 4 scenarios

Scenario 1 Scenario 2 Scenario 3 Scenario 4
HCA/
ACA HCA HCA RA
Imp loss Not
(E) allowed
RA ACA RA HCA
Further: Imp loss Imp loss
Imp loss Reversed Reversed
(E) (I) (I)
RA ACA ACA
HCA: historical carrying amount (depreciated cost) E: expense

ACA: actual carrying amount (which may differ from the HCA) I: income
RA: recoverable amount
Scenario 1: the RA is less than the ACA (which was still the same as the HCA)
Scenario 2: the RA is less than the ACA (the ACA was already less than the HCA due to a prior impairment)
Scenario 3: the RA is bigger than the ACA but still less than the HCA (the ACA was less than the HCA due
to a prior impairment)
Scenario 4: the RA is bigger than the ACA and bigger than the HCA (the ACA was less than the HCA due to
a prior impairment)
The cost model can also be explained by way of a graph. First, plot the ‘magical’ historical
carrying amount line (HCA), otherwise known as the depreciated cost. After this, you need to
plot your actual carrying amount (ACA) and your recoverable amount (RA):
Graph: Using a graph for the cost model
Historical carrying amount line

Cost
0 Useful Life
Notice how the line is a diagonal line which represents the gradual reduction in the historical carrying
amount as the asset is depreciated over its useful life.
When using the cost model, the asset’s actual carrying amount may be decreased below this diagonal
line (HCA) but may never be increased above it. For example, assume that the recoverable amount is
greater than the historical carrying amount.
If the actual carrying amount equalled the historical carrying amount, no adjustment will be made
since this would entail increasing the actual carrying amount above its historical carrying amount.
If the asset had previously been impaired, then the asset’s actual carrying amount would be less
than the historical carrying amount. In this case, the actual carrying amount must be increased, but
only up to the historical carrying amount (reversing a previous impairment loss) but not all the way
up to the recoverable amount (i.e. not above the historical carrying amount).
Let us now try a few examples involving the cost model:

Example 29: how to calculate and journalise an impairment loss
Example 30: how to calculate and journalise an impairment loss reversed
Example 31: impairments and reversals over the life of an asset that is not depreciated
Example 32: impairments and reversals over the life of an asset that is depreciated.
370 Chapter 7
Example 29: Cost model - impairment loss

Cost of plant at 1/1/20X1: C100 000
Depreciation: 20% straight-line per annum (i.e. 5 yr useful life)
Recoverable amount at 31/12/20X1: C60 000
Required: Provide the journals for both 20X1 and 20X2.
Solution 29: Cost model - impairment loss

W1: Impairment loss: 20X1 C
Cost 1/1/20X1 Given 100 000
Accumulated depreciation 20X1 (100 000 x 20% x 1 yr) (20 000)
Actual (and historic) carrying amount 31/12/20X1 80 000
Recoverable amount 31/12/20X1 Given (60 000)
Impairment loss 20X1 The RA is less than CA 20 000
Journals: 20X1 Debit Credit
Depreciation – plant (P/L) (100 000/ 5yrs remaining) 20 000
Depreciation of asset for year ended 31 December 20X1
Impairment loss – plant (P/L) W1 20 000
Plant: accumulated impairment losses (-A) 20 000
Impairment of asset as at 31 December 20X1
Graphical depiction: 31/12/20X1
80 000( HCA & ACA)

Cost
20 000 (Debit impairment loss)

60 000(RA)
0 Useful Life
Journals: 20X2 Debit Credit

Depreciation – plant (P/L) (60 000/ 4yrs remaining (5-1)) 15 000
Note: No further impairment loss was required to be journalised at 31/12/20X2 since the new carrying
amount (60 000 – 15 000 = 45 000) equals the recoverable amount.
Example 30: Cost model - reversal of impairment loss

Depreciation: 20% straight-line per annum (i.e. over a useful life of 5 years)
Required:
Show all journals for 20X2, assuming the recoverable amount at 31/12/20X2 is estimated at:
A. C55 000; and
B. C65 000.
For simplicity, you may combine the accumulated depreciation and accumulated impairment loss
account into a single account called the ‘accumulated depreciation and impairment loss account’.
Chapter 7 371
Solution 30: Cost model - reversal of impairment loss

W1: Historical carrying amount 31/12/20X2: A and B
Cost 100 000
Accumulated depreciation 100 000 x 20% x 2yrs (40 000)
60 000
W2: Actual carrying amount 31/12/20X2 (before the impairment testing): A and B
Cost 100 000
Accum. depr. and imp. losses depr20X1:20 000 + IL20X1: 20 000 + depr20X2: 15 000 (55 000)
45 000
W3: Reversal of impairment loss required: A B

Recoverable amount limited to historical carrying amount 55 000 60 000
A: lower of RA: 55 000 and HCA: 60 000 (W1) = 55 000 (RA not limited)
B: lower of RA: 65 000 and HCA: 60 000 (W1) = 60 000 (RA is limited)
Less actual carrying amount (W2) 45 000 45 000
10 000 15 000
Journals: 20X2 A B
Dr/ (Cr) Dr/ (Cr)
Depreciation – plant (P/L) (60 000/ 4yrs remaining) 15 000 15 000
Plant: accumulated depreciation (-A) (15 000) (15 000)
Plant: accumulated depreciation and impairment losses (-A) 10 000 15 000

Impairment loss reversed – plant (P/L) (10 000) (15 000)
Reversal of impairment loss journal on 31/12/20X2:
Graph depicting A: 31/12/20X2
60 000( HCA)
Cost
55 000(RA)
10 000 (Credit reversal of impairment loss)
45000( ACA)
0 Useful Life
Graph depicting B: 31/12/20X2
65 000(RA)
(No increase allowed)
60 000( HCA)
Cost
15 000 (Credit reversal of impairment loss)

45 000( ACA)
0 Useful Life
372 Chapter 7
Example 31: Cost model – a summary example (the asset is not depreciated)
Cost of land at 1/1/20X1: C100 000
Depreciation: This land is not depreciated
Recoverable amount
31/12/20X1 120 000
31/12/20X2 70 000
31/12/20X3 90 000
31/12/20X4 110 000
Required:
A. Show the ledger accounts for the years ended 31 December.
B. Draft the statement of financial position for the years ended 31 December.
Solution 31A: Cost model – a summary example (the asset is not depreciated)
Ledger accounts:
Land: cost (asset) Land: accumulated impairment losses (asset)
1/1/ X1 Bank (1) 100 000 31/12/X2 IL (2) 30 000
Balance c/f 100 000 Balance c/f 30 000
100 000 100 000 30 000 30 000
Balance b/f 100 000 31/12/20X2:
Balance b/f 30 000
31/12/X3 ILR(3) 20 000
Balance c/f 10 000
30 000 30 000
31/12/X3:
Balance b/f 10 000
Bank 31/12/X4 ILR(4) 10 000

(1)
1/1/X1 Land 100 000 Balance c/f 0
10 000 10 000
31/12/X4
Balance b/f 0
Impairment loss expense Reversal of impairment loss income

31/12/X2 AIL (2) 30 000 31/12/X2 P&L 30 000 31/12/X3 P&L 20 000 31/12/X3 AIL(3) 20 000
31/12/X4 P&L 10 000 31/12/X4 AIL(4) 10 000
Solution 31B: Cost model – a summary example (the asset is not depreciated)
Disclosure in the SOFP:
Company name
As at 31 December (extracts)
20X4 20X3 20X2 20X1
C C C C
ASSETS
Non-current Assets
Land 20X1: Cost: 100 000 – AIL: 0 100 90 000 70 000 100 000
20X2: Cost: 100 000 – AIL:30 000
000
20X3: Cost: 100 000 – AIL:10 000
20X4: Cost: 100 000 – AIL:0
Comment:
As the asset is not depreciated, its historical carrying amount and cost are always equal.
Chapter 7 373
Solution 31A and B: Cost model – a summary example (the asset is not depreciated)
W1: Carrying amount Jnl 20X1 20X2 20X3 20X4

No. Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Opening balance 1 100 000 100 000 70 000 90 000
Depreciation Land not depreciated (0) (0) (0) (0)
Adjustment:
above HCA Not allowed above HCA 0 0
below HCA Dr: Impairment loss 2 (30 000)
up to HCA Cr: Impairment loss reversed 3; 4 20 000 10 000
Closing balance: (lower of RA or CA) 100 000 70 000 90 000 100 000
Recoverable amount (RA) 120 000 70 000 90 000 110 000
Historical carrying amount (CA: cost) 100 000 100 000 100 000 100 000
Example 32: Cost model – a summary example (the asset is depreciated)

Cost of machine at 1/1/20X1: 100 000
Depreciation: 25% per annum to a nil residual value
Recoverable amount at each of the 31 December financial year-ends:
31/12/20X1 120 000
31/12/20X2 40 000
31/12/20X3 60 000
31/12/20X4 0
Required:
Show the statement of financial position and the ledger accounts for each financial year-end.
Solution 32: Cost model – a summary example (the asset is depreciated)

Ledger accounts:
Cost (asset) Bank
1/1/ X1: Bank (1) 100 000 1/1/ X1 Machine 100 000
(1)
Balance c/f 100 000
100 000 100 000
Balance b/f 100 000
Depreciation expense Acc. depreciation & impairment losses

31/12/X1 AD&IL (2) 25 000 31/12/X1 P&L 25 000 31/12/X1 Depr (2) 25 000
31/12/X2 AD&IL (3) 25 000 31/12/X2 P&L 25 000 Balance c/f 25 000
31/12/X3 AD&IL (5) 20 000 31/12/X3 P&L 20 000 25 000 25 000
31/12/X4 AD&IL (7) 25 000 31/12/X4 P&L 25 000 31/12/X2:
Balance b/f 25 000
Depr (3) 25 000

Balance c/f 60 000 Imp loss (4) 10 000
Impairment loss expense 60 000 60 000
31/12/X2 Acc IL (4) 10 000 31/12/X2 P&L 10 000 31/12/X3:
Balance b/f 60 000
ILR (6) 5 000 Depr (5) 20 000
Balance c/f 75 000
80 000 80 000
31/12/X4:
Reversal of impairment loss income Balance b/f 75 000
(6)
31/12/X3 P&L 5 000 31/12/X3 AccIL 5 000 Depr (7) 25 000
Balance c/f 100 000
100 000 100 000
Balance b/f 100 000
374 Chapter 7

Disclosure:
Company name
ASSETS 20X4 20X3 20X2 20X1
Non-current Assets C C C C
Machine 20X1: Cost: 100 000 – AD&IL: 25 000 0 25 000 40 000 75 000
20X2: Cost: 100 000 – AD&IL:60 000
20X3: Cost: 100 000 – AD&IL:75 000
20X4: Cost: 100 000 – AD&IL:100 000
Workings:
W1: Carrying amount and adjustments Jnl 20X1 20X2 20X3 20X4
Opening balance 1 100 000 75 000 40 000 25 000
Depreciation X1: 100 000 / 4;X2: 75 000 / 3; 2,3,5,7 (25 000) (25 000) (20 000) (25 000)
X3: 40 000 / 2;X4: 25 000 / 1
Adjustment:
above HCA Not allowed above HCA 0 0
up to HCA Cr: impairment loss reversed 6 5 000
below HCA Dr: Impairment loss 4 (10 000)
Closing balance: (lower of RA or CA) 75 000 40 000 25 000 0
Recoverable amount (RA) 120 000 40 000 60 000 0
Historical carrying amount (CA = cost – acc depr) 75 000 50 000 25 000 0
5. Derecognition (IAS 16.67-.72)
An item of property, plant and equipment must be Derecognition

derecognised: means to:
on disposal; or remove from the
accounting records.
when no future economic benefits are expected from its
use or disposal.
To derecognise an asset means to remove its carrying amount from the accounting records. To
remove a carrying amount you need to remove all its related accounts. In other words, one
side of the entry requires us to credit its cost account and debit its accumulated depreciation
and accumulated impairment loss accounts. The other side of the entry (i.e. the contra entry) is
to recognise an expense in profit or loss (i.e. you are essentially processing an entry that credits
the carrying amount and debits an expense).
If, when derecognising the asset, the entity earned proceeds on the disposal, these proceeds
would be recognised as income in profit or loss. The amount of these proceeds is measured in
the same way that a transaction price is measured in terms of IFRS 15 Revenue from contracts
with customers.
The expensed carrying amount is then set-off against the proceeds to reflect any gain or loss.
If it results in a gain, this gain may not be classified as revenue (i.e. it is simply classified as
income in profit or loss).
Since we are allowed to offset the expense (i.e. the expensed carrying amount) and the income
(i.e. the proceeds), the process of recognising the carrying amount as an expense and
recognising the proceeds as an income is generally processed in one account, generally called a
‘profit or loss on disposal’ account.
Chapter 7 375
Disposals occur if the asset is sold, leased to someone else under a sale and leaseback
agreement or donated. The date on which the disposal must be recorded depends on how it is
disposed of.
The disposal of an asset by way of a sale and leaseback agreement is explained in the
relevant chapter on leases (chapter 17).
If a disposal occurs in any other way (e.g. by way of a sale or donation), the asset is
derecognised on the date that the recipient obtains control of the item (the recipient is said
to have obtained control when the IFRS 15 criteria for determining when a performance
obligation has been satisfied are met). See IAS 16.69
Please note: although the performance obligation criteria in IFRS 15 are used to determine
when to derecognise an item of property, plant and equipment, any gain on derecognition (e.g.
profit on sale of plant) may not be classified as revenue. Any gain that may be made would
simply be classified as part of ‘other income’.
Sometimes entities, as part of their ordinary activities, rent items of property, plant and
equipment to third parties after which they sell these second hand items. In such cases:
After the entity has stopped renting the item of property, plant and equipment to third
parties and decides to sell it, the carrying amount of this item is transferred to inventory;
the inventory is derecognised when the revenue recognition criteria are met; and
the sale of the asset is then classified as part of revenue because it would be a sale of
inventory and not a sale of property, plant and equipment and the related revenue would
thus be accounted for in terms of IFRS 15 Revenue from contracts with customers.
6. Deferred Tax Consequences (IAS 12)
6.1 Overview
Temporary differences will arise if the tax authorities do

not measure the tax base of the asset in the same way that Deferred tax balance
=
the carrying amount is measured in terms of IFRSs.
Temporary difference x tax rate
Deferred tax should be recognised on temporary differences (unless TD is exempt)
unless: Nil if TD is exempt:
the temporary difference is exempt from deferred tax; or Exemption may occur if a TD
arises on initial acquisition
the temporary difference is a deductible temporary
difference causing a deferred tax asset but where the inflow of future economic benefits is
not probable.
This section merely revises some of the deferred tax consequences of property, plant and
equipment because the deferred tax effects of property, plant and equipment have been
thoroughly explained in Chapter 6: Deferred Tax. If you are unsure of the deferred tax
consequences arising from property, plant and equipment, please revise the following:
Deductible assets: chapter 6: section 6.2;
Non-deductible assets (and the exemption): chapter 6: section 6.3 and section 7;
Sale of property, plant and equipment: chapter 6: section 6.5.
6.2 Comparing the carrying amount and tax base
The carrying amount of an item of property, plant and equipment changes if and when:
the asset is acquired;
the asset is depreciated;
the asset is impaired (or a prior impairment is reversed); and
the asset is sold.
376 Chapter 7
The tax base of an item of property, plant and equipment changes if and when:
the asset is acquired;
deductions are allowed on the cost of the asset; and
the asset is sold.
Carry amount of PPE represents: Tax base of PPE represents:

cost future tax deductions
less accumulated depreciation and
less accumulated impairment losses
Essentially, when the carrying amount and tax base are not the same, it means that the rate at
which the cost of the asset is expensed is different to the rate at which the cost of the asset is
allowed as a tax deduction.
The following examples show the effect on deferred tax of property, plant and equipment that
is measured under the cost model:
Example 33 shows us how to account for deferred tax resulting from basic transactions
involving property, plant and equipment (purchase, depreciation and derecognition through
a sale).
Example 34 shows us how to account for deferred tax when the property, plant and
equipment involves an impairment loss.
Example 35 shows us the deferred tax implications (i.e. a deferred tax exemption) when
accounting for property, plant and equipment that the tax authorities do not allow as a tax
deduction.
Example 33: Deferred tax caused by purchase, depreciation and sale of PPE
An entity buys plant on 2 January 20X0 for C100 000 in cash. Depreciation on plant is
calculated:
- using the straight-line basis
- to a nil residual value
- over 4 years.
The plant is sold on 30 June 20X2 for C80 000.
The tax authorities allow the cost of plant to be deducted from taxable profits at 20%
per annum.
The tax authorities apportion the tax deduction for part of a year.
The company’s year-end is 31 December.
Required: Show all related journal entries possible from the information provided.
Solution 33: Deferred tax caused by the purchase, depreciation and sale of PPE
Comment:
It is not necessary to know how much the asset is sold for when calculating the deferred tax
balance! This is because the selling price has no impact on either the asset’s carrying amount or its
tax base: both are reduced to zero, no matter how much it was sold for.
The selling price is only used in calculating profit before tax and taxable profits, which leads to the
calculation of the current tax charge, (chapter 5 explains the calculation of current tax).
The only effect that a sale of an asset has on the asset account is that its carrying amount is reduced
to zero. If you recall from earlier years of study, when disposing of an asset, you:
transfer the carrying amount of the asset to the disposal account (debit the disposal account);
record the proceeds on sale, if any (and credit the disposal account); and then
transfer the net amount in the disposal account to either profit on sale (if the proceeds exceeded
the carrying amount) or loss on disposal (if the carrying amount exceeded the proceeds).
Chapter 7 377

Debit Credit
Journals
2 January 20X0
Plant: cost (asset) 100 000
Bank 100 000
Purchase of plant for cash
31 December 20X0
Depreciation – plant (P/L) (100 000 – 0) / 4 years x 12 / 12 25 000
Plant: acc. depreciation (-A) 25 000
Depreciation of plant
Deferred tax (asset) W1 or (25 000 – 20 000) x 30% 1 500
Tax expense (P/L) 1 500
Deferred tax adjustment – due to plant – see W1
31 December 20X1
Plant: acc. depreciation (-A) or: (75 000 – 0) / 3 years x 12 / 12 25 000
Deferred tax (asset) W1 or (25 000 – 20 000) x 30% 1 500
Tax expense (P/L) 1 500
30 June 20X2
Plant: acc. depreciation (-A) or: (50 000 – 0) / 2 years x 6 / 12 12 500
Depreciation of plant to date of sale (30 June 20X2)
Plant: acc. depreciation (-A) 25 000 + 25 000 + 12 500 62 500
Plant: cost 100 000
Asset disposal 37 500
Carrying amount of plant transferred to asset disposal
Bank Given 80 000
Asset disposal 80 000
Proceeds on sale of plant
Asset disposal 80 000 – 37 500 42 500
Profit on sale of plant (P/L) 42 500
Profit on sale of plant
31 December 20X2
Tax expense (P/L) W1 or [(12 500 - 42 500) – (10 000 - 3 000
Deferred tax (asset) 50 000)] x 30% 3 000
W1: Deferred tax calculation - Carrying Tax base Temp Deferred Details
Plant amount difference taxation
(TB – CA)
Balance: 1/1/20X0 0 0 0 0
Purchase: 02/01/20X0 100 000 100 000
Depreciation 100 000 / 4 yrs; (25 000) (20 000) 1 500 Dr DT (SOFP)
100 000 x 20% Cr Tax (SOCI)
Balance: 31/12/20X0 75 000 80 000 5 000 1 500 Asset
Depreciation 75 000 / 3 yrs; (25 000) (20 000) 1 500 Dr DT (SOFP)
100 000 x 20% Cr Tax (SOCI)
Balance: 31/12/20X1 50 000 60 000 10 000 3 000 Asset
Depreciation 50 000 / 2 yrs x 6/12; (12 500) (10 000)
100 000 x 20% x 6/12 Cr DT (SOFP)
(3 000)
37 500 50 000 Dr Tax (SOCI)
CA/ TB: Sale of plant: 30/06/X2 (37 500) (50 000)
Balance: 31/12/20X2 0 0 0 0
378 Chapter 7
Example 34: Deferred tax involving the impairment of PPE

A company buys plant on 2 January 20X1 for C100 000 in cash.
Depreciation on plant is calculated using the straight-line basis to a nil residual value over
4 years.
The tax authorities allow the deduction of the plant’s cost from taxable profits at 20% pa.
The recoverable amount of the plant was estimated to be as follows:
- 31 December 20X1: C60 000
- 31 December 20X2: C45 000
- 31 December 20X3: C30 000
Required:
Calculate the deferred tax balance and adjustments using the balance sheet approach for all the affected
years ended 31 December and prepare all journal entries.
Solution 34: Deferred tax involving the impairment of PPE

Journal entries Debit Credit
2 January 20X1
Plant: cost (asset) 100 000
Bank 100 000
31 December 20X1
Depreciation – plant (P/L) (100 000- 0) / 4 years 25 000
Plant: accum depr & imp losses (-A) 25 000
Impairment loss – plant (P/L) CA: (100 000 – 25 000) – RA: 15 000
Plant: accum depr & imp losses (-A) 60 000 15 000
Impairment of plant
Deferred tax (asset) W1 or 6 000
Tax expense (P/L) [(25 000 + 15 000) - 20 000] x 30% 6 000
Deferred tax adjustment – due to plant– see W1
31 December 20X2
Plant: acc depr & imp losses (-A) 20 000
Plant: accum depr & imp losses (-A) CA: (60 000 – 20 000) – RA: 45 000 5 000
Impairment loss reversed (P/L) (not limited by HCA of 50 000) 5 000
Previous impairment of plant now reversed
Tax expense (P/L) W1 or 1 500
Deferred tax (asset) [(20 000 – 5 000) – (20 000)] x 30% 1 500
31 December 20X3
Plant: acc depr & imp losses (-A) CA: (45 000 – 22 500) – RA: 30 000 2 500
Impairment loss reversed (P/L) limited to HCA: 25 000 2 500
Previous impairment of plant now reversed
31 December 20X4
Deferred tax (asset) W1 or 1 500
Tax expense (P/L) (25 000 – 20 000) x 30% 1 500
Chapter 7 379

Tax expense (P/L) W1 or 6 000
Deferred tax (asset) (0 – 20 000) x 30% 6 000
Workings:
W1: Deferred tax on plant Carrying Tax base Temporary Deferred Details
amount difference taxation
(TB – CA) TD x 30%
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Dr DT (SOFP)
Depreciation / tax deduction (25 000) (20 000) 6 000
Cr Tax (SOCI)
Impairment loss (15 000) 0
Balance: 31/12/20X1 60 000 80 000 20 000 6 000 Asset
Depreciation (20 000) (20 000) Cr DT (SOFP)
(1 500)
Impairment loss reversed 5 000 0 Dr Tax (SOCI)
Balance: 31/12/20X2 45 000 60 000 15 000 4 500 Asset
Depreciation (22 500) (20 000)
0 No adjustment
Impairment loss reversed 2 500 0
Balance: 31/12/20X3 25 000 40 000 15 000 4 500 Asset
Dr DT (SOFP)
Depreciation (25 000) (20 000) 1 500
Cr Tax (SOCI)
Balance: 31/12/20X4 0 20 000 20 000 6 000 Asset
Cr DT (SOFP)
Depreciation (0) (20 000) (6 000)
Dr Tax (SOCI)
Balance: 31/12/20X5 0 0 0 0
Calculations:
Tax deduction:
Each year (20X1 – 20X5): 100 000 x 20% = 20 000
Depreciation:
20X1: (100 000 -0) / 4 yr = 25 000
20X2: (60 000 -0) / 3 yr = 20 000
20X3: (45 000-0) / 2 yr = 22 500
20X4: (25 000-0) / 1 yr = 25 000
20X5: nil (fully depreciated)
Impairment loss:
20X1: CA 75 000 – RA 60 000 = 15 000 impairment loss
20X2: CA: 40 000 – RA: 45 000 = 5 000 impairment loss reversed (not limited since HCA: 100 000 x 2 / 4 = 50 000)
20X3: CA: 22 500 – RA: 30 000 = 7 500 impairment loss reversed but limited to 2 500 because the CA of
22 500 must not exceed the HCA and the HCA is 25 000 (100 000 x 1/4)
6.3 Deferred tax exemptions (IAS 12.15)
You may recall from chapter 6 (see section 6.3 and section 7) that an interesting situation
arises when you own an asset that is depreciated but the cost of which the tax authorities do not
allow as a tax deduction. You need to start by remembering that the:
carrying amount represents the cost less accumulated depreciation; and the
tax base represents the future tax deductions.
If the tax authorities do not allow the deduction of the cost of the asset (i.e. do not allow a wear
and tear or similar allowance), the tax base will be zero from the date of purchase because the
future deductions are nil. Since the carrying amount will start off at zero, the purchase of such
an asset will cause a taxable temporary difference immediately on acquisition that will
gradually decrease to zero as the asset is depreciated.
380 Chapter 7
A problem arises, however, in that recognising the deferred tax liability on this temporary
difference means that we will need to know where to process the debit side of the adjustment:
It can’t be debited to tax expense, because the journal that causes the deferred tax is the
purchase journal and this does not affect accounting profit (debit asset and credit bank or
creditors) and clearly does not affect taxable profit (it is not allowed as a deduction);
You might therefore try to argue that it is balance sheet based deferred tax and should
therefore be debited to the account that caused the temporary difference, but this can’t be
done either since this would mean increasing the value of the asset simply because of a
deferred tax liability (which does not reflect a true cost).
Since this question couldn’t be solved in certain cases, the temporary difference is exempted in
terms of IAS 12.15 where it related to:
goodwill; or
the initial recognition of an asset or liability which
- is not a business combination and
- at the time of the transaction, affects neither accounting profit nor taxable profit.
Thus any expense relating to the initial cost (e.g. depreciation) is also exempt. See IAS 12.22
Example 35: Deferred tax involving exempt temporary differences

A company buys an asset on 1 January 20X1 with the following particulars:
Cost: C100 000
Depreciation: straight-line to a nil residual value over 4 years.
The tax authorities do not allow the cost of this asset to be deducted.
Required: Calculate the deferred tax balance and adjustments in 20X1 – 20X4.
Solution 35: Deferred tax involving exempt temporary differences

Comment: Since the movement in temporary differences is exempted, there are no deferred tax journals
and since the cumulative temporary differences are exempt, the deferred tax balances are nil.
W1: Deferred tax calculation
Asset: Carrying Tax Temporary Deferred Details
Depreciable amount base difference taxation
Non-deductible
Balance: 1/1/20X1 0 0 0 0
Purchase: 1 January 20X1 100 000 0 (100 000) 0 Exempt: IAS 12.15
Note 1
Depreciation (25 000) 0 25 000 0 Exempt: IAS 12.15
Balance: 31/12/20X1 75 000 0 (75 000) 0 Exempt: IAS 12.15
Balance: 31/12/20X4 0 0 0 0 Exempt: IAS 12.15
1) (100 000 – 0) / 4 years
7. Disclosure (IAS 16.73 -16.79)
7.1 Overview
The disclosure of property, plant and equipment involves various financial statements:
the statement of comprehensive income;
the statement of financial position;
the notes (for accounting policies, extra detail on statement of financial position and
statement of comprehensive income items including any changes in estimates); and
the statement of changes in equity.
Chapter 7 381
Remember that the topic of property, plant and equipment has been split over two chapters.
The disclosure requirements listed below are therefore not complete. Certain items that should
also be disclosed have been ignored for the purposes of this more basic chapter. The complete
disclosure requirements are provided in the next chapter.
7.2 Accounting policies and estimates
For each class of property, plant and equipment (e.g. land, Accounting policies note:
buildings, machinery, etc) the following policies should be depreciation methods
disclosed: rates (or useful lives)
depreciation methods used (e.g. straight-line method);
useful lives or depreciation rates used (e.g. 5 years or 20% per annum); and
the measurement model used (i.e. the cost model or the revaluation model: the revaluation
model is explained in the next chapter).
The nature and effect of a change in estimate must be disclosed in accordance with IAS 8 (the
standard governing ‘accounting policies, changes in accounting estimates and errors’).
7.3 Statement of comprehensive income disclosure
Property, plant and equipment can affect the statement of SOCI Disclosure
comprehensive income by either:
Decreasing profit: depreciation, impairments and losses Other income line item: profit on
on disposals; or sale of PPE may be included in ‘other
income’
Increasing profit: reversals of depreciation (changes in
Profit before tax note:
estimate), reversals of impairments and profits on
- depreciation,
disposal. - impairment losses/ reversals’
- profit or loss on disposal
Assuming that one were to present the statement of
comprehensive income using the function method, however, depreciation and losses on
disposal of asset would be included in one of the categories of expense (for example:
depreciation on an asset used to manufacture inventories would be included in inventories,
which would then affect profit via cost of sales, depreciation on office computers would be
included directly in administration costs).
Similarly, profit on disposal of items of property, plant and equipment would generally be
included under ‘other income’.
In other words, aspects of property, plant and equipment generally do not appear as separate
line items in the statement of comprehensive income but in the notes instead (a good idea is to
include these in a note that supports the ‘profit before tax’ line item in the statement of
comprehensive income).
The standard requires that the following be disclosed in the notes to the financial statements
and should be shown per class of property, plant and equipment:
depreciation (whether recognised in profit or loss or as part of the cost of another asset);
impairment losses (and the line item of the statement of comprehensive income in which it
is included);
impairment losses reversed (and the line item of the statement of comprehensive income in
which it is included);
profits or losses on the realisation, scrapping or other disposal of a non-current asset.
The nature and effect of a change in estimated depreciation must be disclosed in accordance
with IAS 8 Accounting policies, changes in accounting estimates and errors.
IAS 1 requires that depreciation expensed be separately disclosed. If part of the depreciation is
capitalised to another asset, the depreciation expense will be smaller than the amount disclosed
as depreciation in the asset note.
382 Chapter 7
7.4 Statement of financial position disclosure
IAS 1 requires that property, plant and equipment appears

as a line-item on the face of the statement of financial SOFP Disclosure
position.
One line item: Property, plant & equip
IAS 16 requires that the following main information be PPE note: Reconciliation between
disclosed in the ‘property, plant and equipment’ note, opening and closing balances; Break-
which is the note that supports the ‘property, plant and down of these balances into
equipment’ line item. - gross carrying amount and
- accumulated depreciation
For each class of property, plant and equipment (e.g. land,
buildings, machinery, etc) the following should be disclosed:
‘gross carrying amount’ and ‘accumulated depreciation and impairment losses’ at the
beginning and end of each period;
a reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable (this reconciliation effectively
shows the users the movements that occurred during the period in the cost account,
accumulated depreciation and the accumulated impairment loss accounts):
additions;
disposals;
depreciation;
impairment losses/ (impairment losses reversed);
acquisitions through business combinations;
assets transferred to ‘non-current assets held for sale’ in accordance with IFRS 5;
other movements (e.g. currency translation differences);
the existence and amounts of restrictions on title;
the existence and amounts of property, plant and equipment pledged as security for a
liability;
the costs capitalised in respect of property, plant and equipment being constructed;
the amount of any contractual commitments to acquire property, plant and equipment in
the future.
7.5 Further encouraged disclosure
The following disclosure is encouraged:

the carrying amount of property, plant and equipment that is temporarily idle;
the gross carrying amount of property, plant and equipment that is still in use but that has
been fully depreciated;
the carrying amount of property, plant and equipment that is no longer used and is to be
disposed of (but not yet classified as held for sale in accordance with IFRS 5); and
the fair value of the asset in the event that the cost model is adopted and the difference
between fair value and carrying amount is material.
7.6 Disclosure regarding fair value measurements
Although this chapter focuses on the cost model, you may need to disclose the asset’s fair
value in the note (see ‘further encouraged disclosure’ above), in which case there are further
minimum disclosures required by IFRS 13 Fair value measurement.
These disclosure requirements are summarised in chapter 25.
Chapter 7 383
7.7 Sample disclosure involving property, plant and equipment
ABC Limited
2. Accounting policies
2.1 Property, plant and equipment

Property, plant and equipment is shown at cost less accumulated depreciation and impairment
losses. Depreciation is not provided on land. Depreciation is provided on all other property, plant
and equipment over the expected economic useful life to their expected residual values.
Depreciation is provided on the following assets using the following rates and methods:
- Plant: straight line over 5 years.
3. Property, plant and equipment

20X2 20X1
Total net carrying amount: C C
Land c b
Plant f e
c+f b+e
Land: Plant:
20X2 20X1 20X2 20X1
C C C C
Net carrying amount: 1 January b a e D
Gross carrying amount
Accumulated depreciation & impairment losses
Add additions
Less disposals
Less depreciation
Less impairment losses
Add impairment losses reversed
Other
Net carrying amount: 31 December c b f E
Accumulated depreciation and impairment losses
24. Profit before tax

20X2 20X1
Profit before tax is stated after taking the following into account: C C
Depreciation on plant
Impairment losses on plant
Reversals of previous impairment losses on plant
Profit / (loss) on sale of plant
ABC Limited
20X2 20X1
ASSETS Note C C
Non-current assets
Property, plant and equipment 3 X X
384 Chapter 7
Example 36: Cost model disclosure – no impairment

Flowers Limited own a variety of assets, the carrying amounts of which were as follows at
1/1/20X0:
Land: C50 000 (cost: C50 000 on 1 January 19X7, being Lot XYZ comprising 4 000
square metres, situated in Durban North, South Africa)
Plant: C1 800 000 (cost C3 000 000)
Machines: C400 000 (cost: C500 000, consisting of 5 identical machines)
The only movements in property, plant and equipment during 20X0 was depreciation.
The only movements in property, plant and equipment during 20X1:

Plant purchased on 1 June 20X1 for C100 000
Machine sold on 30 June 20X1 for C70 000 on which date the following was relevant:
o cost: C100 000,
o accumulated depreciation: C35 000)
Depreciation is provided as follows:

Land is not depreciated.
Plant is depreciated at 20% per annum to a nil residual value.
Machines are depreciated at 10% per annum to a nil residual value.
The company pledged both plants as security for a loan. Details of the loan will be provided in note 16.
The company used one of its machines on the installation of the new plant.
This machine was used for one month (June 20X1) in this process.
The plant was installed and ready to use from 1 July 20X1.
Depreciation on machines is usually classified as ‘other costs’ in the statement of comprehensive
income.
Plant is used to manufacture inventories.
Required:
Disclose the plant and related information in the financial statements for the years ended
31 December 20X1 in accordance with the International Financial Reporting Standards.
Solution 36: Cost model disclosure – no impairment
ABC Limited
20X1 20X0
ASSETS Note C C
Non-current Assets
Property, plant and equipment 4 980 750 1 600 000
ABC Limited
Property, plant and equipment is measured at cost less accumulated depreciation.
Depreciation is provided on all property, plant and equipment over the expected economic useful life
to expected residual values using the following rates and methods:
Land: is not depreciated
Machines: 10% per annum, straight-line method
Plant: 20% per annum, straight-line method.
Chapter 7 385

ABC Limited
Notes to the financial statements (extracts) continued ....
4 Property, plant and equipment 20X1 20X0

Property, plant and equipment comprises: C C
Land 50 000 50 000
Machine 240 000 350 000
Plant 690 750 1 200 000
980 750 1 600 000
4.1 Land
Land was purchased for C50 000. Land is not depreciated.
4.2 Machine
Net carrying amount – opening balance 350 000 400 000
Gross carrying amount: 500 000 500 000
Accumulated depreciation 20X0: 500 000 – 400 000 (150 000) (100 000)
Depreciation 20X0: (500 000 – 0) x 10% (45 000) (50 000)
20X1: (500 000 – 100 000 – 0) x 10% +
(100 000 – 0) x 10% x 6/12
Disposals 20X1: 100 000 – 35 000 (65 000) 0
Net carrying amount – closing balance 240 000 350 000
Gross carrying amount 20X1: 500 000 – 100 000 disposal 400 000 500 000
Accumulated depreciation 20X1: 150 000 + 45 000 – 35 000 disp (160 000) (150 000)
4.3 Plant
Net carrying amount – opening balance 1 200 000 1 800 000
Gross carrying amount: 3 000 000 3 000 000
Accumulated depreciation 20X0: 3 000 000 – 1 800 000 (1 800 000) (1 200 000)
Additions 100 000 0
Capitalised depreciation 20X1: (500 000 – 0)/ 5 x 10% x 1/12 833
Depreciation 20X0: (3 000 000 – 0) x 20% (610 083) (600 000)
20X1: (3 000 000 – 0) x 20% + (100 000 +
833 – 0) x 20% x 6/12
Net carrying amount – closing balance 690 750 1 200 000
Gross carrying amount (3 000 000 + 100 000 + 833) 3 100 833 3 000 000
Accumulated depreciation (1 800 000 + 610 083) (2 410 083) (1 800 000)
Plant was pledged as security for a loan. Details of the loan liability are provided in note 16.
20X1 20X0
33. Profit before tax C C
Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
Depreciation on machine 44 167 50 000
- total expense See PPE note 45 000 50 000
- less capitalised to plant (500 000 – 0) / 5 x 10% / 12 (833) (0)
Depreciation on plant 0 0
- total expense See PPE note 610 083 600 000
- less capitalised to inventory (610 083) (600 000)
Profit on sale of machine (70 000 – 65 000) (5 000) 0
Example 37: Cost model disclosure with impairments

Depreciation: 25% straight-line per annum to a nil residual value
386 Chapter 7
The company measures its assets under the cost model.
The following recoverable amounts were calculated:

Recoverable amount at 31 December 20X1 is C60 000
Recoverable amount at 31 December 20X2 is C55 000
There are no other items of property, plant or equipment.
Required:
A. Disclose the plant and all related information in the financial statements for the years ended
31 December 20X1, 20X2, 20X3 and 20X4 in accordance with the International Financial
Reporting Standards, ignoring deferred tax;
B. Show the journals and all additional or revised related disclosure assuming that:
Deductible allowance (wear and tear) granted by the tax authorities 25% straight-line per year
Income tax rate 30%
The company intends to keep the plant. There are no other temporary differences other than those
Solution 37A: Cost model disclosure with impairments

deferred tax ignored
ABC Ltd
20X4 20X3 20X2 20X1
Note C C C C
ASSETS
Non-current Assets
Property, plant and equipment 4 0 25 000 50 000 60 000
ABC Ltd
Plant is measured using the cost model: cost less accumulated depreciation & impairment losses.
Depreciation is provided on all property, plant and equipment over the expected economic useful
life to expected residual values using the following rates and methods:
o Plant: 25% per annum, straight-line method.
4. Property, plant and equipment 20X4 20X3 20X2 20X1

C C C C
Plant
Net carrying amount: 1 January 25 000 50 000 60 000 0
Gross carrying amount: 100 000 100 000 100 000 0
Accum depreciation and imp losses: (75 000) (50 000) (40 000) 0
Additions 0 0 0 100 000
Depreciation (25 000) (25 000) (20 000) (25 000)
Impairment loss 0 0 0 (15 000)
Impairment loss reversed 0 0 10 000 0
Net carrying amount: 31 December 0 25 000 50 000 60 000
Gross carrying amount: 100 000 100 000 100 000 100 000
Accum depreciation and imp losses: (100 000) (75 000) (50 000) (40 000)
Chapter 7 387
Solution 37A: Continued…
ABC Ltd
25. Profit before tax 20X4 20X3 20X2 20X1

C C C C
Depreciation on plant 25 000 25 000 20 000 25 000
Impairment loss 0 0 0 15 000
Impairment loss reversed 0 0 (10 000) 0
Solution 37B: Cost model disclosure with impairments

With related deferred tax effects
Journals:
20X1: Dr/ (Cr)
Plant: cost 100 000
Bank/ Liability (100 000)
Purchase of asset: (1/1/20X1)
Depreciation (E) (100 000 / 4 years remaining) 25 000

Plant: accumulated depreciation and impairment losses (-A) (25 000)
Impairment loss (E) CA: (100 000 – 25 000) – RA: 60 000 15 000
Impairment loss
Deferred tax (A) W1 or [(25 000 + 15 000) – (25 000)] x 30% 4 500
Income tax expense (E) (4 500)
Deferred tax caused by plant/ impairment loss
20X2
Plant: accumulated depreciation and impairment losses (-A) 10 000
Impairment loss reversed (I) CA: (60 000 – 20 000) – RA: 55 000, ltd to HCA:50 000 (10 000)
Impairment loss reversed
Income tax expense (E) W1 or [(20 000 - 10 000) – (25 000)] x 30% 4 500
Deferred tax (A) (4 500)
Deferred tax caused by plant/ impairment loss reversed & revised depreciation
20X3:
Depreciation (E) (50 000 – 0) / 2 years remaining x 1 year 25 000
20X4:
Depreciation (E) (25 000 / 1 year remaining) 25 000
388 Chapter 7
Disclosure:
ABC Ltd
20X4 20X3 20X2 20X1
ASSETS Note C C C C
Non-current Assets
Property, plant and equipment 4 0 25 000 50 000 60 000
Deferred taxation 5 0 0 0 4 500
ABC Limited
Note 20X4 20X3 20X2 20X1
5. Deferred taxation asset/ (liability) C C C C
The deferred taxation balance comprises:
Capital allowances (the balances in W1) 0 0 0 4 500
0 0 0 4 500
26. Income tax expense/ (income)
- current X X X X
- deferred (the movement in W1) 0 0 4 500 (4 500)
All other notes would remain the same.
Workings:
W1: Deferred tax: Carrying Tax Temporary Deferred Details

plant amount base difference taxation
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Depreciation (25 000) (25 000) Movement:
(100 000/ 4 years) 4 500 Dr DT (SOFP)
(100 000 x 25% Cr TE (P/L)
Impairment loss (15 000) 0
Balance: 31/12/20X1 60 000 75 000 15 000 4 500 Asset balance
Depreciation (20 000) (25 000)
Movement:
(60 000/ 3 years)
(4 500) Cr DT (SOFP)
(100 000 x 25%
Dr TE (P/L)
Impairment loss reversed 10 000 0
Balance: 31/12/20X2 50 000 50 000 0 0
Depreciation (25 000) (25 000) 0 Movement
(50 000/ 2 years)
(100 000 x 25%
Balance: 31/12/20X3 25 000 25 000 0 0
Depreciation (25 000) (25 000) 0 Movement
(25 000/ 1 year)
(100 000 x 25%
Balance: 31/12/20X4 0 0 0 0
Chapter 7 389
8. Summary
PROPERTY, PLANT AND EQUIPMENT
Recognition Measurement Disclosure
RECOGNITION
Definition must be met Recognition criteria must be met

tangible items that are probable that future economic benefits
held for use in the production or supply of will flow to the entity AND
goods or services, for rental to others, or cost may be reliably measured
for administrative purposes; and
are expected to be used during more than
one period
Initial versus subsequent costs

Subsequent costs are only recognised as an asset if the recognition
criteria are met (if not met, cost must be expensed):
Day-to-day servicing would be expensed (including replacements
of small parts)
Other replacements and major inspections etc could be
recognised as an asset if the recognition criteria are met. If so,
the replaced part must be derecognised.
MEASUREMENT: PPE
Initial Measurement Subsequent Measurement

PPE is initially measured at cost. Subsequent measurement involves a choice
Cost comprises: between the cost model and the
its purchase price, including import duties revaluation model (this chapter covers the
and non-refundable purchase taxes, after cost model only – the revaluation model is
deducting trade discounts and rebates. explained in chp 8). Both models involve:
any costs directly attributable to bringing Depreciation
the asset to the location and condition Impairments and impairments reversed
necessary for it to be capable of operating (impairments are governed by IAS 36
in the manner intended by management. and are explained further in chp 11)
the initial estimate of the costs of
dismantling and removing the item and
restoring the site on which it is located,
the obligation for which an entity incurs
either when the item is acquired or as a
consequence of having used the item during
a particular period for purposes other than
to produce inventories during that period.
If it is an asset exchange, then cost is:
FV of A given up, unless
FV of A received is more clearly evident (or
if it’s the only FV available)
If no FV available, use CA of A given up
390 Chapter 7
Subsequent Measurement: Depreciation
In general Changes in accounting estimate
The depreciable amount must be depreciated occur if any of the following are changed:
on a systematic basis over the estimated
useful life of the asset. the estimated useful life
the method of depreciation
The method used should reflect
the pattern in which economic benefits are the residual value
expected to be generated from the asset (it the estimated costs of dismantling,
should never be based on related revenue removing or restoring items of PPE.
generated by the asset)
See IAS 8 for more details
The depreciation charge is
expensed unless it is capitalised to another
asset
Subsequent Measurement: Impairments
Impairment loss Impairment loss reversed

If carrying amount (CA) exceeds recoverable If at a subsequent date the RA increases
amount (RA), write the CA down to the RA above CA, increase the CA, but only to the
(before doing so, check that processing extra extent that the CA does not exceed the
depreciation would not be a more appropriate historical carrying amount (i.e. the depreciated
way of reducing the CA, in which case the historic cost)
extra depr would be a processed as a change in
estimate)
DISCLOSURE: PPE
(main points only)
SOFP SOCI NOTES

One line item: One line item: profit before
Property, plant & equip tax includes all, although
profit/ loss on sale of PPE
may also be included in
‘other income’
Accounting policies note: Profit before tax note: Property, plant and equipment
depreciation methods depreciation note:
rates (or useful lives) impairment losses/ Reconciliation between
reversals opening and closing
profit or loss on disposal balances
Break-down of these
balances into
- gross carrying
amount and
- accumulated
depreciation
Chapter 7 391
MEASUREMENT: DEFERRED TAX BALANCE
Deferred tax balance
Temporary difference x tax rate (unless exempted)

DT = nil if TD is exempted: Exemption may occur if a temporary
difference arises on initial acquisition (see chp 6 for the full
story on deferred tax)
Temporary difference
Carrying amount versus Tax base
Carrying amount Tax base
Represents: Represents:
Future economic benefits, being: Future tax deductions, being:
Cost Cost
Less accumulated depreciation and Less accumulated tax deductions
Less accumulated impairment losses
392 Chapter 7
Gripping GAAP Property, plant and equipment: the revaluation model
Chapter 8
Property, Plant and Equipment: The Revaluation Model
Reference: IAS 16, IAS 12 and IFRS 13 (including any amendments to 10 December 2014)
Contents: Page
1. Introduction 395
1.1 Overview of the two models 395
1.2 Choosing between the two models 395
2. Recognition and measurement under the revaluation model 396
2.1 Overview 396
2.2 Recognition 396
2.3 Initial measurement 396
2.4 Subsequent measurement 396
2.4.1 Depreciation 396
2.4.2 Impairment testing 396
2.4.3 The choice of models 396
3. Subsequent measurement: revaluation model 397
3.1 Overview 397
3.2 How to account for increases or decreases in fair value 397
Example 1: Carrying amount increases: no previous revaluation recognised in P/L 397
Example 2: Carrying amount decreases: no balance in revaluation surplus 398
Example 3: Carrying amount decreases: there is a balance in revaluation surplus 398
3.3 The creation of a revaluation surplus account 398
3.4 Transfer of the revaluation surplus to retained earnings 399
Example 4: Transfer of revaluation surplus to retained earnings 400
3.5 Presentation of the revaluation surplus 401
3.6 Diagrammatic explanation of how the revaluation model works 401
3.7 Upward and downward revaluation involving a non-depreciable asset 403
Example 5: Revaluation model- a summary example (the asset is not depreciated) 403
3.8 Upward and downward revaluation involving a depreciable asset 404
Example 6:Revaluation model- a summary example (the asset is depreciated) 404
3.9 The two method of accounting for a revaluation 407
3.9.1 Overview 407
3.9.2 Proportionate restatement method (gross replacement value method) 407
Example 7: Revaluation model – using the gross replacement value
method 408
3.9.3 Elimination restatement method (net replacement value method) 409
Example 8: Revaluation model – using the net replacement value method 409
Example 9: Revaluation model - increase in value, creating a revaluation surplus 410
Example 10: Revaluation model - decrease in value, reversing the revaluation
surplus and creating a revaluation expense 412
Example 11: Revaluation model - increase in value, reversing a previous
revaluation expense and creating a revaluation surplus 413
Chapter 8 393
Contents continued …:
3.10 The revaluation model and impairments 415
Example 12: A low fair value does not necessarily mean an impairment loss 415
4. Deferred tax consequences 417
4.1 Overview 417
4.2 Deferred tax effects of the revaluation surplus 417
4.3 Deferred tax effects of the revaluation surplus and management intentions 418
4.3.1 Deferred tax and a revaluation that does not exceed cost 418
Example 13: Revaluation surplus and deferred tax (revaluation up but
below cost) 418
4.3.2 Deferred tax and a revaluation that exceeds cost 419
4.3.2.1 Deferred tax: Revaluation above cost: intention to keep the asset 420
Example 14: Deferred tax: revaluation above cost: intend to
keep – short example 420
Example 15: Deferred tax: revaluation above cost: intend to
keep – full example 421
4.3.2.2 Deferred tax: Revaluation above cost: intention to sell the asset 424
Example 16: Deferred tax: Revaluation surplus above cost:
intention to sell 424
Example 17: Revaluation above cost: deferred tax: Intend to sell
– short example 425
Example 18: Revaluation above cost: deferred tax: Intention to
sell 426
Example 19: Revaluation above cost: deferred tax: Change in
intention 429
4.3.3 Deferred tax on revalued assets: depreciable but non-deductible assets 429
Example 20: Revaluation above cost: deferred tax: intention to
sell 430
Example 21: Revaluation above cost: deferred tax: intention to
keep 431
4.3.4 Deferred tax on revalued assets: non-depreciable and non-deductible 432
Example 22: Revaluation of land above cost: deferred tax: intention to
keep 432
5. Disclosure 434
5.1 Overview 434
5.2 Accounting policies and estimates 434
5.3 Statement of comprehensive income and related note disclosure 434
5.4 Statement of financial position and related note disclosure 435
5.5 Statement of changes in equity disclosure 435
5.6 Further encouraged disclosure 436
5.7 Sample disclosure involving property, plant and equipment 436
Example 23: Revaluation model disclosure 438
6. Summary 445
394 Chapter 8
1. Introduction
1.1 Overview of the two models
This chapter is a continuation of the previous chapter. Both chapters explain how to apply
IAS 16 Property, plant and equipment but IAS 16 allows entities to choose between using the
cost model and the revaluation model when subsequently measuring its property, plant and
equipment. The previous chapter applied the cost model whereas this chapter explains how to
apply the revaluation model.
The cost model refers to the measurement of an asset’s Subsequent measurement

carrying amount at: of PPE allows choice
cost (often referred to as historic cost); between:
less subsequent accumulated depreciation; Cost model:
less subsequent accumulated impairment losses. - Cost
(IAS 16.30)
Less AD
The revaluation model refers to the measurement of an Less AIL
asset’s carrying amount at: Revaluation model:
fair value (often referred to as the gross carrying - FV on date of revaluation
amount); Less subsequent AD
less subsequent accumulated depreciation; Less subsequent AIL
less subsequent accumulated impairment losses. The model chosen must be used for all
(IAS 16.31)
assets within a class of PPE (e.g. plant)
1.2 Choosing between the two models
You can choose either model (cost or revaluation model) but must then apply that model to an
entire class of assets. IAS 16:29 This means, for example, that an entity may not use the cost
model for a machine that makes bread and the revaluation model for a machine that slices
bread. Machines are considered a separate class of property, plant and equipment and
therefore both machines must be measured using the same model, say the cost model. Using
the cost model for machines would not, however, prevent the entity from measuring its
vehicles using the revaluation model. This is because vehicles are a different class of asset to
machines.
The cost model is the most straight-forward model and is based on the original cost. The
revaluation model requires revaluation of the asset to its fair value.
The cost model is also easier to apply in practice (and Fair value is defined as
research suggests that it is currently the most commonly the:
used model). This does not suggest that the revaluation
model is an unlikely test or exam question though since Price that would be received to sell
the current trend in accounting is to use fair values an asset (or pd to transfer a liability)
(instead of historic costs) for measurement purposes. In an orderly transaction
Fortunately for you, however, the difficulty in applying Between market participants
the revaluation model is not due to any real complexity At the measurement date. IAS 16.6:
from an academic point of view, but is a difficulty from a
practical point of view (i.e. accounting and computer systems may need to be updated to
enable the revaluation model to be used).
The choice of the model applies only to one aspect of subsequent measurement. The
principles that apply to recognition, initial measurement and other aspects of subsequent
measurement (such as depreciation and impairment testing) are identical whether you are
applying the cost model or revaluation model. For your convenience, however, a very quick
summary of these principles are included in section 3.
Chapter 8 395
2. Recognition and Measurement Under The Revaluation Model
2.1 Overview
The recognition and initial measurement principles that apply when using the cost model
(explained in the previous chapter) are exactly the same as those that apply when using the
revaluation model. The use of the revaluation model is a choice that may be applied in the
subsequent measurement of the asset. The following is a very brief overview of the
recognition and measurement principles applicable to property, plant and equipment.
2.2 Recognition
An asset would be recognised as an item of property, plant and equipment only if it met the:
definition of property, plant and equipment; and
the recognition criteria (reliable measurement and probable future economic benefits).
2.3 Initial measurement
Items of property, plant and equipment must always
initially be measured at cost. If the asset is acquired via an The principles of the
asset exchange or by way of a government grant, the cost revaluation model and the
would generally be its fair value. Cost would otherwise be cost model are the same in
the purchase price, directly attributable costs and the terms of:
initial estimate of certain future costs. If the cost is to be Recognition criteria
paid for within normal credit terms, the amount paid must
Initial measurement
not be present valued. However, if the payment is beyond
normal credit terms, the cost would be the present value of Subsequent measurement:
- Depreciation
the payment. The difference between this present value
- Impairments
and the future payment to be made would be recognised as
interest unless it is capitalised in accordance with IAS 23 Borrowing costs.
2.4 Subsequent measurement
2.4.1 Depreciation
Items of property, plant and equipment must be depreciated to their residual values on a
systematic basis over their estimated useful lives. The only exception is land, which generally
has an unlimited useful life.
Each significant part of an item (i.e. where the cost of the part is significant in relation to the
cost of that item) must be depreciated separately.
Depreciation begins when the asset is first available for use and ends when the asset is
derecognised or is classified as held for sale (in terms of IFRS 5), whichever date comes first.
2.4.2 Impairment testing (IAS 36 and IAS 16.63-.66)
At the end of every reporting period, assets must be assessed for possible impairments. If
there is an indication that an asset may be impaired, the asset’s recoverable amount must be
calculated. If the carrying amount exceeds the recoverable amount, the carrying amount must
be reduced. The reduction in the carrying amount is generally expensed, and termed an
impairment loss expense. However, if the revaluation model is used, part of the reduction may
be debited to the revaluation surplus instead (see section 4).
If compensation was received as a result of this impairment (e.g. insurance proceeds), this
compensation is considered to be a separate economic event and must be recognised as
income in profit or loss (it must not be set-off against the impairment loss expense).
2.4.3 The choice of models (IAS 16.29-.42)

The entity may choose to measure its assets using either the cost model or the revaluation
model. However, the revaluation model may only be used if the fair value of an asset is
reliably measurable. The cost model was explained in the previous chapter. The rest of this
chapter is dedicated to explaining the revaluation model.
396 Chapter 8
3. Subsequent Measurement: Revaluation Model (IAS16.31 – 16.42)
3.1 Overview
The revaluation model involves the subsequent measurement of the asset’s carrying amount to
its fair value. It is important to understand that, even when using the revaluation model, the
initial measurement is always at cost. IAS 16.15
The revaluation model may only be used if the fair value can be measured reliably. IAS 16.31
Revaluations to fair value do not have to occur every
The CA under the
year but may be done periodically. However, they must
revaluation model is
be performed regularly enough so that the carrying measured as:
amount of the asset at year-end does not differ materially
FV on date of revaluation
from its fair value at that date.IAS 16.31
Less subsequent AD
If the entity wishes to use the revaluation model for a Less subsequent AIL. IAS 16.31
particular asset, it must remember that it will have to
apply the revaluation model to all assets within that class of assets. IAS 16.36
When using the revaluation model, the carrying amount of an asset may be decreased below
its depreciated cost and also above its depreciated cost (remember that the cost model does
not allow the carrying amount to be increased above depreciated cost).
3.2 How to account for increases or decreases in fair value
Where an asset is revalued to fair value, the carrying amount either increases or decreases.
If the asset’s carrying amount increases as a result of a

revaluation, the increase is: If FV > CA: See IAS 16.39
recognised in profit or loss as a revaluation income if

Debit: asset
it reverses a previous revaluation decrease recognised
in profit or loss: Credit:
i.e. debit carrying amount and credit revaluation - P/L: if it reverses a previous
devaluation expense in P/L
income
- OCI: with any excess
recognised in other comprehensive income as a
revaluation surplus if it does not reverse a previous revaluation decrease recognised in
profit or loss:
i.e. debit carrying amount and credit revaluation surplus. IAS 16.39
In other words, if the asset’s carrying amount increases, the increase would first be
recognised in profit or loss (as a credit to income) to the extent that it reverses a previous
decrease that was recognised in profit or loss. Any increase that does not reverse a previous
decrease recognised in profit or loss is recognised in other comprehensive income (as a credit
to revaluation surplus).
Example 1: Carrying amount increases: no prior revaluation recognised in P/L
An item of plant with a carrying amount of C100 000 is revalued to a fair value of
C120 000. This asset had not previously been revalued.
Required: Show the journal entry to account for the revaluation. Ignore tax.
Solution 1: Carrying amount increases: no prior revaluation recognised in P/L

Debit Credit
Plant: carrying amount FV: 120 000 – CA: 100 000 20 000
Revaluation surplus (OCI) 20 000
Revaluation of plant to fair value: carrying amount increased
Chapter 8 397
If the asset’s carrying amount decreases as a result of a

revaluation, the decrease is: If FV < CA: See IAS 16.40
first recognised in other comprehensive income as a
debit to any revaluation surplus that may exist on Credit: Asset
this asset, thus: Debit:
cr. carrying amount and dr. revaluation surplus; - OCI: if there is a RS balance
from a prior revaluation
then, after any revaluation surplus balance that may - P/L: with any excess.
have existed is reduced to nil, the decrease is
recognised in profit or loss as a revaluation expense; thus:
credit carrying amount and debit revaluation expense. IAS 16.40
In other words, if the asset’s carrying amount is decreased, this decrease must first be debited
to the revaluation surplus account (if any) before being expensed as a revaluation expense.
Example 2: Carrying amount decreases:
no balance in revaluation surplus
An item of plant with a carrying amount of C150 000 is revalued to a fair value of
C130 000. This asset had not previously been revalued.
Solution 2: Carrying amount decreases: no balance in revaluation surplus
Debit Credit
Revaluation expense (E) FV: 130 000 – CA: 150 000 20 000
Plant: carrying amount 20 000
Revaluation of plant to fair value: carrying amount decreased
Example 3: Carrying amount decreases:

there is a balance in the revaluation surplus
An item of plant with a carrying amount of C150 000 is revalued to a fair value of C130 000
on 1 January 20X2. This asset had previously been revalued upwards. The balance on the
revaluation surplus from the previous revaluation was C5 000 on 1 January 20X2.
Solution 3: Carrying amount decreases: there is a balance in the revaluation surplus

Revaluation surplus (OCI) The balance in the RS a/c: given 5 000
Revaluation expense (E) Devaluation: 20 000 – debit to RS: 5 000 15 000
Plant: carrying amount FV: 130 000 – CA: 150 000 20 000
Revaluation of plant to fair value: carrying amount decreased
A revaluation that decreases the carrying amount of the asset does not necessarily mean that
the asset is impaired.
This is because when revaluing, we are restating the carrying amount to a fair value
whereas when an asset is impaired, we are restating it to a recoverable amount.
It is possible for the recoverable amount (higher of fair value less costs of disposal and
value in use) to be greater than the fair value and thus for the asset to be restated
downwards to a lower fair value but yet not be impaired.
Thus, we will use the term ‘revaluation expense’ for decreases in the carrying amount
that are expensed in profit or loss.
3.3 The creation of a revaluation surplus account
If the asset’s carrying amount is increased above its depreciated cost (i.e. its historical
carrying amount), the increase is reflected in a revaluation surplus account (i.e. debit carrying
amount and credit revaluation surplus). This revaluation surplus is recognised as other
comprehensive income and is accumulated in equity. IAS 16.39
398 Chapter 8
The revaluation surplus is recognised as part of other comprehensive income and not as
income. One of the reasons for this can be found in the Conceptual Framework’s definitions:
income requires an increase in economic benefits during the accounting period, whereas
an asset refers to future economic benefits and therefore an increase in the value of an
asset reflects an increase in these future economic benefits.
Therefore, since the debit to an asset’s carrying amount (increase in value) relates to future
benefits, the credit must not be recognised as income, because income refers to benefits
already earned during the current accounting period.
The revaluation surplus is equity because when an asset’s carrying amount increases as a
result of a revaluation, there is no equal increase in liabilities, and thus the increase results in
an increase in equity (equity = assets – liabilities).
3.4 Transfer of the revaluation surplus to retained earnings IAS 16.41
If an asset’s carrying amount is increased above its depreciated cost (i.e. historical carrying
amount), the contra entry is a credit to revaluation surplus. It does not make sense for this
revaluation surplus to stay in the accounts indefinitely and therefore it must be removed from
the accounts by the time that the revalued asset no longer exists.
The revaluation surplus is removed by transferring it to retained earnings. This transfer makes
sense if you consider the effect of the revaluation on depreciation and profits.
If an asset’s carrying amount is increased, its depreciation The RS balance must be

will also increase, thus reducing profits. Thus the transfer transferred directly to
of the revaluation surplus to retained earnings reverses the RE. See IAS 16.41
effect that the artificially increased depreciation has had This can be done:
on profits over the life of the asset. When the asset’s
depreciable amount is zero (i.e. when the asset has been As the asset is used;
fully depreciated), the revaluation surplus account must When the asset is retired; or
also be zero. When the asset is disposed of.
The transfer must be made directly to the retained earnings account, which means that the
transfer is made from one equity account to another equity account: it must be transferred to
retained earnings without being recognised in profit or loss.
Debit Credit
Revaluation surplus xxx
Retained earnings xxx
Transfer of the revaluation surplus to retained earnings
The transfer may be performed in one of three ways:

as the asset is used up (i.e. it will be transferred gradually over the useful life of the asset,
often referred to as an annual transfer to retained earnings); or
when the asset is retired (i.e. it will be transferred as one lump sum); or
when the asset is disposed of (i.e. it will be transferred as one lump sum). IAS 16.41
If the entity chooses to transfer the revaluation surplus to retained earnings over the life of the
asset (i.e. gradually instead of as a lump sum), it means that the revaluation surplus will
decrease at the same rate as the asset’s carrying amount. Thus, if the fair value subsequently
decreases below the carrying amount, the decrease in the carrying amount:
down to the historical carrying amount (the depreciated cost) will be debited to
revaluation surplus (credit carrying amount and debit revaluation surplus); and
below the historical carrying amount (the depreciated cost) will be expensed as a
revaluation expense (credit carrying amount and debit revaluation expense).
Chapter 8 399
If the revaluation surplus is only transferred to retained earnings at the end of the asset’s
useful life or when the asset is disposed of, then the revaluation surplus balance will still
reflect the full original amount of the revaluation surplus on date of the previous upward-
revaluation. This will mean that a decrease below depreciated cost (historical carrying
amount) would not all be debited to profit or loss – some of this would first need to be debited
to the revaluation surplus, to be sure that the revaluation surplus is first reduced to zero.
For the purposes of this text, we will assume that the revaluation surplus is transferred to
retained earnings over the life of the underlying asset unless otherwise indicated.
The following example shows you how to transfer the revaluation surplus using each of the
above three methods.
Example 4: Transfer of revaluation surplus to retained earnings
An asset with a cost of C100 (1/1/20X1) is revalued to fair value of C120 (1/1/20X2).
It is depreciated straight-line to a nil residual value over a 4-year useful life.
It is retired from use at the end of its useful life (31/12/20X4) and is sold on
18/9/20X5.
Required: Ignoring the tax effect, show the journals reducing the revaluation surplus to zero assuming:
A the transfer is done over the life of the asset;
B the transfer is done on retirement of the asset; and
C the transfer is done when the asset is disposed of.
Solution 4: Transfer of revaluation surplus to retained earnings

Workings C
Cost: 1/1/X1 Given 100
Acc. depreciation: 31/12/X1 (100 – 0)/ 4yrs x 1yr (25)
Carrying amount: 31/12/X1 31/12/20X1 75
Revaluation surplus Balancing: FV 120 – CA 75 45
Revalued carrying amount Fair value was given 120
Solution 4A: Revaluation surplus transferred over the life of the asset
Journal: posted at 31 December 20X2 Debit Credit
Revaluation surplus (OCI) 45 / 3 remaining years 15
Retained earnings 15
Transfer of revaluation surplus to retained earnings
Journal: posted at 31 December 20X3
Revaluation surplus (OCI) (45 – 15) / 2 remaining years 15
Journal: posted at 31 December 20X4
Revaluation surplus (OCI) (45 – 15 - 15) / 1 remaining year 15
Solution 4B: Revaluation surplus transferred on retirement of the asset

Journal: posted at 31/12/20X4 Debit Credit
Revaluation surplus (OCI) 45
Transfer of reval surplus to retained earnings at end of asset’s useful life
Solution 4C: Revaluation surplus transferred on disposal of the asset

Journal: posted 18/9/20X5 Debit Credit
Revaluation surplus (OCI) 45
Transfer of revaluation surplus to retained earnings on disposal of asset
400 Chapter 8
3.5 Presentation of the revaluation surplus (IAS 16.39, .41 & IAS 1.82A)
IAS 16 states that the revaluation surplus is recognised in other comprehensive income and
accumulated in equity. This means that:
because a revaluation surplus is ‘other comprehensive income’, an increase or decrease in
the revaluation surplus would be presented in the statement of comprehensive income; and
because other comprehensive income is part of ‘equity’, the revaluation surplus is also
presented in the statement of changes in equity.
IAS 1 requires that other comprehensive income be Presentation of the RS:
presented in the statement of comprehensive income and
that the movement in each component of other SOCI:
comprehensive income be separated into components: - in the OCI section;
that may be reclassified to profit or loss (i.e. when - under the heading:
certain conditions are met); and ‘items that may never be
that may never be reclassified to profit or loss. reclassified to P/L’
SOCIE: in its own column.
Reclassification adjustments are ‘amounts reclassified to
profit or loss in the current period that were recognised in other comprehensive income in the
current or previous periods’. IAS 1.7
Since IAS 16 states that the revaluation surplus may only be transferred directly to retained
earnings, which means that the transfer to retained earnings may not be processed through
profit or loss first, any movement in the revaluation surplus is presented in the other
comprehensive income section of the statement of comprehensive income under the heading:
items that may never be reclassified to profit or loss.
3.6 Diagrammatic explanation of how the revaluation model works
Now that you have an overview of all main aspects of the revaluation model (with the
exception of deferred tax consequences and disclosure), you may find it useful to use the
following diagrams and graphs to visualise the overall ‘big picture’.
These diagrams and graphs assume that the entity has chosen to transfer the revaluation
surplus to retained earnings over the life of the asset, in which case the revaluation surplus
would reduce at the same rate as the asset’s carrying amount.
The diagrams use a variety of acronyms:
HCA: this stands for historical carrying amount. Another name for this would be the
depreciated historic cost. It represents what the carrying amount would be if it was still
based on the original cost less accumulated depreciation.
ACA: this stands for actual carrying amount. This represents what the carrying amount
actually is at a point in time. If had been revalued, then the actual carrying amount would
reflect the fair value at the date of the remeasurement less the subsequent accumulated
depreciation (& impairment losses if applicable) since this remeasurement date. We will
ignore impairment losses for the purposes of understanding the revaluation model.
Diagram 1: Revaluation model summarised (assuming any revaluation surplus is transferred to retained earnings
over the life of the asset)
FV greater than HCA
Recognised in OCI
HCA
Recognised in P/L
FV less than HCA
HCA: historical carrying amount OCI: Other comprehensive income P/L: profit or loss
Please remember: This diagram assumes that the entity has chosen to transfer the revaluation surplus to retained
earnings over the life of the asset.
Chapter 8 401
Diagram 2: Example adjustments using the revaluation model – 3 scenarios

This diagram shows a series of possible situations.
Scenario 1 Scenario 2 Scenario 3

FV ACA
Revaluation
Revaluation surplus
surplus (OCI)
(OCI)
(created/
(reversed/ decreased)
HCA/ increased)
HCA HCA
ACA
Expense (P/L) Income (P/L)
Expense (P/L)
FV ACA FV
HCA: historical carrying amount OCI: other comprehensive income

ACA: actual carrying amount (which may differ from the HCA) P/L: profit or loss
FV: fair value
Remember: This diagram assumes the revaluation surplus is transferred to retained earnings over the asset’s useful life.
Scenario 1: the FV is less than the ACA (which was still the same as the HCA)
Scenario 2: the FV is greater than the ACA (but ACA was less than the HCA due to a prior decrease in value)
Scenario 3: the FV is less than the ACA and also less than the HCA (the ACA was greater than the HCA due to
a prior increase in value)
Graph approach: Using a graph for the revaluation model

You may find it easier to draw a graph of the situation, plotting the depreciated cost line (HCA):

Cost
0 Useful Life
Notice how the line is a diagonal line which represents the gradual reduction in the depreciated cost (historical
carrying amount) as the asset is depreciated over its useful life.
Remember: This diagram assumes the revaluation surplus is transferred to retained earnings over the asset’s useful life.
For a revaluation to fair value, you would then plot your asset’s actual carrying amount (ACA) and fair value (FV)
onto this graph. Then look at your graph carefully:
If you are increasing the asset’s actual carrying amount (which may have been plotted below, on or above the
HCA line) to its fair value, the increase in value would be accounted for as follows:
Any increase up to HCA: the previous devaluation expense that was recognised in profit or loss is now
reversed by recognising this adjustment in profit or loss as a revaluation income; after which
Any increase above HCA: is recognised in other comprehensive income as a revaluation surplus.
If you are decreasing the asset’s actual carrying amount (which may have been plotted below, on or above the
HCA line) to its fair value, the decrease in value would be accounted for as follows:
any decrease down to the HCA: the previous increase that was recognised in other comprehensive income as
a credit to revaluation surplus is now reversed (or perhaps only partially reversed), where this reversal is
also recognised in other comprehensive income but as a debit to the revaluation surplus; after which
any decrease below HCA: is recognised in profit or loss as a debit to revaluation expense (in other words:
any balance in the revaluation surplus account (from a previous increase in value) is first reduced to zero,
after which any further decrease is then recognised as an expense in profit or loss).
402 Chapter 8
The prior examples, graphs and diagrams show how to account for a revaluation by simply
debiting or crediting the asset’s carrying amount. However, we need to know exactly how
much to debit and credit to the separate accounts that make up this carrying amount (i.e. the
cost and accumulated depreciation accounts). This is best explained by first doing examples
involving non-depreciable assets and then doing examples involving depreciable assets.
3.7 Upward and downward revaluation involving a non-depreciable asset
To start with, we will look at an example that involves land, since land is an asset that is
generally not depreciated. This will allow us to see the essence of the revaluation model.
From there we will progress to an example that involves a depreciable asset.
Example 5: Revaluation model – a summary example (the asset is not
depreciated)
Cost of land at 1/1/20X1: 100 000
Depreciation: This piece of land is not depreciated
Fair value
1/1/20X2 120 000
1/1/20X3 90 000
1/1/20X4 70 000
1/1/20X5 110 000
The company’s policy is to leave any balance on the revaluation surplus intact until such time as the
asset is disposed of. The year end is 31 December.
Required: Show the ledger accounts and statement of financial position for 20X1 to 20X5.
Solution 5: Revaluation model - a summary example (asset is not depreciated)

Ledger accounts:
Land: cost (asset) Revaluation surplus
1/1/ 20X1: 1/1/20X2:
Bank (1) 100 000 Bal c/f 100 000 Bal c/f 20 000 Cost (2) 20 000
100 000 100 000 20 000 20 000
31/12/20X1: 1/1/20X3: 31/12/20X2:
Balance b/f 100 000 Cost (3) 20 000 Balance b/f 20 000
20 000 20 000
1/1/20X2: 31/12/20X3/4:
R/ Surp (2) 20 000 Bal c/f 120 000 Balance b/f 0
120 000 120 000
31/12/20X2: 1/1/20X3 1/1/20X5:
Balance b/f 120 000 R/ Surp (3) 20 000 Cost (7) 10 000
Rev Exp (4) 10 000 10 000 10 000
Bal c/f 90 000 31/12/20X5:
120 000 120 000 Balance b/f 10 000
31/12/20X3: 1/1/20X4:
Balance b/f 90 000 RevExp (5) 20 000
Bal c/f 70 000
90 000 90 000 Bank
31/12/20X4: 1/1/ 20X1:
Balance b/f 70 000 Land (1) 100 000
1/1/20X5:
Rev Inc (6) 30 000
Rev Surp (7) 10 000 Bal c/f 110 000
110 000 110 000
31/12/20X5:
Balance b/f 110 000
Chapter 8 403

Ledger accounts: continued ...
Revaluation expense Revaluation income
1/1/20X3: 31/12/20X3 31/12/20X5 1/1/20X5
Cost (4) 10 000 P&L 10 000 P&L 30 000 Cost (6) 30 000
1/1/20X4 31/12/20X4
Cost (5) 20 000 P&L 20 000
Disclosure:
Company name
20X5 20X4 20X3 20X2 20X1
ASSETS C C C C C
Non-current Assets
Land 110 000 70 000 90 000 120 000 100 000
EQUITY AND LIABILITIES
Equity
Revaluation surplus 10 000 0 0 20 000 0
Workings:
W1. Carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
Opening balance *Jnl 1: purchase in 20X1 1* 100 000 120 000 90 000 70 000
Depreciation Land not depreciated (0) (0) (0) (0)
Fair value adjustments:
Above HCA Cr: revaluation surplus 2; 7 20 000 10 000
Down to HCA Dr: revaluation surplus 3 (20 000)
Below HCA Dr: revaluation expense 4; 5 (10 000) (20 000)
Up to HCA Cr: revaluation income 6 30 000
Closing balance fair value 120 000 90 000 70 000 110 000
Historical carrying amount: (cost) 100 000 100 000 100 000 100 000
Comments:
Note that the decrease in CA in 20X3 is accounted for by first debiting RS to the extent that there
was a balance in RS (C20 000) and any further decrease was then debited to the expense (C10 000).
Note that the increase in CA in 20X5 is accounted for by first crediting the revaluation income to
the extent that it reversed a previous revaluation expense (C30 000), thus first bringing the CA up to
HCA. Thereafter, the increase in CA was credited to RS (C10 000).
3.8 Upward and downward revaluation involving a depreciable asset
Now let us do an example that involves a depreciable asset. To keep things simple, we will
start by combining the cost and accumulated depreciation accounts into one account that
reflects carrying amount. It is not difficult to separate the entries between these two accounts,
but is important to see the big picture before getting bogged down with that detail.
Example 6: Revaluation model – a summary example (the asset is depreciated)

The following information relates to a machine:
Cost of machine at 1/1/20X1: 100 000

Depreciation: Straight-line over 10 years to a nil residual value
Fair values as estimated on: 1/1/20X2: 1/1/20X3: 1/1/20X4: 1/1/20X5:
180 000 60 000 77 000 120 000
404 Chapter 8
The company’s policy is to transfer the realised portion of the revaluation surplus to retained earnings as
the asset is used. The year end is 31 December.
Required: Show the statement of financial position and ledger accounts for 20X2 to 20X5. Use a carrying
amount account (i.e. do not prepare separate cost and accumulated depreciation accounts). Ignore tax.
Solution 6: Revaluation model - a summary example (asset is depreciated)

Ledger accounts:
Machine: carrying amount (asset) Revaluation surplus (equity)
1/1/ 20X2: 31/12/20X2 31/12/20X2: 1/1/20X2:
Balance b/f 90 000 Depr (2) 20 000 Ret Earn 10 000 CA (1) 90 000
Rev Surp (1) 90 000 (90 000/ 9)
180 000 180 000 90 000 90 000
31/12/ 20X2: 31/12/
Balance b/f 20X2:
160 000 Balance b/f 80 000
1/1/20X3: 1/1/20X3:
Rev Surp (3) CA (3) 80 000
80 000 Balance c/f 0
Rev Exp (4) 20 000 80 000 80 000
31/12/20X3 31/12/20X3
Depr (5) 7 500 Balance b/f 0
Balance c/f 52 500 31/12/20X4: 1/1/20X4
7 000
Ret Earn 1 000 CA (7)
(7 000/ 7)
Balance c/f 6 000
160 000 160 000 7 000 7 000
31/12/ 20X3: 31/12/20X4
Balance b/f 52 500 Balance b/f 6 000
1/1/20X4 31/12/20X4 31/12/20X5: 1/1/20X5
Rev Inc (6) 17 500 Depr (8) 11 000 Ret Earn 10 000 CA (9) 54 000
Rev Surp (7) 7 000 (60 000/ 6)
77 000 77 000 60 000 60 000
31/12/ 20X4: 31/12/
Balance b/f 20X5:
66 000 Balance b/f 50 000
1/1/20X5 31/12/20X5
Rev Surp (9) 54 000 Depr (10) 20 000
Balance c/f 100 000
120 000 120 000
31/12/ 20X5:
Balance b/f 100 000
Depreciation expense Retained earnings (equity)

31/12/20X2 31/12/20X2 31/12/20X2
CA (2) 20 000 P&L 20 000 Rev Surp 10 000
31/12/20X3 31/12/20X3 31/12/20X4:
CA (5) 7 500 P&L 7 500 Rev Surp 1 000
31/12/20X4 31/12/20X4 31/12/20X5:
CA (8) 11 000 P&L 11 000 Rev Surp 10 000
31/12/20X5 31/12/20X5
CA (10) 20 000 P&L 20 000
Chapter 8 405
Revaluation expense Revaluation income
1/1/20X3: 31/12/20X3 31/12/20X4 1/1/20X4
CA (4) 20 000 P&L 20 000 P&L 17 500 CA (6) 17 500
Disclosure:
Company name
ASSETS 20X5 20X4 20X3 20X2
Non-current assets C C C C
Machine C/ balance per ledger 100 000 66 000 52 500 160 000
Equity
Revaluation surplus C/ balance per ledger 50 000 6 000 0 80 000
Interesting points to note:
The revaluation surplus balance in this statement of financial position is the difference between the year-end actual carrying
amounts and the carrying amounts had the asset not been revalued:
20X5 20X4 20X3 20X2
C C C C
Carrying amount of asset is: c/ balance per ledger 100 000 66 000 52 500 160 000
(a)
Historical carrying amount: original cost – deprec. 50 000 60 000 70 000 80 000
Revaluation surplus c/ balance per ledger 50 000 6 000 0 80 000
a) 100 000 – (100 000 x 10% x 2 years) = 80 000
Another interesting point is that the annual transfer from revaluation surplus to retained earnings reflects the effect that the
revaluation has had on income in each of the years to date:
Cumulative
Effect on statement of comprehensive income between 20X2 and 20X5
C
Actual effect of using the revaluation model on profit:
Depreciation expense: 20X1 to 20X5 10 000 (20X1 depr) +20 000 +7 500 +11 000 +20 000 68 500
Revaluation expense (20X3) 20 000
Revaluation income (20X4) (17 500)
Net effect on profit (between 20X1 and 20X5) 71 000
Effect on profit had the cost model been used instead:
Depreciation expense: 20X1 to 20X5 100 000 x 10% x 5 years (50 000)
Transfer: RS to RE See ledger: 10 000 + 1 000 + 10 000 21 000
Workings:
W1: Carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
Opening balance 20X2: 100 000 / 10 x 9 yr 90 000 160 000 52 500 66 000
Adjustment:
Above HCA Cr: revaluation surplus 1;7; 9 90 000 7 000 54 000
Down to HCA Dr: revaluation surplus 3 (80 000)
Below HCA Dr: revaluation expense 4 (20 000)
Up to HCA Cr: revaluation income 6 17 500
Fair value 180 000 60 000 77 000 120 000
Depreciation: See calcs below 2;5;8;10 (20 000) (7 500) (11 000) (20 000)
Closing balance 160 000 52 500 66 000 100 000
Historical carrying amount on date of revaluation 90 000 80 000 70 000 60 000

Depreciation
calculations: X2: 180 000/ 9 yrs X3: 60 000 / 8 yrs X4: 77 000 / 7 yrs X5: 120 000 / 6 yrs
406 Chapter 8
The above example showed how to account for a revaluation but did not specify the
adjustments that would need to be made to the cost account and accumulated depreciation
account. Instead, these examples made use of a ‘carrying amount’ account. The adjustments
that would be made to the cost and accumulated depreciation accounts depend on which of
the following two methods are used (explained in section 3.9 below):
the gross replacement value method (or proportional restatement method); or
the net replacement value method (or net method).
3.9 The two method of accounting for a revaluation (IAS 16.35)
3.9.1 Overview
As mentioned in the cost model chapter, whether the cost model or the revaluation model is
used, the asset’s carrying amount is represented by the following accounts:
Cost account (disclosed as gross carrying amount: GCA); and
Accumulated depreciation and impairment loss account.
Under the cost model, adjustments to the carrying amount only occur in the accumulated
depreciation and impairment loss accounts. In other words, under the cost model, the cost
account continues to reflect cost.
Under the revaluation model, however, if the revaluation involves a depreciable asset,
adjustments to the carrying amount could be made to the cost account and/ or to the
accumulated depreciation account. Since adjustments are sometimes made to the cost account,
the cost account would no longer reflect cost, and thus this account is referred to as ‘gross
carrying amount’ in the financial statements.
When making adjustments to an asset’s carrying amount Two methods to journalise

under the revaluation model, the entity may choose to the effect on the CA:
account for the adjustment using:
the proportionate restatement method (or gross Proportionate restatement method
(gross method or gross replacement
replacement value method); or
value method)
the elimination restatement method (or net
Elimination restatement method (net
replacement value method). method or net replacement value
method)
Irrespective of the model used (gross or net methods),
the carrying amount of the asset would be the same after processing the revaluation.
Immediately after the revaluation, the carrying amount will reflect its fair value (net
replacement value).
However, the balances in the separate accounts that constitute carrying amount will differ
depending on whether the gross or net method was used. Since the balances on these separate
accounts will need to be separately disclosed in the notes, we must know how to process the
journal entries using each of these methods.
3.9.2 Proportionate restatement method (gross replacement value method) IAS 16.35(a)
The proportionate restatement method is often referred to as the gross replacement value
method (or simply, the gross method). Re-measuring the carrying amount to the fair value on
date of revaluation (i.e. sometimes referred to as the ‘net replacement value’) using this
method requires that we:
proportionately restate the cost account, and
proportionately restate the accumulated depreciation account.
Proportionately restating the cost account means adjusting the balance in the cost account to
reflect the gross replacement value. The gross replacement value is the re-estimated original
economic benefits that were embodied in the asset on date of purchase. In other words, the
gross replacement value reflects the estimated fair value on date of purchase (or, simply, the
amount that the valuer thinks you should have paid for the asset on date of purchase).
Chapter 8 407
Proportionately restating the accumulated depreciation

account requires adjusting the balance in the Proportionate restatement:
accumulated depreciation account to reflect how much
of the asset’s re-estimated total original economic Proportionately restate (adjust):
benefits would have been earned by now (or, in very - Cost account; and
basic terms, what the accumulated depreciation would - AD account
have been had you bought the asset at the gross So that net effect is CA = FV
replacement value instead of at its actual cost).
Thus, when using the proportionate restatement method (i.e. the gross method), the carrying
amount immediately after the revaluation will reflect the fair value on date of revaluation
(often called the net replacement value), but the cost account will reflect the fair value on
date of original purchase (often called the gross replacement value).
Example 7: Revaluation model – using the gross replacement value method
Plant cost at 1/1/20X1: C100 000 (cash)
Depreciation: straight-line over 5 years to a nil residual value
Fair value at 1/1/20X3 C90 000
Required:
A Calculate the gross replacement value.
B Show all journals for the years ended 31 December 20X1 - 20X3 using the gross replacement value
method. Ignore tax and the transfer from the revaluation surplus.
Solution 7A: Calculation of the gross replacement value

The gross replacement value = (90 000 / 3 remaining years x 5 total years) = C150 000.
Comment:
The first thing to remember is that an asset’s carrying amount reflects the future economic benefits that it is
expected to bring in over its remaining useful life.
This means that a fair value that is estimated as at, for example, 1 January 20X3, is an estimation of the future
economic benefits that are still remaining in this asset calculated as at this date.
The fair value of C90 000 was determined as at 1 January 20X3, 2 years after it was first available for use,
leaving a remaining life of 3 years. This means that the valuer is expecting future benefits of C90 000 to be
earned over the remaining useful life of 3 years, or C30 000 per year (90 000 / 3 years). Using this same
estimation of C30 000 per year, the total future benefits on the date the asset was originally purchased (i.e. the
fair value as at 1 January 20X1) would have been estimated to be C150 000 (30 000 pa x 5 total years).
The valuer is effectively saying the asset was actually worth C150 000 on 1 January 20X1 (i.e. not the
C100 000 that we actually paid) and the accumulated depreciation on 1 January 20X3 should thus have been
C60 000 [ (150 000 – 0)/ 5yrs x 2 yrs = 60 000].
The following working is not necessary in answering the question, but may help you understand the solution:
Plant accounts at 1/1/X3 Using cost Using FV Reval. surplus

Cost 100 000 5 years in total 150 000 90 000 / 3 x 5 yrs (GRV)
Acc depr 100K / 5 x 2 (40 000) 2 years used (60 000) 90 000 / 3 x 2 yrs
Carrying amount: 1/1/X3 60 000 3 years left 90 000 Fair value (NRV) 30 000
Solution 7B: Journals using gross replacement value method

20X1 Journals Debit Credit
1/1/20X1
Plant: cost (A) Given 100 000
Bank 100 000
Purchase of asset
31/12/20X1
Depreciation – plant (E) 100 000 / 5 years 20 000
Plant: acc depreciation (-A) 20 000
Depreciation of asset
\
408 Chapter 8

31/12/20X2
Depreciation – plant (E) 100 000 / 5 remaining years 20 000
20X3 Journals
1/1/20X3
Plant: cost (A) GRV: 150 000 (Part A) – Cost: 100 000 50 000
Plant: acc depreciation (-A) (150 000 – 0) / 5 x 2 yrs – (20 000 + 20 000) 20 000
Revaluation surplus (OCI) FV: 90 000 – CA: 60 000 or balancing 30 000
Revaluation of asset (GRVM):
the cost account now shows the GRV of 150 000
31/12/20X3
Depreciation – plant (E) FV/ NRV: 90 000 / 3 remaining years 30 000
Plant: acc. Depreciation (-A) 30 000
3.9.3 Elimination restatement method (net replacement value method) IAS 16.35(b)
This method involves a journal immediately prior to re-measuring the asset’s carrying amount
to its fair value. This first journal removes the balance that was in the accumulated
depreciation account and sets it off against the cost account (i.e. debit accumulated
depreciation and credit cost). In other words, the net method firstly eliminates the balance in
the accumulated depreciation account resulting in the cost account now reflecting the carrying
amount of the asset immediately prior to the revaluation. The next journal would be to adjust
this balance in the cost account to reflect the fair value (otherwise known as the net
replacement value).
The elimination restatement method is often called the net Elimination

replacement value method (or just the net method). restatement:
First set off:
Thus, when using the elimination restatement method (i.e. - AD account against
the net method), both the carrying amount and the cost - Cost account
account immediately after the revaluation will reflect the - So that the cost account
fair value on date of revaluation (i.e. the net replacement shows CA before revaluation
value). The accumulated depreciation account will have a Adjust this cost account (showing
nil balance. CA) so that the cost account = FV
Example 8: revaluation model – using the net replacement value method

Plant cost at 1/1/20X1: C100 000 (cash)
Fair value at 1/1/20X3: C90 000
Required:
A Calculate the net replacement value.
B Provide the journals for the years ended 31 December 20X1 - 20X3.
Ignore tax and the transfer from the revaluation surplus.
Solution 8A: Calculation of net replacement value

The net replacement value on 1/1/20X3 = the fair value on 1/1/20X3 = C90 000
Comment: The net method means:
netting (eliminating) the accumulated depreciation account against the cost account (debit acc
deprec and credit cost); and then restating the balance in the cost account to the fair value: the cost
account then shows the fair value and the accumulated depreciation shows nil.
The working on the next page is not necessary, but may help you understand the solution.
Chapter 8 409

Workings:
Plant accounts at 1/1/X3 Using cost Using FV Reval. surplus
Cost 100 000 5 years in total 90 000 Given
Acc deprec 100K / 5 x 2 (40 000) 2 years used (0)
Carrying amount: 1/1/X3 60 000 3 years remaining 90 000 Given 30 000
Solution 8B: Journals using the net replacement value method

1/1/20X1
Bank 100 000
Purchase of asset
31/12/20X1
Depreciation – plant (E) 100 000 / 5 years 20 000
20X2 Journals
31/12/20X2
Depreciation – plant (E) 100 000 / 5 years; OR 20 000
Plant: acc depreciation (-A) CA: 80 000 / 4 remaining years 20 000
20X3 Journals
1/1/20X3
Plant: acc depreciation (-A) 20 000 + 20 000 40 000
Plant: cost 40 000
Netting off of acc depr immediately before revaluation
Plant: cost (A) 30 000
Revaluation surplus (OCI) FV: 90 000 - CA: 60 000 30 000
Revaluation of asset (the cost account now shows the FV of 90 000)
31/12/20X3
Depreciation – plant (E) 90 000 / 3 remaining years 30 000
Compare the previous example (example 7) and this example (example 8). Notice that all accounts are the same as at
31 December 20X3 except for the cost and accumulated depreciation accounts:
GRVM (Ex 7) NRVM (Ex 8) Difference
Carrying amount at 31/12/X3 60 000 60 000 0
- Cost account 150 000 90 000 60 000
- Accumulated depreciation account (90 000) (30 000) (60 000)
Revaluation surplus at 31/12/X3 30 000 30 000 0
Depreciation in 20X3 30 000 30 000 0
The following examples continue to compare the gross and net method, but also show the
transfer of revaluation surplus to retained earnings. These ignore the effects of deferred tax
(the deferred tax effects of revaluations are not difficult but are covered later in the chapter).
Example 9: Revaluation model – increase in value, creating a revaluation surplus

Plant purchased on 1/1/20X1 at a cost of: C100 000
The revaluation surplus is transferred to retained earnings over the life of the asset.
Required: Show the journals for the years ended 31 December 20X1 and 20X2 using the:
A net replacement value method (NRVM)
B gross replacement value method (GRVM)
410 Chapter 8
Solution 9: Revaluation model – increase creating a revaluation surplus

Journals Ex 9A Ex 9B
NRVM GRVM
1/1/20X1 Dr/ (Cr) Dr/ (Cr)
Plant: cost (A) 100 000 100 000
Bank/ Liability (100 000) (100 000)
Purchase of asset: (1/1/20X1)
31/12/20X1
Depreciation (E) 100 000 / 5 years remaining 20 000 20 000
Depreciation: 100 000 / 5 years remaining (31/12/20X1)
1/1/20X2: revaluation (increase)
Plant: accumulated depreciation (-A) 20 000 N/A
Plant: cost (20 000) N/A
NRVM: set-off of acc. depreciation before revaluing asset
Plant: cost (A) W2 or 90 000 – 80 000 10 000 N/A
Revaluation surplus (OCI) (10 000) N/A
NRVM: Revaluation journal – cost account now reflects fair value
Plant: cost (A) 112 500 (W3) - 100 000 N/A 12 500
Plant: accumulated depreciation (-A) 22 500 (W3) - 20 000 N/A (2 500)
Revaluation surplus 90 000 - 80 000; or Balancing N/A (10 000)
GRVM: revaluation of asset: (1/1/20X2)
31/12/20X2: depreciation and transfer of revaluation surplus
Depreciation (E) 90 000 / 4 years remaining 22 500 22 500
Depreciation: new CA over remaining useful life
Revaluation surplus (OCI) 10 000 / 4 years remaining 2 500 2 500
Retained earnings (2 500) (2 500)
Transfer of revaluation surplus to retained earnings: over life of asset
(the extra depreciation for 20X2 due to the revaluation above HCA)
(22 500 revalued depreciation – 20 000 historic depreciation)
Workings: applicable to both (A) and (B)

C
W1: Actual (and historic) carrying amount 1/1/20X2:
Cost: 1/1/20X1 Given 100 000
Accumulated depreciation: 31/1/20X1 100 000 x 20% x 1 yr (20 000)
80 000
W2: Revaluation required at 1/1/20X2:
Fair value Given 90 000
Actual carrying amount W1 (80 000)
10 000
Graph depicting both (A) and (B): 1/1/20X2
90 000 (FV)
10 000 (Credit revaluation surplus)
80 000 (HCA & ACA)
Cost
0 Useful Life
Chapter 8 411

W3: For GRVM only: C
Gross replacement value (GRV): 1/1/20X1 90 000 / 4 years remaining x 5 total years 112 500
Accum. depreciation on GRV: 31/12/20X1 112 500 / 5 total years x 1 year to date (22 500)
Fair value: 1/1/20X2 Given 90 000
Example 10: Revaluation model - decrease in value, reversing the revaluation

surplus and creating a revaluation expense:
Use the same information as that in the last example with the following extra information:
Required: Show the journals for the year ended 31 December 20X3 using the:
A net replacement value method (NRVM)
B gross replacement value method (GRVM)
Solution 10: Journals

C
W1: NRVM (A) & GRVM (B): Historical carrying amount at 1/1/20X3:
Cost: 1/1/20X1 Given 100 000
Accumulated depreciation: 31/1/20X2 100 000 x 20% x 2 yr (40 000)
60 000
W2: NRVM (A) & GRVM (B): Actual carrying amount at 1/1/20X3:
Carrying amount at 1/1/20X2 after revaluation to FV 90 000
Depreciation in 20X2 (90 000/ 4yrs) or (112 500/ 5 yrs) (22 500)
67 500
W3: NRVM (A) & GRVM (B): Devaluation required at 1/1/20X3:
Fair value 54 000
Actual carrying amount (67 500)
(13 500)
- reverse revaluation surplus (down to HCA: ACA: 67 500 – HCA: 60 000) 7 500
- revaluation expense (below HCA: HCA: 60 000 – NRV: 54 000) 6 000
Graph relevant to both NRVM (A) and GRVM (B): 1/1/20X3:
67 500 (ACA)
7 500 (Debit revaluation surplus)
60 000 (HCA)
Cost
6 000 (Debit revaluation expense)
54 000(FV) Historical carrying amount line
0 Useful Life
C
W4: For GRVM only:
Gross replacement value (GRV): 54 000 / 3 years remaining x 5 total years 90 000
1/1/20X1
Accum. depreciation on GRV: 90 000 / 5 total years x 2 years to date (36 000)
31/12/20X2
412 Chapter 8

Journals: 20X3: Ex 10A Ex 10B
NRVM GRVM
1/1/20X3: revaluation (decrease) Dr/ (Cr) Dr/ (Cr)
Plant: accum. depreciation (-A) From example 9A 22 500 N/A
Plant: cost (A) (22 500) N/A
Set off of accumulated depreciation against cost (NRVM)
Revaluation surplus (OCI) The balance in the RS acc from Ex 9A 7 500 N/A
Revaluation expense (E) Further decrease expensed: 13 500 – 7 500 6 000 N/A
Plant: cost (A) CA (Ex 9A or W2): 67 500 – FV: 54 000 (13 500) N/A
Revaluation surplus (OCI) The balance in this account from Ex 9B N/A 7 500
Revaluation expense (E) Further decrease expensed: 13 500 – 7 500 N/A 6 000
Plant: cost (A) GRV (W4) 90 000 – Cost (Ex 9B) 112 500 N/A (22 500)
Plant: accum. depreciation (-A) AD (W4) 36 000 – AD (Ex 9B) 45 000 N/A 9 000
GRVM: Revaluation journal – cost account now reflects GRV, the acc
depr account now reflects AD on GRV to date and the CA now reflects
FV The first adjustment reduces the revaluation surplus and any excess
thereafter is debited to revaluation expense. Note: the cost dropped
C6 000 below the historical cost of 100 000, thus C6 000 was expensed
31/12/20X3: depreciation
Depreciation – plant (E) FV: 54 000 / 3 years remaining 18 000 18 000
Plant: accum. depreciation (-A) (18 000) (18 000)
Depreciation for 20X3: new carrying amount over remaining useful life
Comment:
Please note that the difference between the journals using the NRVM and the GRVM are purely
for disclosure purposes. The essence of the above adjustments can be more clearly seen in the
following simplified journal:
NRVM and GRVM
Debit Credit
Revaluation surplus 7 500
Revaluation expense 6 000
Plant at net carrying amount 13 500
Please also note that in this example, the asset’s carrying amount was reduced to below historical
carrying amount and therefore the revaluation surplus had been reduced to zero. There was
therefore no journal transferring revaluation surplus to retained earnings in 20X3.
Example 11: Revaluation model - increase in value, reversing a previous

revaluation expense and creating a revaluation surplus
Assume the same information as that given in the previous example as well as the following:
Required: Show the journals for the year ended 31 December 20X4 using the:
A. net replacement value method (NRVM)
B. gross replacement value method (GRVM)
Solution 11: Revaluation model - increase in value, reversing a previous revaluation

expense and creating a revaluation surplus
Workings applicable to both (A) and (B)
W1: Historical carrying amount at 1/1/20X4: C

Cost 100 000
Accumulated depreciation (100 000 x 20% x 3yrs) (60 000)
40 000
Chapter 8 413

W2: Actual carrying amount at 1/1/20X4: C
Carrying amount at 1/1/20X3 after revaluation on 1/1/20X3 54 000
Depreciation in 20X3 (FV: 54 000/ 3 rem yrs) or (GRV: 90 000/ 5 total yrs) (18 000)
36 000
W3: Increase in value required at 1/1/20X4:
Fair value on 1/1/20X4 44 000
Actual carrying amount on 1/1/20X4 W2 (36 000)
8 000
- revaluation income (up to HCA: 36 000 – 40 000) 4 000
- revaluation surplus (above HCA: 40 000 – 44 000) 4 000
Graph depicting both (A) and (B): 1/1/20X4
44 000 (FV)
4 000 (Credit revaluation surplus)
40 000 (HCA)
Cost
4 000 (Credit reversal of revaluation expense)

36 000 (ACA)
0 Useful Life
W4: For GRVM only: C

Gross replacement value (GRV): 1/1/20X1 44 000 / 2 years remaining x 5 total yrs 110 000
Accum. depreciation on GRV: 31/12/20X3 110 000 / 5 total years x 3 years to date (66 000)
Journals: 20X4: Ex 11A Ex 11B

NRVM GRVM
1/1/20X4: revaluation (increase) Dr/ (Cr) Dr/ (Cr)
Plant: accum. depreciation (-A) 18 000 N/A
Plant: cost (A) (18 000) N/A
NRVM: Set off of accumulated depreciation against cost
Plant: cost (A) FV: 44 000 – CA: 36 000 (W2) 8 000 N/A
Revaluation income (I) CA: 36 000 – HCA: 40 000 (W3) (4 000) N/A
Revaluation surplus (OCI) HCA: 40 000 – FV: 44 000 (W3) (4 000) N/A
Plant: cost (A) GRV (W4): 110 000 – Cost (Ex 10B): 90 000 N/A 20 000
Plant: accum deprec. (-A) AD (W4): 66 000 – AD (Ex 10B): 54 000 N/A (12 000)
Revaluation income (I) CA: 36 000 – HCA: 40 000 (W3) N/A (4 000)
Revaluation surplus (OCI) HCA: 40 000 – FV: 44 000 (W3) N/A (4 000)
GRVM: Revaluation journal – cost account now reflects GRV, the acc
depr account now reflects AD on GRV to date and the net reflects FV
31/12/20X4: depreciation and transfer of RS to RE
Depreciation – plant (E) FV 44 000 / 2 remaining yrs 22 000 22 000
Plant: accum deprec (-A) (22 000) (22 000)
Depreciation - 20X4: new carrying amount over remaining useful life
Revaluation surplus (OCI) RS 4 000/ 2 remaining yrs 2 000 2 000
Retained earnings (Eq) (2 000) (2 000)
Transfer of revaluation surplus to retained earnings: over life of asset
(the extra depreciation for 20X4 due to the revaluation above HCA:
Revalued depr 22 000 – Historical depr 20 000)
414 Chapter 8
3.10 The revaluation model and impairments (IAS 36 and IAS 16.63-.66)
All property, plant and equipment must undergo an impairment indicator test at the end of
every financial year – even those measured under the revaluation model. The indicator test is
merely a test for indicators that the asset may be impaired and is not the actual test for
impairment. If there is an indication that the asset may be impaired, an impairment test is
followed out. This involves calculating the recoverable amount and comparing it to the
carrying amount. If the recoverable amount is less than the carrying amount, the carrying
amount must be reduced to the recoverable amount.
When using the revaluation
Recoverable amount is measured at the higher of: model, we must still check
Value in use; and for impairments unless:
Fair value less costs of disposal. Costs of disposal are negligible.
See IAS 36.5
The only exception to the requirement to calculate the recoverable amount is if an asset,
measured in terms of the revaluation model, has costs of disposal that are negligible. If costs
of disposal are negligible, there is no need to calculate the recoverable amount because the
fair value less costs of disposal (FV-CoD) will not differ materially from fair value, and thus
the recoverable amount (greater of value in use & fair value less costs of disposal) either will:
not differ materially from the carrying amount, in which case there is no impairment; or
exceed the carrying amount, in which case there will be no impairment. IAS 36.5
If CA is measured at FV = 100 and if costs to sell are negligible, then FV- CoD = 100 (+-), then, if:
VIU = 120, the RA = 120 (greater of VIU and FV-CoD) & since RA: 120 > CA: 100: = no impairment
VIU = 80, the RA = 100 (greater of VIU and FV-CoD) & since RA: 100 = CA: 100: = no impairment.
Thus, if costs of disposal are negligible, the calculation of the recoverable amount is not required.
Although IAS 16 does not provide any guidance as to the naming of the resultant income and
expense accounts, when making an adjustment to an asset’s carrying amount where the
adjustment is to be recognised as an expense in profit or loss, one should differentiate
between adjustments to a fair value (a revaluation expense) from adjustments to a recoverable
amount (an impairment expense).
This differentiation is relevant, it is submitted because a decrease to a lower fair value does
not necessarily mean that the recoverable amount has decreased (the recoverable amount
could be higher than carrying amount) and therefore it does not mean that the asset is
impaired. Consider the following example.
Example 12: A low fair value does not necessarily mean an impairment loss
1/1/20X1 Cost of plant (paid for in cash) C100 000
Depreciation 5 years; straight-line; residual value is nil
31/12/20X1 Fair value C70 000
31/12/20X1 Value in use C110 000
31/12/20X1 Costs of disposal C10 000
Required: Provide the journal entries necessary in 20X1.
Solution 12: A low fair value does not necessarily mean an impairment loss
W1: Revalue to fair value C
Cost Given 100 000
Depreciation (100 000 – 0) / 5 x 1 (20 000)
Carrying amount As calculated above, unchanged 80 000
Revaluation expense Balancing (10 000)
Fair value Given 70 000
W2: Check for impairment losses or reversals C
Carrying amount Fair value 70 000
Recoverable amount Higher of: FV-CoD (70 000 – 10 000) or VIU 110 000 110 000
Impairment/ reversal Impairment loss: N/A because the RA > CA 0
Impairment reversal: N/A: there are no prior impairments
Chapter 8 415

Comment
The asset is measured under the revaluation model and thus must first be revalued to fair value.
The decrease in value is called a revaluation expense (or something similar – no guidance is
provided in either of the standards: IAS 16 or IAS 36), but should not be called an impairment loss
expense.
IAS 36 Impairment of assets requires that, at the end of the reporting period, items of property,
plant and equipment be checked for impairments unless the costs of disposal are negligible. In
terms of IAS 36.5(c), when the costs of disposal are not negligible, as it is in this example, an
impairment is possible. However, in this example, although the fair value less costs of disposal
(60 000) is less than the carrying amount (fair value: 70 000), the actual recoverable amount
(110 000) is greater than the carrying amount (recoverable amount is the greater of fair value less
costs of disposal and value in use). There is therefore no impairment loss.
Notice how there was a revaluation expense but the asset is not impaired.

1/1/20X1
Bank (A) 100 000
Purchase of plant
31/12/20X1
Depreciation (E) W1 20 000
Revaluation expense (E) W1 10 000
Revaluation of plant to fair value of C70 000
In summary then:
If the carrying amount is decreased and part or all of the decrease is to be recognised as
an expense, this expense is referred to as:
- a revaluation expense if the CA is being decreased to a fair value; or
- an impairment loss expense if the CA is being decreased to a recoverable amount.
If the carrying amount is increased and part or all of the increase is to be recognised as an
income, this income is referred to as:
- a revaluation income if the CA is being increased to a fair value;
- an impairment loss reversed if the CA is being increased to a recoverable amount.
Examples showing the impairment of an asset measured under the revaluation model are
included in the chapter on impairments.
Please note: irrespective of whether or not you interpret IAS 16 and IAS 36 to require
differentiation, the carrying amount is the same. The most important thing to grasp is whether
an adjustment is recognised in other comprehensive income (OCI) or in profit or loss (P/L).
Adjustments above historical carrying amount (depreciated cost) are recognised in OCI.
Adjustments below historical carrying amount (depreciated cost) are recognised in P/L.
An impairment reversal that exceeds depreciated cost (historical carrying amount) is

recognised in other comprehensive income as a revaluation surplus.
When reversing a previous impairment, be careful not to increase the carrying amount above
the carrying amount that the asset would have had had the asset not been impaired. In other
words, the carrying amount is limited to the previous fair value less subsequent accumulated
depreciation (depreciated fair value).
416 Chapter 8
4. Deferred Tax Consequences
4.1 Overview
Deferred tax consequences arise if the tax authorities do not measure the tax base of the asset
in the same way that IAS 16 measures its carrying amount. Deferred tax should be recognised
on these temporary differences unless:
the temporary difference is exempt from deferred tax (see chapter 6, section 6.3 and 7); or
the temporary difference is a deductible temporary difference thus causing a deferred tax
asset but where the inflow of future economic benefits is not probable (chapter 6, section 9).
As explained in chapter 7, deferred tax can arise from basic transactions such as:
buying the asset;
depreciating and impairing the asset;
selling the asset.
When using the revaluation model, the carrying amount could be increased by crediting
revaluation surplus. This increase affects other comprehensive income and does not affect the
profit or loss. Thus the deferred tax effect on the revaluation surplus must also be recognised
in other comprehensive income and is thus called a balance-sheet based deferred tax
adjustment. This is explained in section 5.2.
Similarly, when using the revaluation model, the asset is measured at fair value: if this fair
value exceeds cost, we must remember that the deferred tax balance must reflect the expected
tax consequences from the expected manner of recovery of the economic benefits inherent in
the asset. This is explained in section 5.3 and 5.4.
4.2 Deferred tax effects of the revaluation surplus
A big difference between the cost model and the revaluation model, however, is that when
using the revaluation model, the carrying amount may be increased above its historical
carrying amount. Such an increase is credited to revaluation surplus account, which is part of
other comprehensive income and therefore does not affect profit.
When deferred tax arises from items that are recognised in
profit or loss (such as depreciation and impairments), the A revaluation surplus
reflects extra FEB
deferred tax is also recognised in profit or loss. This means which means extra
that these deferred tax adjustments will be debited or credited future tax:
to the tax expense in the profit or loss section of the statement Thus the recognition of a RS
of comprehensive income. These adjustments are often called Means we must recognise the
income statement-based deferred tax adjustments. DT on the RS.
When deferred tax arises from items that are recognised in other comprehensive income (e.g.
an adjustment to revaluation surplus) the related deferred tax adjustment must also be
recognised in other comprehensive income. This deferred tax adjustment will thus be debited
or credited to the revaluation surplus and will thus be presented in the other comprehensive
income section of the statement of comprehensive income (i.e. this deferred tax adjustment
will not be included in tax expense). These deferred tax adjustments are often referred to as
balance sheet-based deferred tax adjustments. IAS 12.61A - .62
In summary, there are two types of deferred tax adjustments: DT caused by the
creation of a RS is
Income statement based deferred tax adjustments: journalised as:
adjustments made to the tax expense account as a result Debit RS
of temporary differences that affected profit;
Cr DT.
Balance sheet based deferred tax adjustments:
adjustments made directly to an equity account as a result of temporary differences that
did not affect profit (in other words: where the temporary difference arose from a
revaluation surplus, the deferred tax contra-entry must be to the same revaluation surplus
account).
Chapter 8 417
4.3 Deferred tax effects of the revaluation surplus and management intentions
Another big difference between the cost model and the revaluation model is that it is entirely
possible that the carrying amount of the asset could be increased not only above its historical
carrying amount, but it could actually be increased above its original cost.
If management intends to earn the future economic benefits from the sale of the asset rather
than the use of the asset, the fact that the asset could be
revalued above original cost could impact on the The measurement of the
DT on a RS is affected by
measurement of the deferred tax balance if the tax
whether mgmt intends to:
authorities tax capital profits at a different rate / in a
different manner to other profits. Use the asset:
- measure DT normally
Bearing in mind that the deferred tax balance must Sell the asset:
reflect the tax consequences that are expected from the If the CA = / < Cost:
inflow of future economic benefits, we must consider the - measure DT normally
possible effect of managements’ intentions/ expectations If the CA > Cost,
regarding the recovery of the asset’s carrying amount on - measure DT in a way that takes
the measurement of deferred tax. The effect of into account that part of the
managements’ intentions on the measurement of deferred potential profit on sale would be
taxed as a capital gain.
tax is explained in chapter 6, section 6.4.2 and 6.4.3.
However, if the item of revalued property, plant and equipment is non-depreciable (i.e. land),
then we ignore management’s actual intentions and presume that the management intention is
to sell the land. IAS 12.51B Presumed intentions are explained in chapter 6, section 6.4.2.
4.3.1 Deferred tax and a revaluation that does not exceed cost
If you have a revaluation surplus, it means that the asset’s carrying amount has been increased
above its historical carrying amount. However, if this revalued carrying amount does not
exceed its original cost, there can be no expected capital profit. This makes the deferred tax
calculation easier. Depending on management’s intentions, the increased carrying amount
refers to future economic benefits expected from:
sales revenue (e.g. from selling the items manufactured from the asset), if the entity
intends to keep the asset: these sales will be taxed at the income tax rate; or
proceeds on sale of the asset if the entity intends to sell the asset: the proceeds could
result in a recoupment of tax allowances that will be taxed at the income tax rate or a
scrapping allowance, being a tax saving, measured at the income tax rate.
Thus, if the carrying amount does not exceed cost, management intentions may be ignored
because the deferred tax consequences will be measured at income tax rates.
Example 13: Revaluation surplus and deferred tax:
revaluation up but below cost
A plant (cost: C150 000) is revalued to a fair value of C140 000, on which date it had:
a carrying amount of C100 000 (historical and actual),
a tax base on date of revaluation of C100 000.
The tax rate is 30%.
For the purposes of this example, you may combine the cost and accumulated depreciation accounts.
Required:
A Explain whether the intentions of management will affect the measurement of the deferred tax.
B Show the revaluation journal and the journal showing the deferred tax consequences thereof.
Solution 13A: Discussion
Since the revaluated carrying amount does not exceed cost, the intentions of management would not
affect the measurement of the deferred tax balance.
If the intention was to keep (use) the asset, the carrying amount would reflect future income from
the sale of the plant’s output: C
Future sales income Carrying amount at fair value 140 000
Future wear and tear deductions Tax base 100 000
Future taxable profits 40 000
Future tax 40 000 x 30% 12 000
418 Chapter 8

If the intention was to sell the asset, the carrying amount would reflect future income from the
proceeds on sale of the plant: C
Future selling price of plant limited to cost price CA at fair value, limited to cost 140 000
(see chapter 5)
Future tax base Tax base 100 000
Future recoupment on sale 40 000
Future tax 40 000 x 30% 12 000
A diagrammatic way of explaining the deferred tax based on the intention to sell the asset is as follows:
Tax base 100 Recoupment: 12

40 x 30%
Revalued carrying amount 140
Original cost 150 Capital gain: 0
N/A (1)
12
(1) There is no capital gain because the revalued carrying amount is less than the original cost.
Solution 13B: Revaluation surplus up but below cost: deferred tax: journals
Journal: Debit Credit
Plant (Asset: carrying amount) FV 140 000 – CA 100 000 40 000

Revaluation above historical carrying amount
Revaluation surplus (OCI) W1 * or (40 000 x 30%) 12 000

Deferred tax (Liability) 12 000
Deferred tax on the revaluation surplus – see comment below
W1: Calculation of deferred tax

Asset: plant amount base difference taxation Calculations
Balances before revaluation 100 000 100 000 0 0
Revaluation surplus 40 000 0 (40 000) (12 000) Cr DT Dr RS *
Balances after revaluation 140 000 100 000 (40 000) (12 000) Liability: 0-12+0
Historical carrying amount/ tax base 100 000 100 000 0 0 (100-100) x 30%
Revaluation surplus - up to cost 40 000 0 (40 000) (12 000) (0-40) x 30%
Revaluation surplus - above cost 0 0 0 0 N/A
Comment:
When the CA is increased from 100 000 to 140 000, it creates a temporary difference of 40 000.
Since the extra 40 000 is credited to revaluation surplus (OCI) and not to income (P/L), the deferred
tax contra entry will be to the revaluation surplus account – not tax expense.
4.3.2 Deferred tax and a revaluation that exceeds cost
As already mentioned, if an asset is valued above its historical carrying amount, it is

important to ascertain whether it has also been increased above its original cost.
If the revalued carrying amount exceeds its original cost, it is important to ascertain whether
management intends to keep the asset or to sell the asset. This is because the tax legislation
may differ depending on what kind of income we earn. For example, the tax legislation
applicable to income from normal trading (e.g. sales revenue) may be different to the tax
legislation applicable to income from the sale of an asset (e.g. profit on sale of an asset).
Chapter 8 419
In summary, the intention of the entity must be considered when estimating the future tax
liability since the deferred tax balance must reflect how much tax we are expecting to pay,
and the amount of this future tax may be affected by the type of income we are expecting. If
the intention is to:
keep the asset, the future economic benefits will be the expected future revenue from
normal trading activities;
sell the asset, the future economic benefits will be the expected future proceeds on sale;
keep the asset for a while and then to sell it, the future economic benefits will represent a
mixture of revenue from normal trading activities and proceeds on sale.
An exception occurs when the deferred tax balance relates to revalued non-depreciable assets
(land), in which case we must always presume that management intends to sell the asset
irrespective of management’s actual intention. IAS 12.51 B
4.3.2.1 Deferred tax: Revaluation above cost: intention to keep the asset
If the intention is to keep the asset (i.e. use it rather than sell it), then the entire carrying
amount (the extra future economic benefits) is expected to be earned by way of normal
trading profits. In other words, we expect that the future economic benefits (i.e. inflows)
relating to the asset will come in the form of sales or other related trading activities.
These future economic benefits that are expected to be earned through normal trading
activities will be taxed at the normal rate of income tax. If the asset is revalued upwards, the
extra future economic benefits (represented by the revaluation surplus) will also be taxed at
the income tax rate. Therefore, assuming, for example, that trading profits are taxed at an
income tax rate of 30%, the future tax on the revaluation surplus will be estimated at 30%.
Note: when measuring deferred tax relating to land, we ignore management’s actual intention
to keep the land and presume that management intends to sell the land. IAS 12.51B
Example 14: Deferred tax: revaluation above cost: intend to keep – short
example
A machine is revalued to C140 000 when:
its carrying amount (actual and historical) is C100 000;
it original cost was C110 000 (not C150 000 as in the previous example);
its tax base is C100 000.
The intention is to keep the asset.
Required: Calculate the deferred tax balance and show the related journal entries.
Solution 14: Deferred tax: revaluation above cost: intend to keep

Comment:
In this case, there will be no capital profit (since this only occurs on disposal of the asset) and therefore,
the increase in value represents future profits expected from the use of the asset.

Machine (carrying amount) (A) (140 000 – 100 000) 40 000
Increase in asset value above historical carrying amount
Revaluation surplus (OCI) W1 * or (40 000 x 30%) 12 000
Deferred tax (Asset): income tax 12 000
Deferred tax on the revaluation surplus – see W1
420 Chapter 8

W1: Calculation of deferred tax:
Asset – intention to keep CA TB TD DT Calculations
Revaluation surplus 40 000 0 (40 000) (12 000) Cr DT Dr RS * (2)
Balances after revaluation: 140 000 100 000 (40 000) (12 000) Liability (3)
Historical carrying amount/ tax base 100 000 100 000 0 0 (100-100) x 30% (1)
Revaluation surplus - up to cost 10 000 0 (10 000) (3 000) (0-10) x 30% (3)
Revaluation surplus – above cost 30 000 0 (30 000) (9 000) (0-30) x 30% (3)
1) There are no temporary differences at this point since the historical carrying amount and tax base are the same,
and therefore there is no deferred tax.
2) The entire revaluation surplus of 40 000 (10 000 + 30 000) represents future profits from the use of the asset in
excess of those originally expected. Since trading profits are taxed at 30%, deferred tax of 12 000 (40 000 x
30%) must be provided.
3) Although the revalued amount is greater than original cost, this profit is expected to be earned through the use of
the asset – and not through the sale of the asset and therefore all future profits will be taxed at the income tax rate
of 30%. There is therefore no need at all to show this breakdown of the balances after revaluation into the
components of 100 000, 10 000 and 30 000.
This can be illustrated as follows:
Tax base 100 000 Profits in excess of tax base: 10 000 x 30% 3 000
Original cost (and base cost) 110 000

Further profits: 30 000 x 30% 9 000
Revalued carrying amount 140 000
12 000
Yet another way of explaining the deferred tax balance is, imagine that we intend to keep the asset. If we
revalue the asset to 140 000, it means that we are expecting future sales of 140 000. A tax base of 100 000
means that we will be able to deduct 100 000 against this future revenue:
Future sales revenue 140 000
Less future tax allowances (100 000)
Future taxable profit 40 000
Future tax payable 12 000
Example 15: Deferred tax: revaluation above cost: intend to keep – full example
A machine is purchased for C100 000 on 2 January 20X1.
The machine is depreciated at 25% per annum straight-line to a nil residual value.
Machines are revalued to fair value using the net replacement value method.
The fair values were:
1 January 20X2: C120 000
1 January 20X3: C60 000
The tax authorities allow the cost to be deducted at 20% pa and levy income tax at 30%.
The intention is to keep the asset.
Required: Provide all journals.

20X1 Journals: Debit Credit
2 January 20X1
Machine: cost (A) 100 000
Bank (A) 100 000
Purchase of machine
Chapter 8 421
20X1 Journals continued ... Debit Credit

31 December 20X1
Depreciation – machine (E) (100 000 – 0) / 4 years x 12 / 12 25 000
Depreciation on machine:
Deferred tax: income tax (A/L) (25 000 – 20 000) x 30% 1 500
Tax expense: income tax (E) 1 500
Deferred tax on depreciation versus wear and tear – see W1
20X2 Journals:
1 January 20X2
NRVM: accumulated depreciation set-off against cost
Machine: cost (A) 120 000 – (100 000 – 25 000) 45 000
Revaluation of machine (increase in value)
Revaluation surplus (OCI) 45 000 x 30% 13 500
Deferred tax (A/L) 13 500
Deferred tax on revaluation surplus
31 December 20X2
Depreciation – machine (E) (120 000 – 0) / 3 years 40 000
Revaluation surplus (OCI) (45 000 – 13 500) / 3 years 10 500
Retained earnings (Eq) 10 500
A portion of revaluation surplus transferred to retained earnings
20X3 Journals:
1 January 20X3
Revaluation surplus (OCI) FV 60 000 – CA (120 000 – 20 000
Machine: cost (A) 40 000) 20 000
Revaluation of machine (decrease in value)
Deferred tax (A/L) 20 000 x 30% 6 000
Deferred tax on revaluation surplus (decrease in future tax liability
because future benefits decreased)
31 December 20X3
Revaluation surplus (OCI) (45 000 – 13 500 – 10 500 – 3 500
Retained earnings (Eq) 20 000 + 6 000) / 2 years 3 500
422 Chapter 8

Debit Credit
20X4 Journals:
31 December 20X4
Revaluation surplus (OCI) (45 000 – 13 500 – 10 500 – 20 000 + 3 500
Retained earnings (Eq) 6 000 – 3 500)/ 1 year 3 500
20X5 Journals:
31 December 20X5
Tax expense: income tax (E) (0 – 20 000) x 30% 6 000
Deferred tax: income tax (A/L) 6 000
W1: Deferred tax: machines Carrying Tax Temporary Deferred Details Revaluation
amount base difference taxation Surplus
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Dr DT (SOFP)
Depreciation/ deduction (25 000) (20 000) 5 000 1 500
Cr TE (P/L)
100 000 / 4 years; 100 000 x 20%
Balance: 31/12/20X1 75 000 80 000 5 000 1 500 Asset
(1) Cr DT (SOFP) (45 000)
Revaluation surplus (increase) 45 000 0 (45 000) (13 500)
Dr RS (OCI) (3) 13 500
120 000 80 000 (40 000) (12 000) Liability (31 500)
Depreciation/ deduction Dr DT (SOFP) (4)

(40 000) (20 000) 20 000 6 000 10 500
120 000 / 3 years; 100 000 x 20% Cr TE (P/L)
Balance: 31/12/20X2 80 000 60 000 (20 000) (6 000) Liability (21 000)
Dr DT (SOFP) 20 000
Revaluation surplus (decrease) (20 000) 0 20 000 6 000(2)
Cr RS (OCI)(3) (6 000)
60 000 60 000 0 0 (7 000)

(30 000) (20 000) 10 000 3 000 3 500
60 000 / 2 years; 100 000 x 20% Cr TE (P/L)
Balance: 31/12/20X3 30 000 40 000 10 000 3 000 Asset (3 500)

(30 000) (20 000) 10 000 3 000 3 500
30 000 / 1 years; 100 000 x 20% Cr TE (P/L)
Balance: 31/12/20X4 0 20 000 20 000 6 000 Asset 0
Depreciation/ deduction Cr DT (SOFP)

(0) (20 000) (20 000) (6 000)
N/A;100 000 x 20% Dr TE (P/L)
Balance: 31/12/20X5 0 0 0 0 Liability
1) Since the intention is to keep the asset, there is no need to separate out any capital profit: the entire increase (or
decrease) in carrying amount is expected to be realised through normal trading activities, which are taxed at 30%:
45 000 x 30% = 13 500
2) The drop in carrying amount reflects a drop in expected trading activities. A drop in trading activities will result in a
corresponding decrease in income tax: 20 000 x 30% = 6 000
3) Also note: the deferred tax contra entry is the revaluation surplus (not the tax expense account).
4) Transfer from revaluation surplus to retained earnings:
20X2: 31 500 / 3 years = 10 500
20X3: 7 000 / 2 years = 3 500
20X4: 3 500 / 1 year = 3 500
Chapter 8 423
4.3.2.2 Deferred tax: Revaluation above cost: intention to sell the asset
If the intention is to sell the asset, then the fair value is assumed to represent the expected
selling price of the asset.
This means that the amount by which the fair value exceeds the historical carrying amount
represents the expected profit on sale. If the asset is revalued to the fair value, the revaluation
surplus will reflect this expected profit on sale.
If the fair value is above its original cost, the amount by which the fair value exceeds cost
will represent an expected ‘capital profit on disposal’, part of which may be exempt. The rest
of the profit on sale will represent a non-capital profit on sale.
Therefore, this revaluation surplus will reflect a capital profit on sale (part of which may be
exempt from tax) and a non-capital profit on sale.
Example 16: Deferred tax: Revaluation surplus above cost: intention to sell
A plant (carrying amount of 60 000 and original cost of 100 000) is revalued to a fair value of
110 000.
Required: Calculate the revaluation surplus and analyse it into a capital and non-capital components.
Solution 16: Deferred tax: Revaluation surplus above cost: intention to sell
Comment: the trick here is to see the revaluation surplus being made up of a number of components:
part of the revaluation surplus brought the asset’s carrying amount back up to cost (i.e. from 60 000 to
100 000, thus reversing previous depreciation) and
part of the asset’s carrying amount increased the carrying amount above cost (i.e. from 100 000 to
110 000, thus representing a potential capital profit – if the asset were ever sold).
The deferred tax on each component will be taxed differently.

C
Revaluation surplus: profit on sale FV (SP): 110 000 – HCA: 60 000 50 000
Capital profit FV: 110 000 – Cost: 100 000 10 000
Non-capital profit Cost: 100 000 – HCA: 60 000 40 000
If the tax authorities allow an entity to deduct the cost of its asset by way of annual tax
allowances and the asset is sold, either:
a taxable recoupment of some or all of the past tax allowances could occur; or
a further tax allowance may be deducted if the tax authorities recognise a loss on the sale.
If, however, the asset is sold at more than the cost, then there will also be a capital profit. No
tax is recognised on this capital profit if it is exempt from tax. On the other hand, tax is
recognised on this capital profit if it is taxable to some degree or other.
For example, in some tax jurisdictions:

a capital profit is totally exempt from tax, in which case tax is not recognised on the
capital portion;
a capital profit is completely taxable, in which case tax is recognised on the capital
portion (i.e. the full capital portion x the income tax rate); or
a capital profit is partially exempt and partially taxable, in which case tax is recognised on
the capital portion that is taxable (i.e. the taxable capital portion x the income tax rate).
The idea is simply that the deferred tax balance should be estimated based on the tax that
would be levied if the asset were sold and bearing in mind that this sale may involve a
combination of:
a recoupment of past tax allowances (taxable) or a further allowance (deductible); and/ or
a capital gain (exempt or taxable – in full or partially).
424 Chapter 8
The impact of our intention on the deferred tax balance is best understood by way of a
comparative example: an asset where we intend to keep it and then where we intend to sell it.
Example 17: Revaluation above cost: Deferred tax: Intend to sell – short
example
A machine is revalued to C140 000 when:
its carrying amount (actual and historical) is C100 000;
it original cost was C110 000 (equal to its base cost for tax purposes);
its tax base is C100 000.
The tax rate is 30% and the inclusion rate for taxable capital gains is 50%.
The intention is to sell the asset.
Required: Show the related journal entries.
Solution 17: Revaluation above cost: deferred tax: intend to sell – short example
Comment: Since the intention is to sell the asset, the FV reflects the selling price. Since this exceeds the
cost price, there is an expected capital gain, half of which would be taxable. The measurement of the
deferred tax balance must take this into account.
Journals Debit Credit
Machine (A: carrying amt) (140 000 – 100 000) 40 000
Revaluation surplus (OCI) [(SP 140 000 – BC: 110 000) x 50% + 7 500
Deferred tax (Liability) SP, ltd to CP: 110 000 – TB: 100 000] x 30% 7 500
Deferred tax caused by the creation of the revaluation surplus: taxable
capital gain of 15 000 plus recoupment of 10 000
Workings
Asset – intention to keep CA TB TD DT Calculations
(2)
Revaluation surplus 40 000 0 (40 000) (7 500) Cr DT Dr RS
Balances after revaluation 140 000 100 000 (40 000) (7 500) Liability (3)
Historical carrying amount/ tax base 100 000 100 000 0 0 (100-100) x 30% (1)
Revaluation surplus - up to cost 10 000 0 (10 000) (3 000) (0-10) x 30% (3)
Revaluation surplus – above cost 30 000 0 (30 000) (4 500) (0-30) x 50% x 30% (3)
1) There are no temporary differences at this point since the historical carrying amount and tax base are the same,
and therefore there is no deferred tax.
2) The entire revaluation surplus of 40 000 (10 000 + 30 000) represents future profits on sale of the asset. Part of
the profit that exceeds cost price is a capital profit, part of which is exempt. The measurement of the deferred tax
balance must take this into account.
3) The deferred tax balance is calculated based on the intention to sell and the related tax legislation:
The profit on sale up to cost is a recoupment of past wear and tear and will be taxed at 30%.
The profit on sale above cost will be taxed as a capital gain: 50% of this gain x 30%
Other workings that may help you understand if you are battling:
W2: Deferred tax balance
Tax base 100 000 Recoupment: 3 000

10 000 x 30%
Taxable capital gain: 4 500
Revalued carrying amount 140 000 30 000 x 50% x 30% (see 3 above)
7 500
Chapter 8 425

W3: Proof: deferred tax using income statement approach Taxable profits Deferred tax
Capital portion
Future selling price Fair value 140 000
Cost and base cost (110 000)
Capital profit 30 000
Taxable capital profit 30 000 x 50% 15 000
Tax on capital profit 15 000 x 30% 4 500
Non-capital portion
Proceeds limited to cost 140 000 ltd to 110 000 110 000
Tax base Given (100 000)
Taxable recoupment 10 000 10 000
Tax on recoupment 40 000 x 30% 3 000
Future taxable profits and deferred tax 25 000 7 500
Example 18: Revaluation above cost: Deferred tax: Intention to sell

A machine is purchased for C100 000 on 2 January 20X1. The company:
measures it under the revaluation model and revalued it to C120 000 on 1 January 20X2
depreciates it at 25% per annum straight-line to a nil residual value
transfers the entire revaluation surplus to retained earnings on sale of the asset
uses the net replacement value method to record its revaluations
On date of revaluation (1 January 20X2), the entity’s intention is to sell the asset.
The criteria for reclassification as a non-current asset held for sale are not met.
The asset is not sold until 1 January 20X3 (for C80 000).
The tax authorities:
allow the deduction of the cost of the asset at 20% of the cost per annum.
will use a base cost of C100 000 and apply a 50% inclusion rate if sold at a capital gain.
levy income tax at 30%.
Required: Calculate the deferred tax and provide all related journal entries.
Solution 18: Revaluation above cost: deferred tax: intention to sell

Journals:
20X1 Debit Credit
2 January 20X1
Bank (A) 100 000
Purchase of machine
31 December 20X1
Depreciation – machine (E) (100 000 – 0) / 4 years x 12 / 12 25 000
Machine: acc depreciation (-A) 25 000
20X2
1 January 20X2
Machine: cost (A) 120 000 – (100 000 – 25 000) 45 000
NRVM: Revaluation of machine (increase in value)
Revaluation surplus (OCI) W1 or 10 500
Deferred tax (A) (20 000 x 15% + 25 000 x 30%) 10 500
Balance sheet based deferred tax: deferred tax on revaluation surplus
426 Chapter 8
Solution 18:Continued…
20X2 journals continued ... Debit Credit

31 December 20X2
Depreciation on machine (remember: CA = FV and RUL = 3
Deferred tax: income tax (A/L) W1 3 000
Income statement based deferred tax. Depreciation compared with tax
allowance. See W1 or see comment below.
Comment: the income statement based deferred tax adjustment in 20X2 can be easily picked up from the
deferred tax table. If, however, you are battling to understand why this adjustment is not calculated at 30%
of the temporary difference of 20 000, remember that from a profit perspective, you need to consider the
tax effect of depreciation of 40 000 in 2 parts:
a) 20 000 brings the CA down to cost (120 000 – 20 000 = 100 000).
The first 20 000 of the depreciation dropped the CA to cost, which means that the previously expected
capital profit is no longer expected to be earned and therefore the tax on the capital profit won’t be
charged either: the tax on this part of depreciation is therefore calculated at 15%: 20 000 x 15% =
3 000 (the tax on the capital profit that won’t be charged now).
b) 20 000 brings the CA below cost (100 000 – 20 000 = 80 000):
Whereas the first 20 000 of the depreciation dropped the CA down to cost, the rest of the depreciation
simply dropped the carrying amount below cost. The tax effect of this depreciation is estimated at
30% of the difference between this ‘normal depreciation’ and the tax allowance granted: (depreciation
below cost: 20 000 – tax allowance: 20 000) x 30% = 0
Journals continued …: Debit Credit

20X3
1 January 20X3
Asset disposal account (Temporary) 80 000
Sale of machine – transfer carrying amount to the disposal account
Bank (A) 80 000
Asset disposal account (Temporary) 80 000
Proceeds on sale (no profit: proceeds equalled carrying amount)
Deferred tax (L) W1 or [profit on sale: 0 – recoupment on sale: (80 000 6 000
Tax expense (E) – 60 000)] x 30% 6 000
Income statement based deferred tax.
Revaluation surplus (OCI) 45 000 – 10 500 34 500
Retained earnings (Eq) 34 500
Revaluation surplus to retained earnings on date of sale of machine
Carrying Tax Temporary Deferred Details Revaluation

Machine
amount base difference taxation surplus
O/balance: X1 0 0 0 0
Purchase 100 000 100 000 Dr DT (SOFP)
Depr/ tax deduction (25 000) (20 000) 1 500(5) Cr Tax (P/L)
C/ balance: X1 75 000 80 000 5 000 1 500(1) Asset
Cr DT (SOFP) 45 000
Reval surplus 45 000 0 (10 500)(5) Dr RS (OCI) (10 500)
Fair value 120 000 80 000 (40 000) (9 000)(2) Interim bal
(5) Dr DT (SOFP)
Depr/ tax deduction (40 000) (20 000) 3 000 Cr Tax (P/L)
C/ balance: X2 80 000 60 000 (20 000) (6 000)(3) Liability 34 500
Sale (80 000) (60 000) 6 000(5) Dr DT (SOFP) (34 500)
Cr Tax (CI)
C/ balance: X3 0 0 0 0 (4) 0
Chapter 8 427

Depreciation calculations:
20X1 = 100 000 / 4 years = 25 000
20X2 = 120 000 / 3 years = 40 000
Tax deduction calculations:

20X1 & 20X2 = 100 000 x 20% = 20 000
1) 31/12/20X1: The deferred tax balance. Whether the intention is to sell the asset or to keep the asset, the deferred
tax implications will be the same. This is because the carrying amount of the asset does not exceed the cost. The
deferred tax balance is calculated as follows:
Carrying amount 75 000 If we sell: scrapping allowance; or

If we keep: loss from normal trade 1 500
Both: 5 000 x 30%
Tax base 80 000
1 500 A
2) 1/1/20X2: The deferred tax balance (an interim balance immediately after the revaluation). Since we revalued
above cost and since the intention is to sell the asset, the capital profit is separated out: part of the increase in
carrying amount is expected to be realised through a recoupment of past allowances (taxed at 30%) and the rest
of the increase is an expected capital gain, which will be taxed at an effective rate of 15%:
Tax base 80 000

Recoupment:
(6 000)
20 000 x 30%
Capital gain: (3 000)
Revalued carrying amount 120 000 20 000 x 50% x 30%
(9 000) L
3) 31/12/20X2: The deferred tax balance. Since the intention is still to sell the asset, any expected capital profit on
sale must be separated out: part of the increase in carrying amount is expected to be realised through a
recoupment of past allowances (taxed at 30%) and any capital gain would be taxed at an effective rate of 15%.
However: now that the carrying amount has dropped below the cost, there is no expected capital profit and
therefore the deferred tax is estimated at 30% on the entire temporary difference:
Tax base 60 000

Recoupment:
(6 000)
20 000 x 30%
N/A: 0
Original cost (and base cost) 100 000 Carrying amount < Cost
(6 000) L
4) 1/1/20X3: The deferred tax balance.

Since the asset has been sold, the carrying amount and the tax base are both zero. There is thus no temporary
difference and therefore no deferred tax.
5) Deferred tax adjustments resulting from the difference between the opening and closing balances of deferred tax.
The adjustment is calculated as a balancing item (what entry is necessary to convert the opening balance into the
closing balance). A summary of the adjustments:
Deferred tax A/ (L) 31/12/20X1 1/1/20X2 31/12/20X2 1/1/20X3 Total
Closing balance 1 500 (9 000) (6 000) 0 0
Opening balance 0 1 500 (9 000) (6 000) 0
Adjustment **1 500 *(10 500) **3 000 **6 000 0
*The adjustment is the creation of a reval surplus and the contra entries are therefore: RS and DT
** These adjustments relate to the movement in the carrying amount caused by items that affected profit(e.g.
depreciation and profit on sale) and therefore, the deferred tax contra entries must all affect profit (therefore
the contra entry is tax expense): DT and TE.
428 Chapter 8
Example 19: Revaluation above cost: Deferred tax: Change in intention

We own an asset with the following characteristics:
Cost: 100 000 (this is also the base cost for capital gains tax purposes)
Fair value: 110 000 (this is the first revaluation: dated 31 December 20X3)
Carrying amount and tax base: 60 000 (on date of revaluation)
The company intention was originally to keep the asset, but on 1 January 20X4, the company changed its
intention to that of selling the asset.
The criteria for reclassification as non-current asset held for sale were not met.
The income tax rate is 30%. Only 50% of the capital gain (selling price – base cost) is taxable.
The financial year-end is 31 December.
Required: Show the deferred tax journal on 1 January 20X4 to account for the change in intention.
Solution 19: Revaluation surplus: deferred tax: change in intention
Comment: If we change our intention from one of keeping the asset to wanting to sell the asset, our
deferred tax balance will have to be reduced (because if we sell the asset, 50% of the 10 000 capital profit
is exempt from tax and will therefore save us 5 000 x 15% = 1 500)!
Journal: 01/01/20X4 Debit Credit

Deferred tax W1 1 500
Decrease in the deferred tax liability due to change in intention
W1: Deferred tax adjustment calculation C

Def. tax balance was (FV: 110 000 – TB: 60 000)x30% Credit balance 15 000
Def. tax balance must now be: (FV:110 000 – BC: 100 000) x 50% x 30% + Credit balance 13 500
(Cost: 100 000 –TB: 60 000) x 30%
Deferred tax balance to be decreased by: 1 500
4.3.3 Deferred tax on revalued assets: depreciable but non-deductible assets

If you depreciate the cost of your asset but the tax authority does not allow a deduction of the
cost of your asset by way of annual capital allowances, a temporary difference will arise
immediately on the purchase of your asset (because the carrying amount is the cost and, since
there will be no future tax deductions, the tax base will be nil).
As was explained in the previous chapter, deferred tax is

not recognised on the temporary differences resulting DT on the revaluation
surplus of a depreciable,
from this purchase since they are exempted in terms of non-deductible asset:
IAS 12.15 and 12.24. The exemption does not apply,
Intention to sell:
however, to any subsequent temporary differences
caused by a revaluation above the historical carrying - FV - Cost: Tax @ CGT rates
amount of such an asset. - Cost - CA: Exempt
Intention to keep:
If such an asset is revalued and the intention is to keep - FV - CA: Tax @ Normal rates
the asset, the revaluation surplus represents the future
profits expected from the use of the asset in excess of the profits originally expected. When
these profits are earned through use, they will be taxed at 30% and therefore deferred tax is
calculated at 30% of the entire revaluation surplus.
Where, however, the intention is to sell the asset, deferred tax should be provided on the
portion of the revaluation surplus representing the increase in value above original cost to the
extent that the capital profit is taxable under any capital gains tax legislation. If, for example,
only 50% of the capital profit is taxable, and the tax rate is 30%, then deferred tax should be
calculated as: capital gain x 50% x 30%.
Chapter 8 429
Example 20: Revaluation above cost: Deferred tax: Intention to sell:

depreciable,
non-deductible
An asset is revalued to C140 000
Its carrying amount (actual and historical) is C100 000 on date of revaluation
Its original cost was C110 000 (and the base cost is C110 000).

do not grant deductible allowances on this building and therefore its tax base is C0
tax capital gains (calculated at cost less base cost) using an inclusion rate of 50%
levy income tax at 30%.
The company intends to sell this asset but the criteria for reclassification as a non-current asset held for
sale are not met.
Required: Show the journal entries relating to the revaluation.
Solution 20: Revaluation: deferred tax: intention to sell

Comment:
This situation (a non-deductible, depreciable asset that is to be sold) is also covered in chapter 6’s
example 14: example 14 shows the calculation and disclosure of current and deferred tax.
Journals on date of revaluation: Debit Credit
Property, plant and equipment (carrying amount) 40 000


Deferred tax (Liability): see calculation below 4 500
PPE – sell: CA TB TD DT Calculations

Depreciable
Non-deductible
Balance before revaluation 100 000 0 (100 000) 0 (0-100) x 0% (1)
Revaluation surplus 40 000 0 (40 000) (4 500) Balancing adjustment
Balance after revaluation 140 000 0 140 000 (4 500) Liability (4)
Historical CA/ TB 100 000 0 (100 000) 0 (0-100) x 0% (1)
Carrying amount before revaluation
Revaluation surplus - up to cost: 10 000 0 (10 000) 0 (0-10) x 0% (2)
100 000 – 110 000
110 000 – 140 000
1) This temporary difference is exempt in terms of paragraph 15 & 24 of IAS 12.

2) This would normally reflect the tax on a recoupment, but there is no tax in this case since there can
be no recoupment on the grounds that there were no capital allowances granted.
3) This portion of the revaluation surplus represents the capital profit that would be earned if the asset
were to be sold. Of the capital gain, only 50% is taxable.
4) Notice that the deferred tax does not equal 30% of the temporary difference. This is because:
temporary differences relating to the cost were exempt in terms of IAS 12.15 &.24 and also
part of the capital profit was exempt from tax due to the capital gains tax legislation.
430 Chapter 8

Another way of explaining this deferred tax balance is as follows:
Tax base 0
NOTE 1
Recoupment: 110 000 x 0% 0
Capital gain: 30 x 50% x 30% 4 500

4 500
Note 1: this temporary difference is exempt in terms of IAS 12.15. Another way of explaining the 0%
tax rate is that there can be no recoupment because no deductions were ever granted: if there were no
previous deductions granted, no recoupment of previous deductions is possible.
Example 21: Revaluation above cost: Deferred tax: Intention to keep

depreciable,
non-deductible asset
Assume the same information given in the previous example.
Required: Show the journal entries assuming that the intention is to keep the asset.
Solution 21: Revaluation: deferred tax: intention to keep

Comment:
This is an asset that is revalued in terms of IAS 16’s revaluation model but since the asset is
depreciable, management’s real intention to keep the asset is not over-ridden by IAS 12.51B’s
presumed intention to sell (see chapter 6, section 6.4.2 for more about presumed intentions).
This situation is also covered in chapter 6’s example 12, where example 12 focuses on how the
deferred tax balance should be measured.
Property, plant and equipment (A: carrying amount) 40 000
Deferred tax (L): see calculation below 12 000

PPE – keep: CA TB TD DT Calculations
Depreciable
Non-deductible
Revaluation surplus - up to cost: 10 000 0 (10 000) (3 000) (0-10) x 30% (2)
100 000 – 110 000
Revaluation surplus – above cost 30 000 0 (30 000) (9 000) (0-30) x 30% (2)
110 000 – 140 000
1) This temporary difference is exempt in terms of paragraph 15 and 24 since the tax authorities did not allow the
deduction of tax allowances on the cost of 100.
2) The entire revaluation surplus of 40 (10 + 30) represents future profits from the use of the asset in excess of
those originally expected. Since trading profits are taxed at 30%, deferred tax of 12 (40 x 30%) must be
provided.
Chapter 8 431
3) Since the entire temporary difference relates to the revaluation surplus and since this entire revaluation surplus
represents extra profits that will be taxed at 30%, the deferred tax equals 30% of the temporary difference.
Tax base 0
Profits up to cost:
3 000
100 000 x 0% (1) + 10 000 x 30%
Original cost (and base cost) 110
Profits above cost: 9 000
Revalued carrying amount 140 30 000 x 30% (2)
12 000
1) This temporary difference is exempt in terms of paragraph 15 & 24.
4.3.4 Deferred tax on revalued assets: non-depreciable and non-deductible

If you do not depreciate the cost of your asset and the tax authority does not deduct the cost
of your asset by way of annual capital allowances, a temporary difference will immediately
arise on the purchase of your asset:
the carrying amount is the cost and yet
the tax base will be nil, since there will be no future tax deductions.
As was explained in the previous chapter, deferred tax is not recognised on the related
temporary differences since these are exempted in terms of IAS 12.15.
The exemption does not apply, however, to any further temporary differences caused by a
revaluation above the historical carrying amount.
Where an asset that is not depreciated, the carrying amount will remain at cost (unless it is
revalued). The exempt temporary difference will always be the same: carrying amount,
representing the unchanging cost, less tax base.
DT on the reval. surplus of
If this non-depreciable asset is revalued, however, then a non-depreciable, non-
deductible asset:
the carrying amount will no longer reflect cost, but a fair
value instead. The extra temporary difference caused by Always assume intention to sell:
the revaluation is not exempt from deferred tax and the - FV - Cost: Tax @ CGT rates
calculation of the related deferred tax must always be
based on an assumed intention to sell (i.e. the carrying amount is always assumed to represent
the expected selling price even if the intention is actually to keep the asset!): IAS 12.51B
since a non-depreciable asset (e.g. land) never gets ‘used up’, it is argued that it is not
possible to calculate a fair value based on future use and
therefore the fair value can only be estimated using its expected selling price.
The result is that the revaluation surplus above historical cost will be subject to deferred tax to
the extent that the capital profit is considered taxable under the capital gains tax legislation.
In summary: when dealing with non-depreciable assets: and non-deductible assets
The revaluation surplus above cost is not exempt
The deferred tax on this revaluation surplus is always based on an assumed intention to
sell, even if your stated intention is to keep the asset.
Example 22: Revaluation of land above cost: Deferred tax: Intention to keep:
non-depreciable,
non-deductible asset
A company owns land that cost C100 000. This land is not depreciated.
The land is revalued to C140 000.
The tax authorities allow no capital allowances to be deducted on this land.
Required: Show the journal entries for the revaluation assuming that the intention is to:
A sell the asset
B keep the asset.
432 Chapter 8
Solution 22: Revaluation (land): deferred tax: management’s intention to keep is

overridden by the presumed intention to sell (IAS 12.51B)
Comment:
This asset is revalued in terms of IAS 16’s revaluation model and since the asset is non-depreciable,
management’s real intention to keep the asset is over-ridden by IAS 12.51B’s presumed intention. The
deferred tax is thus measured on the presumed intention to sell the asset even though management’s real
intention is to keep the asset.
This situation is also covered in chapter 6’s example 15: example 15 shows the calculation and disclosure of
current and deferred tax.
Solution 22A: Revaluation (land): deferred tax: intention to sell

Land (cost) 40 000
Deferred tax (Asset): see calculation above 6 000
Land – sell: Carrying Tax Temp Deferred Calculations
Non-depreciable amount base difference taxation
Non-deductible
Revaluation surplus - up to cost: 0 0 0 0 (0-0) x 30% (2)
No depreciation was provided
100 000 – 140 000
1) This temporary difference is exempt in terms of paragraph 15 and 24.

2) Since there is no depreciation, no part of the revaluation surplus reflects an increase in value back up to cost.
3) Since, in the case of land, it is assumed that the fair value must represent the expected selling price (no matter
whether the company intends to keep or sell it), this revaluation surplus is treated as an expected capital
profit which would be taxed at 15% (50% x 30%).
4) Notice that the deferred tax does not equal 30% of the temporary difference since only part of the temporary
5) difference represents a capital profit, and this part is effectively taxed at 15%.
Tax base 0 Recoupment:

100 000 x 0% 0
Original cost (and base cost) 100
Capital profit: 6 000
Revalued carrying amount 140 40 000 x 50% x 30%
6 000
Solution 22B: Revaluation (land): deferred tax: intention to keep

The answer is the same as in example 22A in that we must apply IAS 12.51B. The reasoning is as follows:
Since the land is a non-depreciable asset, it is clear that the asset has an indefinite useful life.
When we revalue such an asset to fair value, we therefore have to assume that the fair value was based on
market values because it would not be humanly possible to calculate it based on its future use (indefinite).
Therefore, irrespective of our stated intention to keep the land, we need to measure deferred tax as if we are
intending to sell it (since the fair value we used would have been based on the current market price).
Chapter 8 433
5. Disclosure (IAS 16.73 – 16.79)
5.1 Overview
The disclosure of property, plant and equipment involves various aspects: accounting policies
to be included in the notes to the financial statements, disclosure in the statement of
comprehensive income, statement of financial position and the statement of changes in equity.
5.2 Accounting policies and estimates
For each class of property, plant and equipment (e.g. land, buildings, machinery, etc) the
following should be disclosed:
depreciation methods used (e.g. straight-line method);
useful lives or depreciation rates used (e.g. 5 years or 20% per annum); and
the measurement model used (cost model or revaluation model);
measurement bases used to calculate the gross carrying amount (e.g. net or gross method).
The nature and effect of a change in estimate must be disclosed in accordance with IAS 8 (the
standard governing ‘accounting policies, changes in accounting estimates and errors’).
5.3 Statement of comprehensive income and related note disclosure
The note that supports the ‘profit before tax’ line item in the statement of comprehensive
income should include the following items, disclosed per class of property, plant and
equipment (including these items in this one note helps to reduce time wastage in exams):
depreciation expense (whether in profit or loss or included in the cost of another asset);
impairment losses and the line item of the statement of comprehensive income in which it
is included, (i.e. this loss arises if the recoverable amount is less than carrying amount and
any revaluation surplus has already been written off);
reversal of impairment losses and the line item of the statement of comprehensive income
in which it is included, (i.e. this reversal arises if the recoverable amount is greater than
carrying amount, but will only reflect the increase in carrying amount up to historical
carrying amount and only if it reverses a previous impairment loss);
revaluation expense (i.e. if the fair value is less than depreciated cost and there is no
balance in the revaluation surplus account, the decrease is a revaluation expense);
revaluation income (i.e. if the fair value is greater than depreciated cost and the increase
in carrying amount up to depreciated cost reverses a previous revaluation expense);
profits or losses on the realisation, scrapping or other disposal of a non-current asset.
Where an asset is measured under the revaluation model with the result that a revaluation
surplus has been created or adjusted, this creation or adjustment to the revaluation surplus:
must be presented as a separate line item under ‘other comprehensive income’, under the
sub-heading ‘items that may never be reclassified to profit or loss’.
must be presented per class of property, plant and equipment (i.e. if there is a revaluation
surplus on machines and a revaluation surplus on plant, each of these movements in
revaluation surplus must be disclosed as separate line items).
may be shown on the face of the statement of comprehensive income either:
- after tax, with the gross and tax effects shown in a separate supporting note; or
- before tax, with the gross and tax effects shown on the face of the statement of
Any restrictions on the distribution to shareholders of a revaluation surplus must be disclosed:

this can be provided in the note supporting the other comprehensive income line item in the
statement of comprehensive income or in the property, plant and equipment note.
434 Chapter 8
5.4 Statement of financial position and related note disclosure (IAS 16 and IFRS 13)
The following is the primary information that IAS 16 requires to be disclosed in the note to
the ‘property, plant and equipment’ line item in the statement of financial position.
This information must be disclosed separately for each class of property, plant and equipment
(e.g. land, buildings, machinery, etc):
‘gross carrying amount’ and ‘accumulated depreciation and impairment losses’ at the
beginning and end of each period;
a reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable:
additions;
disposals;
depreciation;
impairment losses recognised in the statement of comprehensive income;
impairment losses reversed through the statement of comprehensive income;
increases through revaluation income;
increases in a related revaluation surplus;
decreases in a related revaluation surplus;
decreases through revaluation expense;
assets transferred to ‘non-current assets held for sale’ in accordance with IFRS 5;
other movements (e.g. currency translation differences);
the existence and amounts of restrictions on title;
the existence and amounts of assets that have been pledged as security for a liability;
the costs capitalised in respect of property, plant and equipment being constructed;
the amount of any contractual commitments to acquire assets in the future;
when the revaluation model is adopted, then disclose:
the effective date of the latest revaluation;
whether or not the valuer was independent;
the carrying amount of the property, plant and equipment had the cost model been
adopted (per class of revalued property, plant and equipment).
The standard also requires that the accumulated depreciation be disclosed (as opposed to the
aggregate of the accumulated depreciation and accumulated impairment losses that is given in
the reconciliation of the carrying amount of the asset) at the end of the period.
IFRS 13 Fair value measurement requires certain minimum disclosures relating to how the
fair value was measured (the following is a brief outline of these requirements: details are
provided in chapter 26):
If the asset is measured using the revaluation model, detailed disclosures are required in
relation to:
the valuation techniques (e.g. market, cost or income approach);
the inputs (e.g. quoted price for identical assets in an active market; an observable
price for similar assets in an active market) and whether these inputs were considered
to be level 1 inputs (most reliable) or level 3 inputs (least reliable). IFRS 13.91 and IFRS 13.93
If the asset is measured using the cost model and thus its measurement does not involve
fair value but its fair value still needs to be disclosed in the note (see further encouraged
disclosure, section 6.6 below), the required disclosures are similar but fewer. IFRS 13.97
5.5 Statement of changes in equity disclosure
If the property, plant and equipment is revalued using the revaluation model, there may be a
revaluation surplus which would need to be disclosed as follows:
increase or decrease in revaluation surplus during the period (net of tax): this will be per
the statement of comprehensive income;
realisations of revaluation surplus (e.g. transfer to retained earnings as the asset is used);
any restrictions on the distribution of the surplus to shareholders.
Chapter 8 435
5.6 Further encouraged disclosure
The following disclosure is encouraged:

the carrying amount of property, plant and equipment that is temporarily idle;
the gross amount of property, plant and equipment that is still in use but that has been
fully depreciated;
the carrying amount of property, plant and equipment that is no longer used and is to be
disposed of (but not yet classified as held for sale in accordance with IFRS 5); and
the fair value of the asset in the event that the cost model is adopted and the difference
between fair value and carrying amount is material.
5.7 Sample disclosure involving property, plant and equipment
ABC Limited
Depreciation is not provided on land and buildings since it is considered to be an investment
property. Depreciation is provided on all other property, plant and equipment over the expected
economic useful life to expected residual values using the following rates and methods:
- Plant at 10% per annum, reducing balance method.
Plant is revalued annually to fair values and is thus carried at fair value less accumulated
depreciation and impairment losses. All other property, plant and equipment is shown at cost less
accumulated depreciation and impairment losses.

20X2 20X1
Total net carrying amount: C C
Land and buildings c b
Plant f e
c+f b+e
Land and Buildings: Plant

20X2 20X1 20X2 20X1
C C C C
Net carrying amount: 1 January b a e d
Accumulated depreciation & impairment losses
Additions
(Disposals)
(Depreciation)
(Impairment loss)/ Impairment loss reversed
Revaluation increase/ (decrease) through OCI
Revaluation increase/ (decrease) through P/L
Other
Net carrying amount: 31 December c b f e
Accumulated depreciation and impairment losses
Land was revalued on 1/1/20X1, by an independent sworn appraiser, to its fair value.
The valuation technique used to determine fair value was the market approach and the inputs used
included observable prices for similar assets in an active market. All inputs are level 1 inputs.
The fair value adjustment was recorded on a net replacement value basis.
Revaluations are performed annually.
Had the cost model been adopted, the carrying amount would have been CXXX (20X0: CXXX).
Plant is provided as security for a loan (see note 15: loans).
436 Chapter 8
ABC Limited
Notes to the financial statements Continued ...
27. Profit before tax 20X2 20X1

C C
Profit before tax is stated after taking the following into account:
Revaluation expense (income) on plant
Impairment losses (reversals of losses) on plant
20X2 20X1
28. Other Comprehensive Income: Revaluation Surplus: PPE C C
Increase/ (decrease) in revaluation surplus before tax

Deferred tax on increase/ (decrease) in revaluation surplus
Increase/ (decrease) in revaluation surplus, net of tax
There are no restrictions on the transfer of this revaluation surplus to shareholders.
ABC Limited
20X2 20X1
... Note C C
Profit for the year 27
Other comprehensive income for the year
- Revaluation surplus, net of tax: Property, plant and equipment 28
Total comprehensive income for the year
ABC Limited
Revaluation Retained Total
surplus: PPE earnings
C C C
Balance at 1 January 20X1
Total comprehensive income
Realised portion transferred to retained earnings
Balance at 31 Dec 20X1
Total comprehensive income
Realised portion transferred to retained earnings
Balance at 31 December 20X2
ABC Limited
20X2 20X1
ASSETS Note C C
Non-current Assets
Property, plant and equipment 4
Chapter 8 437
Example 23: Revaluation model disclosure

Depreciation: 20% straight-line per annum to a nil residual value
The company revalues its plant on an annual basis and records the fair value adjustments using the net
replacement value basis. The following revaluations were performed:
Fair value at 1/1/20X2 is C90 000
The fair values were all measured using the income approach and inputs included inputs based on market
expectations of future net cash inflows from the use of the asset. All inputs are level one inputs.
Revaluation surplus is recognised in retained earnings over the useful life of the plant.
There are no other items of property, plant or equipment.

Profit for each year is C100 000 (after tax).
There are no components of other comprehensive income other than that which is evident from the
information provided.
Required:
A. Disclose the plant and all related information in the financial statements for the years ended
31 December 20X1, 20X2, 20X3 and 20X4 in accordance with IAS 16 and IFRS 13.91(a).
B. Repeat the journals (using the net replacement value method) and show all additional or revised
related disclosure assuming that:
Deductible allowance (wear and tear) granted by the tax authorities 20% straight-line p.a.
Income tax rate 30%
The company intends to keep the plant.
There are no other temporary differences other than those evident in the information provided.
Other comprehensive income is presented net of tax in the statement of comprehensive income.
C. Assume the information given in B above except that the company presents other comprehensive
income gross and net on the face of the statement of comprehensive income. Show how the
disclosure would change.
Solution 23A: Revaluation model disclosure - no deferred tax
The journals for part A may be found under examples 10, 11 and 12.
ABC Limited
20X4 20X3 20X2 20X1
C C C C
Plant is revalued annually to fair values and is thus carried at fair value less accumulated depreciation
and impairment losses.
Depreciation is provided on all property, plant and equipment over the expected economic useful life
to expected residual values using the following rates and methods:
Plant: 20% per annum, straight-line method.
438 Chapter 8
ABC Limited
For the year ended 31 December 20X4 (extracts) continued …
20X4 20X3 20X2 20X1
12. Property, plant & equipment (extract) C C C C
Plant
Net carrying amount: 1 January 36 000 67 500 80 000
Gross carrying amount: 54 000 90 000 100 000 0
Accum. deprec. and impairment losses (18 000) (22 500) (20 000) 0
Additions 0 0 0 100 000
Depreciation (22 000) (18 000) (22 500) (20 000)
Revaluation surplus increase/ (decrease) 4 000 (7 500) 10 000 0
Revaluation income/ (expense) 4 000 (6 000) 0 0
Net carrying amount: 31 December 22 000 36 000 67 500 80 000
Gross carrying amount: 44 000 54 000 90 000 100 000
Accum. deprec. and impairment losses (22 000) (18 000) (22 500) (20 000)
The last revaluation was performed on 1/1/20X4 by an independent sworn appraiser to its fair value.
The valuation technique used to determine fair value was the income approach, where the inputs
included the market expectations regarding discounted future cash flows. All inputs are level 1
inputs. The fair value adjustment was recorded on a net replacement value basis. Revaluations are
performed annually.
Carrying amount if the cost model was used: 20 000 40 000 60 000 80 000
Depreciation on plant 22 000 18 000 22 500 20 000
Revaluation expense 0 6 000 0 0
Revaluation income (4 000) 0 0 0
33. Other Comprehensive Income : Revaluation Surplus: Property, plant and equipment
Increase/ (decrease) in revaluation surplus 4 000 (7 500) 10 000 0

Deferred tax on increase/ (decrease) N/A* N/A* N/A* 0
Revaluation surplus movement, net of tax 4 000 (7 500) 10 000 0
There are no restrictions on the distribution of this revaluation surplus to shareholders.
*: Part A ignores tax.
ABC Ltd
Notes 20X4 20X3 20X2 20X1
C C C C
Profit for the period 100 000 100 000 100 000 100 000
Other comprehensive income for the period 4 000 (7 500) 10 000 0
Items that may not be reclassified to profit/loss
Revaluation surplus increase/
33 4 000 (7 500) 10 000 0
(decrease), net of tax: PPE
Total comprehensive income for the period 104 000 92 500 110 000 100 000
Chapter 8 439
ABC Ltd
C C C
Balance at 1 January 20X1 0 X X
Total comprehensive income 0 100 000 100 000
Balance at 31 December 20X1 0 X X
Realised portion transferred to retained earnings (2 500) 2 500
Balance at 31 December 20X2 7 500 X X
Total comprehensive income (7 500) 100 000 92 500
Realised portion transferred to retained earnings (2 000) 2 000
ABC Ltd
20X4 20X3 20X2 20X1
ASSETS Note C C C C
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000
Revaluation surplus (from SOCIE) 2 000 0 7 500 0
Solution 23B: Revaluation model disclosure - with deferred tax

Journals Dr/ (Cr)
1/1/20X1
Bank/ Loan (A/L) (100 000)
Purchase of asset
31/12/20X1
Plant: accumulated depreciation (-A) (20 000)
Depreciation
1/1/20X2:
Plant: cost (A) (20 000)
NRVM: set-off of accumulated depreciation before revaluing asset
Plant: cost (A) W1 10 000
Revaluation surplus (OCI) (10 000)
NRVM: revaluation of asset
Revaluation surplus (OCI) W1 3 000
Deferred tax (L) (3 000)
Deferred tax on revaluation of asset
440 Chapter 8
Journals Continued ... Dr/ (Cr)
31/12/20X2:
Revaluation surplus (OCI) (7 000 / 4 years remaining) or (22 500 revalued depreciatio 1 750
Retained earnings (Equity) – 20 000 historic depreciation) x 70% (1 750)
Artificial decrease in after-tax profits reversed: (31/12/20X2)
Deferred tax (L is reduced) W1 750
Taxation (E) (750)
Depreciation versus tax deductible allowance: (31/12/20X2)
1/1/20X3
Revaluation surplus (OCI) W1: balance in revaluation surplus 7 500
Revaluation expense (E) W1: (13 500 - 7 500) 6 000
Plant: cost (A) 67 500 -54 000 (13 500)
Devaluation of plant to fair value
Deferred tax (L is reduced) W1; or 7 500 x 30% 2 250
Revaluation surplus (OCI) (2 250)
Deferred tax on reversal of equity:
Deferred tax (A) W1 1 200
Tax expense (E) (1 200)
Depreciation & impairment loss versus tax deductible allowance
1/1/20X4
Plant: cost (A) 36 000 – 44 000 8 000
Revaluation income (I) W1: up to historical carrying amount (4 000)
Revaluation surplus (OCI) W1: above historical carrying amount (4 000)
Revaluation to an increased fair value
Revaluation surplus (OCI) W1; or 4 000 x 30% 1 200
Deferred taxation (A is reduced) (1 200)
Deferred tax on revaluation surplus
31/12/20X4
Revaluation surplus (OCI) (2 800) / 2 years; OR (22 000 revalued depreciation – 1 400
Retained earnings (Equity) 20 000 historic depreciation) x 70% (1 400)
Artificial decrease in after-tax profits reversed
Tax expense (E) W1: 1 200 - 600 600
Deferred tax (L) (600)
Depreciation & impairment loss reversed versus tax deductible allowance:
Chapter 8 441
Disclosure:
ABC Ltd
20X4 20X3 20X2 20X1
ASSETS Note C C C C
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000
Equity
Revaluation surplus (from SOCIE) 7 1400 0 5 250 0
ABC Ltd
Notes 20X4 20X3 20X2 20X1
C C C C
Other comprehensive income 2 800 (5 250) 7 000 0
Items that may not be reclassified to profit/loss
Revaluation surplus increase / 7 2 800 (5 250) 7 000 0
(decrease), net of tax: PPE
Total comprehensive income 102 800 94 750 107 000 100 000
ABC Ltd
C C C
Balance at 1 January 20X1 0 X X
Total comprehensive income 0 100 000 100 000
Realised portion transferred to retained earnings (1 750) 1 750 0
Total comprehensive income (5 250) 100 000 94 750
Realised portion transferred to retained earnings (1 400) 1 400 0
442 Chapter 8
ABC Limited
20X4 20X3 20X2 20X1
4. Deferred taxation asset/ (liability) C C C C
The deferred taxation balance comprises:
Property, plant and equipment (600) 1 200 (2 250) 0
(600) 1 200 (2 250) 0
Reconciliation:
Opening balance 1 200 (2 250) 0 0
Deferred tax: charged to profit or loss (600) 1 200 750 0
Deferred tax: other comprehensive income (1 200) 2 250 (3 000) 0
Closing balance (600) 1 200 (2 250) 0
6. Income tax expense/ (income)

current X X X X
deferred 600 (1 200) (750) 0
7. Other comprehensive income: Revaluation surplus: Property, plant and equipment

Increase/ (decrease) in revaluation surplus 4 000 (7 500) 10 000 0
Deferred tax on increase/ (decrease) (1 200) 2 250 (3 000) 0
Movement in revaluation surplus, net of tax 2 800 (5 250) 7 000 0
There are no restrictions on the distribution of this revaluation surplus to shareholders.
Workings
W1: Deferred tax calculation:
Carrying Tax Temp Deferred Details Revaluation
Plant
amount base diff taxation surplus
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000 0 0
Depreciation 1 (20 000) (20 000) 0 0
Balance: 31/12/20X1 80 000 80 000 0 0
Revaluation surplus 10 000 0 (10 000) (3 000) Cr DT (SOFP) (10 000)
(equity increase) Dr RS (OCI) 3 000
Fair value 90 000 80 000 (7 000)
Depreciation 2 (22 500) (20 000) 2 500 750 Dr DT (SOFP) 1 750
Cr TE (P/L)
Balance: 31/12/20X2 67 500 60 000 (7 500) (2 250) Liability (5 250)
Revaluation surplus (7 500) 0 7 500 2 250 Dr DT (SOFP) 7 500
(equity decrease) Cr RS (OCI) (2 250)
Depreciated cost: HCA 60 000 60 000 0 0
Revaluation expense (6 000) 0 6 000 Dr DT (SOFP)
1 200
Fair value 54 000 60 000 Cr TE (P/L)
Depreciation 3 (18 000) (20 000) (2 000)
Balance: 31/12/20X3 36 000 40 000 4 000 1 200 Asset 0
Revaluation income 4 000 0 (4 000) (1 200) Cr DT (SOFP)
Dr TE (P/L)
Depreciated cost: HCA 40 000 40 000
Revaluation surplus 4 000 0 (4 000) (1 200) Cr DT (SOFP) (4 000)
(equity increase) Dr RS (OCI) 1 200
Fair value 44 000 40 000 2 800
Depreciation 4 (22 000) (20 000) 2 000 600 Dr DT (SOFP) (1 400)
Cr TE (SOCI)
Balance: 31/12/20X4 22 000 20 000 (2 000) (600) Liability 1 400
Chapter 8 443
Calculations:
(1) Depreciation 20X1 (100 000/ 5 years)
Solution 23C: Revaluation model disclosure – with deferred tax
Comment: the only difference between Part C and Part B is that other comprehensive income is shown
gross (i.e. before tax) and net of tax. Such disclosure on the face of the statement of comprehensive
income is shown below. Since the disclosure on the face is so detailed, the note entitled ‘tax on other
comprehensive income’ (see 23B, note number 7) is no longer required. The journals and workings for
Part C are identical to those in Part B. There are no other changes to the required disclosure.
ABC Ltd
Notes 20X4 20X3 20X2 20X1
C C C C
Other comprehensive income for the period 2 800 (5 250) 7 000 0

Items that may never be reclassified to profit/loss
Revaluation surplus increase/ (decrease) on 4 000 (7 500) 10 000 0
property, plant and equipment, before tax
Taxation effect of revaluation surplus 7 (1 200) 2 250 (3 000) 0
increase/ (decrease)
Total comprehensive income for the period 102 800 94 750 107 000 100 000
444 Chapter 8
6. Summary
Measurement models
Cost model (explained in Ch 7) Revaluation model (explained in Ch 8)

Measurement of the carrying amount: Measurement of the carrying amount:
cost fair value on date of revaluation
less accumulated depreciation less subsequent accumulated depreciation
less accumulated impairment losses less subsequent accumulated impairment
losses
The rule: The rule:
an asset may be written down below HCA, but the asset may be valued at its fair value (if
may never be revalued above its HCA greater/ less than its HCA)
Increase in CA: previous impairment reversed Increase in CA:

debit asset; debit asset (FV – ACA);
credit reversal of impairment loss (I) credit income (to extent reverses
limited to the carrying amount that it would previous decrease: HCA – ACA)
have had had there never been an impairment credit revaluation surplus (FV – HCA)
loss (i.e. its historical carrying amount)
Decrease in CA: impairment Decrease in CA:

debit impairment loss (E); credit asset (FV – ACA);
credit asset debit RS (to extent reverses previous
increases: ACA – HCA)
debit expense (HCA - FV)
The revaluation surplus:

transferred annually to retained earnings
(amount transferred equals after tax
effect on profits as a result of increased
depreciation); OR
transferred to retained earnings when
the asset is fully depreciated; OR
transferred to retained earnings when
the asset is disposed of.
Revaluation model: deferred tax
Depreciable Depreciable Non-depreciable

Deductible Non-deductible Non-deductible
Intention to keep: Intention to keep: Intention to keep:
TDs x 30% Split TDs as follows: Measure DT as if your
- Up to HCA: @ 0% intention was to sell
(because exempt)
- Up to Cost: @30%
- Above cost: @ 30%
Intention to sell: Intention to sell: Intention to sell:
Split TDs as follows: Split TDs as follows: Split TDs as follows:
- Up to cost: - Up to cost: - Up to cost:
@ 30% @ 0% (exempt) @ 0% (exempt)
- Above cost: - Above cost: - Above cost:
@ 50% x 30% @ 50% x 30% @ 50% x 30%
Chapter 8 445
Disclosure (main points only)
Accounting policies
depreciation methods
rates (or useful lives)
cost or revaluation model
Statement of Statement of Statement of

comprehensive income changes in equity financial position
Depreciation Increase or decrease in RS Reconciliation between
Impairment losses Tax effect of creation or opening and closing
Reversals of impairments increase in RS balances
Revaluation expense Transfers from RS to RE Break-down of these
Revaluation income Any restrictions on balances into gross
distributions to carrying amount and
shareholders accum. depreciation and
impairment losses
If revaluation model, also
show:
- CA using cost model
- Valuation technique
and inputs used for
FV measurement
- Effective date of
revaluation
- Valuer independent
- Reversal of RS
- Imp. loss expensed
- Increase in/
creation of RS
- Reversal of imp. loss
If cost model used:
- the FV may have to
be disclosed in note.
Certain IFRS 13 disclosure
446 Chapter 8
Gripping GAAP Intangible assets
Chapter 9
Intangible Assets
Reference: IAS 38, IAS 36, IFRS 13, IFRS 3, IAS 1 & SIC 32 (incl. amendments to 10 December 2014)
Contents: Page
1. Introduction 449
2. Scope 449
3. Recognition and initial measurement 449
3.1 Overview 449
3.2 Recognition 449
3.2.1 Overview 449
3.2.2 Definition 449
3.2.3 Recognition criteria 450
3.3 Initial measurement 450
3.3.1 Overview 450
3.3.2 Purchase price 450
3.3.3 Directly attributable costs 450
Example 1: Recognition and initial measurement 451
3.4 Difficulties in meeting the definition of intangible assets 452
3.4.1 The item must be without physical substance 452
Example 2: Physical substance and a fishing licence 452
Example 3: Physical substance and software 452
Example 4: Physical substance and a prototype 452
3.4.2 The item must be identifiable 453
Example 5: Identifiability 453
Example 6: Identifiability in a business combination 454
3.4.3 The item must be controllable 454
Example 7: Control 454
3.5 Recognition and initial measurement depending on the method of acquisition 455
3.5.1 Overview of the methods of acquisition 455
3.5.2 The effect of the method of acquisition on the initial measurement 455
3.5.3 Intangible assets acquired through a separate purchase 455
3.5.3.1 Recognition 455
3.5.3.2 Initial measurement 456
3.5.4 Intangible assets acquired through an exchange of assets 456
3.5.5 Intangible assets acquired by government grant 456
3.5.6 Intangible assets acquired in a business combination 457
Example 8: Intangible asset acquired in a business combination 458
3.5.7 Intangible items that are internally generated 459
3.5.7.2 Internally generated goodwill 459
3.5.7.3 Internally generated intangible items other than goodwill 460
3.5.7.3.1 Overview of issues regarding recognition 460
3.5.7.3.2 Certain internally generated items are banned from 460
being capitalised 460
3.5.7.3.3 The stages of internal generation 460
3.5.7.3.4 Recognition of costs in the research phase 461
3.5.7.3.5 Recognition and measurement of costs in the
development phase 461
Example 9: Research and development costs 463
3.5.7.3.6 In-process research and development that is purchased 464
Example 10: In-process research and development 464
3.5.7.4 Web site costs 465
Chapter 9 447
Contents: Page
4. Recognition of subsequent expenditure 466
5. Subsequent measurement: amortisation and impairment testing 466
5.1 Overview 466
5.2 Amortisation 467
5.2.1 Overview 467
5.2.2 Residual value and the depreciable amount 467
5.2.3 Period of amortisation 468
Example 11: Amortisation period and renewable rights 468
5.2.4 Method of amortisation 469
5.2.5 Annual review 470
5.3 Impairment testing 470
5.3.1 Overview 470
5.3.2 Impairment testing of intangible assets with finite useful lives 471
5.3.3 Impairment testing of intangible assets with indefinite useful lives 471
Example 12: Impairment test of an indefinite useful life intangible asset 471
5.3.4 Impairment testing of intangible assets not yet available for use 472
5.3.5 Reversing an impairment 473
Example 13:Impairments and reversals of an asset not yet available for use 473
6. Subsequent measurement: the two models 474
6.1 Overview 474
6.2 Cost model 474
6.3 Revaluation model 475
7. Derecognition 476
8. Disclosure 477
8.1 General 477
8.2 Sample disclosure involving intangible assets (excluding goodwill) 478
9. Goodwill 480
9.1 Overview 480
9.2 Internally generated goodwill 480
9.3 Purchased goodwill 481
9.3.1 Positive goodwill: asset 481
Example 14: Positive purchased goodwill: asset 481
9.3.2 Negative goodwill: income 481
Example 15: Negative purchased goodwill: income 482
9.3.3 Initial recognition measured provisionally 482
Example 16: Provisional accounting of fair values 482
9.3.4 Adjustment in the initial accounting 483
9.3.5 Subsequent measurement of purchased goodwill 483
9.4 Disclosure of goodwill 484
9.4.1 Disclosure: positive goodwill: asset 484
9.4.2 Disclosure: negative goodwill: income 484
9.4.3 Sample disclosure involving goodwill 484
10. Black Economic Empowerment (BEE) transactions 485
Example 17: BEE equity credentials 485
11. Summary 486
448 Chapter 9
1. Introduction
The Oxford dictionary defines intangible as something that is ‘unable to be touched’. Thus
this chapter is simply about assets that have no physical substance. A few examples of items
without physical substance include, inter alia, research and development costs, software,
patents, trademarks, copyrights, brands, licences and training.
Intangible assets are interesting in that, although we may know they exist, the fact that we
can’t see or touch them can sometimes make it difficult to prove they exist, in which case we
will not be able to recognise them as asset and thus any costs related to the invisible asset will
have to be expensed instead.
2. Scope
The standard on intangible assets (IAS 38) covers all intangible assets unless the asset:
is covered by another accounting standard, for example, intangible assets that are:
- inventories, deferred tax assets, leases, goodwill arising from a business combination,
employee benefits, non-current assets held for sale, assets arising from contracts with
customers that are recognised in accordance with IFRS 15 and financial assets as
defined in IAS 32 Financial instruments: presentation;
relates to mineral rights and expenditure on the exploration for and evaluation of, or
development and extraction of non-regenerative resources such as minerals and oils.
3. Recognition and Initial Measurement (IAS 38.18 - .71)
3.1 Overview
Before an intangible asset may be recognised, it must meet both:

the definition of an intangible asset; and
If the item meets the definition and recognition criteria of an intangible asset, it must be
recognised as an asset. This means we will need to process a journal entry and thus we will
need an amount to recognise it at. This is referred to as its initial measurement. Initial
measurement is always at cost.
There are some interesting difficulties that arise during the

Recognition:
recognition and initial measurement of intangible assets.
These difficulties arise due to the nature of intangible assets Recognise as an IA if it meets the:
and can be compounded by the manner in which the asset is definition of IA (includes asset
acquired. def.)
See IAS 38.18
recognition criteria.
We will first discuss the recognition requirements and the
initial measurement of intangible assets in general. After that
we will discuss the general difficulties in meeting the Initial measurement:
definition and then consider the various peculiarities that
arise depending on the method of acquisition. at cost. See IAS 38.24
.
3.2 Recognition (IAS 38.18-.23)
3.2.1 Overview
An item may only be recognised as an intangible asset if it meets the:

definition of an intangible asset and
the recognition criteria. See IAS 38.18
Chapter 9 449
3.2.2 Definition Both definition and recognition

criteria must be met:
An intangible asset is defined as an identifiable, non-
monetary asset without physical substance. IAS 38.8 IA definition
identifiable
The intangible asset definition refers to the word asset non-monetary
and thus, for an item to meet the intangible asset asset:
definition means it must also meet the asset definition. - a resource controlled by the entity
- as a result of past events
Due to the nature of intangible assets, there may be - from which an inflow of FEB are
expected
difficulties in meeting this definition, for example:
without physical substance. Reworded IAS 38.8
if we cannot touch it or see it,
- how can we say the asset is identifiable? IA recognition criteria
- how can we prove that we control an asset? the expected inflow of FEB are probable
(P.S. the asset definition requires control) the cost is reliably measured. See IAS 38.21
we may also have difficulty in deciding whether or not the asset has physical substance
(interestingly, this is not always as obvious as it may seem!).
3.2.3 Recognition criteria
The recognition criteria provided in IAS 38 are the same as those provided in the CF:
the expected inflow of FEB from the asset must be probable; and
the cost must be reliably measured.
The nature of intangible assets can also lead to difficulties in meeting the recognition criteria.
Possibly the greatest difficulty would be in proving that the cost of the asset is ‘reliably
measurable’. Consider the following: a reliable measure is obviously possible if the intangible
asset was the only asset purchased as part of a purchase transaction. However, if an intangible
asset was purchased as part of a group of assets, for example, the purchase price would reflect
the cost of the group of assets. In such a case we would need to be able to prove that we can
reliably measure the portion of the cost that should be allocated to the intangible asset included
in this group of assets. To be able to reliably measure the portion of the cost that should be
allocated to an invisible asset is way more difficult than measuring it for an asset we can see.
3.3 Initial measurement (IAS 38.24 - .32)
3.3.1 Overview
Cost includes:
Intangible assets are initially measured at cost. See IAS 38.24
purchase price and
This cost can be broken down into: directly attributable costs. See IAS 38.27
the purchase price; and - those that are necessary to
- bring the asset to a condition that
any directly attributable costs. See IAS 38.27 - enables it to be used in the manner
management intended. See IAS 38.31
3.3.2 Purchase price (IAS 38.27 & .32)
The purchase price must be calculated after: Spot the difference!

deducting: discounts, rebates, refundable taxes and interest
included due to the payment being deferred beyond normal Costs capitalised to PPE
credit terms; include:
adding: import duties and non-refundable taxes. Purchase price
Directly attributable costs
3.3.3 Directly attributable costs Future costs of dismantling,
removal and site restoration.
Costs are considered to be directly attributable costs, if: Ans: The third bullet doesn’t apply to IAs.
they were necessary

to bring the asset to a condition that enables it to be used as intended by management.
See IAS 38.30-.31
450 Chapter 9
The fact that the costs must be necessary means that any income and expenses arising from
incidental operations occurring before or during the development or acquisition of an
intangible asset may not be included in the cost of the asset (i.e. they may not be recognised
as part of the asset – they must be recognised in profit or loss instead). IAS 38.31
The fact that the only costs that may be capitalised are those that bring the asset to a particular
condition that enables it to be used as management intended means that capitalisation of costs
must cease as soon as the asset has been brought to Quick! Do this…
that condition. IAS 38.30
Compare the list of examples of
IAS 38 lists examples of directly attributable costs: directly attributable costs in
IAS 38 with the list of examples of directly
a) cost of employee benefits arising directly from attributable costs in IAS 16 (see chp 7
bringing the asset to its working condition; section 4.3.2). See if you can explain why
b) professional fees arising directly from bringing the these differences exist.
asset to its working condition; and Ans: The directly attributable costs that apply to PPE include a few
extra examples that cannot apply to IAs due to the nature of IAs (e.g.
c) cost of testing whether the asset is functioning it is impossible to install an IA and thus the list of directly attributable
properly. costs given in IAS 38 does not include ‘installation costs’).
Example 1: Recognition and initial measurement

On 30 June 20X4, Bee Limited discovered that it had been manufacturing a product
illegally since this product happened to be a patented product for which it did not have the
necessary rights. Bee immediately shut down its factory and hired a firm of lawyers to act on its behalf
in the acquisition of the necessary rights to manufacture this patented product.
Legal fees of C50 000 were incurred during July 20X4.
The legal process was finalised on 31 July 20X4, when Bee was then required to pay C800 000 to
purchase the rights, including C80 000 in refundable VAT.
During the July factory shut-down:
- overhead costs of C40 000 were incurred; and
- significant market share was lost with the result that Bee’s total sales over August and
September was C20 000 but its expenses were C50 000, resulting in a loss of C30 000.
To increase market share, Bee spent an extra C25 000 aggressively marketing their product. This
marketing campaign was successful, resulting in sales returning to profitable levels in October.
The accountant wishes to capitalise the cost of the patent at:
Purchase price: C800 000 + Legal fees: C50 000 + Overheads during the forced shut-down in July:
C40 000 + Operating loss in Aug & Sept: C30 000 + Extra marketing required: C25 000 = C 945 000
Required: Briefly explain whether or not each of the costs identified may be capitalised.
Solution 1: Recognition and initial measurement

Calculations C
Purchase price: The purchase price should be capitalised, 800 000 – 80 000 720 000
but this must exclude refundable taxes.
Legal costs: This is a directly attributable cost. Directly Given 50 000
attributable costs must be capitalised.
Overhead costs: This is an incidental cost not necessary to Incidental costs may -
the acquisition of the rights (the shut-down was only not be capitalised
necessary because Bee had been operating illegally).
Operating loss: The operating loss incurred while demand Costs incurred after the -
for the product increased to its normal level is an example IA is available for use
of a cost that was incurred after the rights were acquired. may not be capitalised
Advertising campaign: The extra advertising incurred in Costs incurred after the -
order to recover market share is an example of a cost that IA is available for use
was incurred after the rights were acquired. Furthermore, may not be capitalised
advertising costs are listed in IAS 38 as one of the costs
that may never be capitalised as an intangible asset.
770 000
Chapter 9 451
IAS 38 also includes a list of examples that may never be capitalised to the cost of an
intangible asset. These include costs related to:
a) introducing a new product or service (including advertising or promotions);
b) conducting business in a new area or with a new class of customer (including staff
training); and
c) administration and other general overheads. Reworded from IAS 38.29
3.4 Difficulties in meeting the definition of intangible assets
3.4.1 The item must have no physical substance (IAS 38.4 - .7)
Costs are frequently incurred on items that have both intangible

and tangible aspects. This requires us to use our judgment to No physical substance
assess which element is more significant: the tangible
(physical) or the intangible (non-physical) aspects. The If the item has physical and
standard that should be applied to the asset depends on which non-physical aspects:
aspect is the most significant, either: apply IAS 38 or IAS 16
depending on which aspect is
IAS 38 Intangible Assets; or more significant.
IAS 16 Property, Plant and Equipment or another
We use judgement to make this
appropriate standard. assessment.
Example 2: Physical substance and a fishing licence

Dee Limited acquired a fishing licence. The directors insist that it is a physical asset since it
is written on a piece of paper.
Required: Briefly explain whether or not Dee should recognise the licence as an intangible asset.
Solution 2: Physical substance and a fishing licence

Although the fishing licence has a physical form (the related legal documentation), the licence is
considered intangible rather than tangible since the most significant aspect is the licensed ‘ability’ to
fish rather than the physical proof thereof. Such a right (whether documented or not) is always
considered to be intangible.
Example 3: Physical substance and software

Fee Limited acquired a machine that incorporates specialised software that monitors core
functions necessary in the operation of the machine and enables product design and
manages output quantity and quality.
Required: Briefly explain whether or not Fee should recognise the software as an intangible asset.
Solution 3: Physical substance and software

The most significant element would be the tangible machine. Since the software is integral to the
machine (i.e. it is not stand-alone software, but is software that has been designed specifically to enable
the operation of this machine), the cost of the software would be recognised as part of the machine and
thus accounted for as property, plant and equipment (IAS 16). However, if the software was ‘stand-
alone’ software (i.e. the software could be used on a different platform and the machine could operate
without it, e.g. the software simply enhanced its operations), it would have been accounted for as an
intangible asset (IAS 38).
Example 4: Physical substance and a prototype

Gee Limited has been researching and developing a wallet that is electronically connected
to one’s bank balance. The wallet is programmed to scream if you try to remove a credit
card when the related bank balance has reached a certain limit. If you insist on removing the cash from
the wallet despite the scream, the wallet phones the owner’s parent or partner in order to ‘get help’. Gee
has managed to create the first working prototype for this wallet.
Required: Briefly explain whether Gee should recognise the cost of the prototype as an intangible asset.
452 Chapter 9
Solution 4: Physical substance and a prototype

Research and development is the pursuit of knowledge with the ultimate goal being to create a product
that can be produced and sold. Thus, although a prototype has a physical form, it is essentially the
culmination of these years of research and development, and thus is more the embodiment of
knowledge than the mere physical parts making up its physical form. Thus the prototype must be
accounted for as an intangible asset (IAS 38).
3.4.2 The item must be identifiable (IAS 38.11 - .12)
An important aspect of the definition of an intangible asset Identifiable: an item is

is that the asset must be identifiable. Assets that are not identifiable if it:
identifiable are accounted for as goodwill instead.
is separable; or
There are two kinds of goodwill: arises from legal rights.
See IAS 38.12
Acquired goodwill, which is recognised an asset: it arises during business combinations

and represents the synergies of all those assets that were acquired but which were not
separately identifiable and thus not able to be separately recognised.
Internally generated goodwill, which is recognised as an expense: it also refers to the
synergies from a group of assets but the costs involved in creating internally generated
goodwill are so similar to the general running costs of a business, that they are expensed.
If one cannot prove that the asset is identifiable it must not be recognised as a separate asset.
It would thus be included with goodwill (i.e. recognised as part of the acquired goodwill asset
or recognised as an expense if related to internally generated goodwill). Acquired goodwill is
not covered by the standard on ‘intangible assets’ (IAS 38) but rather by the standard on
‘business combinations’ (IFRS 3). However, since acquired goodwill is closely linked to
intangible assets, it is discussed later in this chapter (see section 9).
An asset is identifiable if either it: If it is not identifiable:

is separable or
arises from contractual or other legal rights. See IAS 38.12 it is not an IA
it is goodwill.
For something to be separable, it must be: Goodwill: is not an intangible asset
capable of being because it is not identifiable.
- separated or divided from the entity, and
- sold, transferred, licensed, rented or exchanged,
- either individually or together with a related contract, asset or liability,
regardless of whether the entity intends to do so or not. IAS 38.12(a)
Even if the asset is not separable, identifiability can still be proved through the existence of
contractual or other legal rights. These rights must be considered even if they are:
not transferrable or separable
from the entity or from other rights and obligations. IAS 38.12 (b)
Example 5: Identifiability
Guff Limited incurred C300 000 on a massive marketing campaign to promote a new
product. The accountant wishes to capitalise these costs.
Required: Briefly explain whether these costs are considered to be identifiable or not.
Solution 5: Identifiability
The cost of the advertising campaign is not separable as it cannot be separated from the entity and sold,
transferred, rented or exchanged etcetera.
Furthermore, the advertising campaign does not arise from contractual or legal rights.
Thus the cost of the advertising campaign is not identifiable. Even if the other aspects of the definition
and recognition criteria are met, the advertising costs may not be recognised as an intangible asset: they
create internally generated goodwill and must thus be expensed.
Chapter 9 453
Example 6: Identifiability in a business combination

Haw Limited acquired valuable business rights when it acquired Hee Limited.
These rights, valued at C900 000, were acquired by Hee Limited as part of a contract
that was awarded to it by the local government.
Contractual terms stipulate that they belong exclusively to Hee Limited and may not be
transferred in any way to another entity.
Required: Briefly explain whether these costs are considered to be identifiable or not.
Solution 6: Identifiability in a business combination

The business rights are not separable since the contract expressly states that the rights may not be
transferred by Hee Limited to another entity. However, identifiability of an asset does not require it to
be separable – it can also be proved if it arises from contractual or legal rights. Thus, since the
business rights were awarded by way of a contract, they are contractual rights and are thus considered
to be identifiable. If the other aspects of the definition and the recognition criteria are met, these rights
will be recognised as a separate intangible asset.
3.4.3 The item must be controllable (IAS 38.13 - .16)
The definition of an ‘intangible asset’ includes the definition of an asset and thus the definition
of an ‘asset’ must also be met: the intangible asset must be controlled by the entity as a result
of a past event and must result in an expected inflow of future economic benefits (either
through increased revenue or decreased costs). Control
We must be able to control the
Control over an intangible asset is difficult to prove, but it asset’s FEB:
may be achieved if the entity has:
We control the FEB if we:
the ability to restrict accessibility to others of the
asset’s future economic benefits; and can restrict access to the FEB; &
the power to obtain the asset’s future economic have the power to obtain the FEB.
See IAS 38.13
benefits. See IAS 38.13
Legal rights: are useful when trying to
An asset’s future economic benefits can be controlled prove control but are not necessary!
through legally enforceable rights (e.g. copyright) but
legal rights are not necessary to prove control: it is just more difficult to prove that control
exists if legal rights do not exist. See IAS 38.13
For example, an entity may be able to identify a team of skilled staff, a portfolio of customers,
market share or technical knowledge that will give rise to future economic benefits. However,
the lack of control over the flow of future economic benefits means that these items seldom
meet the definition of an intangible asset. On the other hand, control over technical knowledge
and market knowledge may be protected by legal rights such as copyrights and restraint of
trade agreements, in which case these would meet the requirement of control.
Example 7: Control
Awe Limited incurred C200 000 on specialised training to a core team of employees. The
accountant wishes to capitalise these costs.
Required: Briefly explain whether these costs could possibly be recognised as an asset.
Solution 7: Control
Even if this training can be linked to an expected increase in future economic benefits, the training cost
is unlikely to be recognised as an intangible asset as, despite permanent employment contracts, it is
difficult to prove that there is sufficient control over both the employees (who can still resign) and the
future economic benefits that they might generate. If we cannot prove control,
the item is not an asset – and
if the item is not an asset, it automatically cannot be an intangible asset either.
454 Chapter 9
3.5 Recognition and initial measurement depending on the method of acquisition

3.5.1 Overview of the methods of acquisition
Intangible assets must meet the definition and recognition criteria if they are to be recognised.
If they are to be recognised, they must be initially measured at cost. However, both the
recognition of the intangible asset and the initial measurement of its cost may be affected by
the manner in which the intangible asset was acquired or created. It could have been:
acquired as a separate purchase (i.e. purchased as a separate asset); or
acquired by way of an exchange of assets; or
acquired as part of a business combination; or
acquired by way of a government grant; or
internally generated.
3.5.2 The effect of the method of acquisition on the initial measurement
If the intangible asset is acquired for cash, the Method of acquisition and initial
measurement of cost is straight-forward. If, measurement
however, the intangible asset was acquired in Initial measurement = cost
any other way (e.g. through an exchange of Cost is measured at FV, unless the asset was
assets or by way of a government grant) its cost purchased as a separate asset (then follow normal
will be measured at its fair value. rules).
IFRS 13 provides guidance on how fair value should be measured and defines fair value as:
the price that would be received to sell an asset (or paid to transfer a liability)
between market participants
at the measurement date. IFRS 13: Appendix A
IFRS 13’s definition refers to market participants, and thus the fair value is a market-based
measurement. IAS 38 emphasises the fact that the fair value is a market-based measurement
when it clarified that the fair value of an intangible asset that is acquired in a business
combination reflects the market participants’ expectations at acquisition-date of the probability
of the inflow of future economic benefits resulting from the intangible asset. IAS 38.33
Although the definition of fair value requires that market participants exist, the fair value on
initial measurement of the asset does not require that an active market for the asset exists. Of
course, an active market would make it easier to determine the fair value, but where one does
not exist, IFRS 13 allows the fair value for purposes of initial measurement to be determined
in terms of valuation techniques instead. It should be noted, however, that although the initial
measurement at fair value does not require the existence of an active market (i.e. valuation
techniques can be used instead), the subsequent measurement at fair value in terms of the
revaluation model does require that the fair value be determined in terms of an active market.
The revaluation model is explained in section 6.
3.5.3 Intangible assets acquired through a separate purchase (IAS 38.25-.26)

3.5.3.1 Recognition
In order to recognise an asset that was acquired via If acquired through a separate
a separate purchase, we only need to prove that the purchase:
intangible asset definition is met. This is because Recognition: only need to meet the definition
the recognition criteria are met automatically: (the recognition criteria are always met)
The asset has a value that is automatically Measurement: cost (follow normal rules (see
reliably measured (being its purchase price); section 3.3)
The fact that the asset was purchased in the
first place is an indication that the entity expects that there are probable future economic
benefits that will flow from the use of this asset. This means that the probability criterion
is also automatically met.
Chapter 9 455
3.5.3.2 Initial measurement

If the asset was acquired on an individual basis (i.e. not as part of a ‘bundle of assets’) for
cash, the cost is relatively easy to measure and follows the general rules (see section 3.3):
its purchase price, calculated after:
- deducting: discounts, rebates, refundable taxes and interest included due to the
payment being deferred beyond normal credit terms;
- adding: import duties and non-refundable taxes
directly attributable costs. Reworded IAS 38.27 & .32
3.5.4 Intangible assets acquired through an exchange of assets (IAS 38.45-.46)
3.5.4.1 Recognition If acquired through an asset

exchange:
In order to recognise an asset that was acquired via
an asset exchange, it must meet both the definition Recognition: only if it meets the definition
and recognition criteria & only recognise if
and recognition criteria. However, the asset acquired transaction has commercial substance
will only be recognised and the asset given up will Measurement: cost, where cost is:
only be derecognised, if the transaction has - FV of asset given up; or
commercial substance. A transaction is said to have - FV of asset acquired (if more clearly
commercial substance if its future cash flows are evident); or
expected to change as a result of the transaction. - CA of asset given up (if no FV).

In the case of the exchange of assets, the cost of the intangible asset acquired will be a fair
value, measured as the:
fair value of the asset given up; or the
fair value of the acquired asset if this is more clearly evident; or the
carrying amount of the asset given up if neither of the fair values are available or the
transaction lacks commercial substance. IAS 38.45 & .47
For examples on the exchange of assets, see the chapter on property, plant and equipment.
3.5.5 Intangible assets acquired by government grant (IAS 38.44)
3.5.5.1 Recognition If acquired through a

government grant:
On occasion, the government may grant an entity an
intangible asset, such as a broadcasting licence to the South Recognition: if it meets the
African Broadcasting Corporation. This asset may be definition and recognition criteria
(i.e. it follows the normal rules)
granted either at no charge or at a nominal amount.
Measurement: cost where cost is
measured at:
The recognition of an intangible asset acquired by way of a
- FV of asset acquired; or
government grant simply follows the general principles: - Nominal amount plus directly
meet the definition of an intangible asset and the attributable costs
recognition criteria.

The initial measurement of an intangible asset acquired by way of government grant is at cost,
where the entity may choose to measure cost at either:
the fair value of the asset acquired, or
the nominal amount plus any directly attributable costs (i.e. those necessarily incurred in
order to prepare the asset for its intended use).
For further information on intangible assets acquired by way of a government grant, please see
the chapter entitled Government Grants.
456 Chapter 9
3.5.6 Intangible assets acquired in a business combination (IAS 38.33 -.37)
3.5.6.1 Recognition If acquired through a

business combination:
When one entity, say A, acquires another entity, say B, it Recognition: if it meets the definition
acquires all the assets and liabilities of B, including any (i.e. recognition criteria always met)
intangible assets previously belonging to B. Measurement: cost where cost is
measured at:
The acquirer (A) must recognise each intangible asset FV on acquisition date.
acquired on condition that it meets the intangible asset definition. The recognition criteria are
automatically considered to be met.
The recognition criteria are always assumed to be met in a business combination because:
the reliable measure criteria is always assumed to be met because:
if it is possible to identify the intangible asset (and remember: to meet the intangible asset
definition, the intangible asset would have already had to be identifiable) the standard
states that there will be sufficient information available for it to be reliably measured;
the probability criteria is always assumed to be met because:
the cost of an intangible asset acquired in a business combination is its fair value and this
fair value reflects the market expectations as to the probability that future economic
benefits will flow to the entity as a result of the intangible asset; IAS 38.33 as amended by IFRS 13
thus if the fair value is reliably measurable, there is no need to still have to prove that the
flow of future economic benefits is probable because the fair value is the market
expectation of the probable inflow of future economic benefits.
Interestingly, this means that all intangible assets that the acquiree (B) was unable to recognise
because the recognition criteria were not met, will now be recognised by the acquirer (A) in a
business combination. For example,
Internally generated goodwill is prohibited from being capitalised by the entity that
created it. This is because the costs of generating goodwill are inextricably mixed up with
the costs incurred in running a business i.e. there is no reliable way of separating the
portion of the costs that relate to the creation of the goodwill from the general running
costs (e.g. how much of a teller’s salary relates to her (a) doing her job, which must be
expensed; and (b) her smiley face which pleases our customers and thus generates
goodwill?). The fact that the cost of creating goodwill and the cost of simply running a
business means that internally generated goodwill is not reliably measurable.
Purchased goodwill may, however, be capitalised. Purchased goodwill arises when an
entity is purchased for a price that is more than the fair value of the individual net assets.
This excess is an asset that is recognised in the acquirer’s books as ‘purchased goodwill’:
Purchase price paid for entity – net asset value of entity = goodwill (purchased)
Thus, the company that created the goodwill will not recognise it as an asset in its own
books (because it is not reliably measurable), but if another company buys it and pays a
premium for it, this premium (purchased goodwill) is recognised as an asset in the
purchaser’s books. The logic is that, by buying a company at a premium over the fair
value of its assets, it means that a reliable measure of its value has finally been established.
If an intangible asset does not meet the definition in full (e.g. it is not identifiable), then its
value is excluded from the ‘net asset value of the entity’ and the value of the unrecognised
intangible asset is effectively included and recognised as part of the purchased goodwill.
Another issue: For an asset to meet the intangible asset definition it must be identifiable. One
way to prove identifiability is to be ‘separable’. However, an intangible asset acquired in a
business combination may be separable from the company that is being acquired but only if it
is grouped with certain other assets (e.g. a trademark for a chocolate may be useless without
the related recipe). In such cases, the group of related intangible assets (trademark and recipe)
is recognised as a single asset, provided that the individual assets have similar useful lives.
Chapter 9 457
The initial measurement of each intangible asset to be recognised as a result of a business

combination is at cost, where cost is its fair value on acquisition date.
The fair value is measured in terms of IFRS 13 Fair value measurement.
Example 8: Intangible asset acquired in a business combination

Great Limited acquires Stuff Limited for C700 000. Stuff’s net assets and liabilities are:
Property, plant and equipment C500 000 Fair value
Patent C100 000 See the required below
Liabilities C200 000 Fair value
Required: Journalise the acquisition of Stuff Limited in the books of Great Limited assuming:
A the fair value of the patent is reliably measurable at C100 000;
B the fair value of the patent is not reliably measurable and the value given above (C100 000) is
therefore the carrying amount based on the depreciated cost to Stuff Limited; and
C the purchase price of Stuff was C300 000 (not C700 000) and all values are fair values.
Solution 8A: Intangible asset acquired in a business combination

Calculations/ comments Debit Credit
Property, plant and equipment Given 500 000
Patent Given: FV reliably measured at 100 000 100 000
Liabilities Given 200 000
Bank Given 700 000
Goodwill (Asset) Balancing 300 000
Acquisition of Stuff Limited
Solution 8B: Intangible asset acquired in a business combination

Bank Given 700 000
Goodwill (Asset) Balancing 400 000
Comment:
The patent is not recognised as an intangible asset since its cost (FV) is not reliably measured.
This results in an increase in the goodwill amount from C300 000 (see solution 8A) to C400 000. This means
that the patent is actually recognised, not as an intangible asset, but as part of the goodwill instead.
Solution 8C: Intangible asset acquired in a business combination

Patent Given: fair value reliably measured 100 000
Bank Given: revised in part C to 300 000 300 000
Goodwill (Income) Balancing 100 000
Comment:
The goodwill is credited: this is called a gain on a bargain purchase (negative goodwill).
This is recognised immediately as income (not as an asset as in 8A and 8B).
It is recognised as income since Great paid less for Stuff than Stuff’s net asset value and thus Great effectively
made a profit on the acquisition.
458 Chapter 9
3.5.7 Intangible items that are internally generated (IAS 38.48 - .67)
3.5.7.1 Overview
A company may expend resources on the creation of intangible items with the intention to
generate future economic benefits. Not all costs incurred on creating an intangible item may
be recognised as an intangible asset. The intangible items may be very specific (e.g. patents
and trademarks) or items that are perhaps a bit more ‘vague’ but which promote the creation of
a successful business (e.g. customer loyalty and efficient staff). Intangible items that promote
the creation of a successful business are contributing to ‘goodwill’. Since the entity is creating
it (as opposed to purchasing another entity’s goodwill) it is referred to as ‘internally generated
goodwill’. Internally generated goodwill does not meet the intangible asset definition or
recognition criteria and thus it is always expensed. Other intangible items may meet the
intangible asset definition and recognition criteria, in which case they must be recognised as
intangible assets but sometimes they won’t, in which case they are expensed.
Internally generated items
Internally generated goodwill Internally generated items other than goodwill
IA def. & recog. IA def. &/or recog.

IA def. & recognition criteria: not met
criteria: met criteria: not met
Expense Int. Gen. Asset Expense
3.5.7.2 Internally generated goodwill (IAS 38.48 -.50)
Costs such as those that develop customer loyalty, market Internally generated
share, efficient and happy staff members are costs that goodwill is:
generally lead to the development of a successful business. not an intangible asset!
These costs thus help create internally generated goodwill. always expensed
These costs are very difficult to identify and measure separately from the general costs of
simply running the business (as opposed to running a successful business) and thus, although
internally generated goodwill is expected to render future economic benefits, it may not be
capitalised because it does not completely meet the definition and recognition criteria:
it is not an identifiable resource (i.e. it is not separable from the costs of running a
business and it does not arise from any contractual or legal right);
it may not be possible to control items such as customer loyalty; and more importantly
it is impossible to reliably measure the value thereof. See IAS 38.49
Interestingly, whereas internally generated goodwill is Important comparison!

always expensed by the entity that creates it, if this
goodwill is then purchased by another entity in a business Goodwill that is:
combination, it becomes purchased goodwill which is internally generated: expensed
capitalised by the purchaser. This is because internally purchased: capitalised
generated goodwill is not reliably measurable while it is being created but purchased goodwill
is reliably measurable, using the following equation:
Purchase price of entity – Fair value of the entity’s recognised net assets.
Some argue that the entity that creates the internally generated goodwill should be allowed
to recognise it by measuring it using an adaptation of the above equation by simply replacing
‘purchase price’ with the ‘fair value’ of the entity. Problems with this idea include:
the fair value of the entity would reflect a wide range of factors (including, for instance, the economic
state of the country), not all of which relate to the customer loyalty or other items forming part of
internally generated goodwill and thus would not be a good indicator of cost; and
there is no control over these factors (e.g. we may be able to influence but we are unable to control
the economic state of the country or customer loyalty) and thus the asset definition would not be met.
Chapter 9 459
3.5.7.3 Internally generated intangible items other than goodwill (IAS 38.51 - 67)
3.5.7.3.1 Overview of issues regarding recognition
An entity may have an intangible item that has been internally generated. As always, before
an item may be recognised as an intangible asset, it must meet both the definition of an
intangible asset and the recognition criteria.
Recognising an internally generated intangible asset can sometimes be difficult because:

it may be difficult to identify ‘whether and when there is an identifiable asset that will
generate expected future economic benefits’; and
it may be difficult to determine the cost of the asset reliably, because the costs incurred in
creating an intangible asset internally are sometimes very similar to costs incurred
‘maintaining or enhancing the entity’s internally generated goodwill or of running day-to-
day operations’, where these should be expensed as internally generated goodwill. IAS 38.51
IAS 38 bans certain internally generated items from being capitalised (see section 3.5.7.3.2).
If the internally generated item is not banned and it does not relate to internally generated
goodwill, we must consider whether we can capitalise the costs by first assessing at what
stage of the process of internal generation the cost was incurred (see section 3.5.7.3.3).
3.5.7.3.2 Certain internally generated items are banned from being capitalised
Costs incurred on the creation of certain internally Internally generated items

generated items may never be capitalised (i.e. must be that are never capitalised:
expensed) since they are not separately identifiable from
goodwill (see section 3.5.7.2);
the costs of developing the business as a whole. See IAS 38.64
brands;
For the full list of these items, see alongside.
mastheads;
publishing titles;
Interestingly, had these items been acquired in any way customer lists; and
other than through internal generation (e.g. through a other similar items IAS 38.48 & .63
separate purchase) they would have been able to be
recognised as intangible assets. The reason that the internal generation of these items results
in them being expensed is because the nature of the costs incurred in the process of creating
them are very similar to the costs that are related to simply operating a business. In other
words, it is impossible to separate the one from the other and reliably measure the costs to be
capitalised. On the other hand, had they been purchased, there would be a reliable measure –
the purchase price!
3.5.7.3.3 The stages of internal generation (IAS 38.54 - .62)
There are two distinct stages (phases) that occur during the process of creating an intangible
asset, each of which will be discussed separately: Internal generation is
research (IAS 38.54 - .56); split between 2 phases:
development (IAS 38.57 - .62). research phase;
development phase.
The research phase is essentially the gathering of knowledge and understanding. This is then
applied to the development phase which is when the entity uses this knowledge and
understanding to create a plan or design.
It is only once the research stage is completed, that the development stage may begin. Once
development is complete, the completed plan or design is available for use or production.
The ability to prove that the future economic benefits are probable (i.e. being one of the two
recognition criteria) differs depending on what phase the item is in (research or development).
Thus, in order to assess whether the costs incurred in the internal generation of an intangible
asset meet the criteria to be recognised as an asset or must be expensed, we must separate the
costs into those that were incurred during each of these two phases.
460 Chapter 9
3.5.7.3.4 Recognition of costs in the research phase (IAS 38.54 - .56)
Research is the first stage of the creation of the Research:

intangible item, where research is merely a project to
investigate if there are possible future economic Recognition: expense See IAS 38.54
benefits. There is therefore no guarantee at this stage Definition:
that the future economic benefits are: - original & planned investigation
expected (thus the definition is not met); or - undertaken with the prospect
probable (thus the recognition criteria are not met). - of gaining new
- scientific/ technical
Thus research costs are always expensed. - knowledge and understanding. IAS38.8
Examples of research activities include:
activities aimed at obtaining new knowledge;

the search for, evaluation and final selection of, applications of research findings or other knowledge;
the search for alternatives for materials, devices, products, processes, systems or services;
the formulation, design, evaluation and final selection of possible alternatives for new or improved materials,
devices, products, processes, systems or services. IAS 38.56
3.5.7.3.5 Recognition and measurement of costs in the development phase (IAS 38.57 - .71)
Development is the second stage of the creation of the

Development:
intangible item. It involves the application of research
findings to the creation of a plan or design that will then be Recognition: asset or expense
used or put into production. Definition:
- the application
Since it is a more advanced stage of creation, it may be - of research findings or other
possible to prove that the future economic benefits from the knowledge
item are expected and probable. - to a plan or design
Since the research was considered successful enough - for the production of
to have been allowed to progress to the development - new or substantially improved
stage, we can conclude that future economic benefits
- materials, devices, products,
are expected. processes, systems or services
However, in order for us to be able to prove that these
- prior to the commencement of
expected future economic benefits are probable, we commercial production or use. IAS 38.8
are given five extra recognition criteria to consider.
Thus, before development costs may be recognised as an intangible asset, we must be able to
prove that six recognition criteria are met (i.e. the first 5 help us prove that the future economic
benefits are probable and the 6th criteria requires that the cost is reliably measurable).
The 6 recognition criteria relating to development costs:

(1) the technical feasibility of completing the asset;
(2) the intention to complete the asset and to either use or sell it;
(3) the ability to use or sell the asset;
(4) how the asset will generate future economic benefits, through, for instance, demonstrating that there is
a market to sell to, or if the asset is to be used internally, then its usefulness;
(5) the adequate availability of necessary resources (technical, financial or otherwise) to complete the
development and to sell or use the asset; and
IAS 38.57
(6) the ability to reliably measure the cost of the development of the asset.
If just one of these criteria is not met, then the related costs must be expensed.
However, if all these criteria are met it is said that the recognition criteria are met. Then,
assuming the definition of an intangible asset was also met, the item must be capitalised.
Chapter 9 461
Examples of development activities include:

the design, construction and testing of pre-production or pre-use prototypes and models;
the design of tools, jigs, moulds and dies involving new technology;
the design, construction and operation of a pilot plant that is not of a scale economically feasible for
commercial production; and
the design, construction and testing of a chosen alternative for new or improved materials, devices, products,
processes, systems or services. IAS 38.59
Diagram: Summary of the recognition of research and development costs
Costs incurred creating internally generated assets are split between:
Research phase Development phase
Expense Expense Asset

If any of the 6
Always If all 6 criteria met
criteria are not met
Once an internally generated item meets the definition and recognition criteria (as discussed
above), the next step is to decide which of the related costs may be capitalised.
Costs that may be capitalised are only those that are: Only costs that are
directly attributable ‘directly attributable’ may
to creating, producing and preparing the asset be capitalised. See IAS 38.66
to be able to operate in the manner intended by management. Reworded from IAS 38.66
Professional judgement is required to decide whether or not a cost is ‘directly attributable’.

The costs of materials, services, professional fees (e.g. to register a patent) and employee
benefits that were necessary in the creation of the intangible asset would all be considered
directly attributable. If other patents and licences were used to create the intangible asset, the
amortisation thereof would be considered ‘directly attributable’. Similarly, if the creation of
the intangible asset required money to be borrowed, then the borrowing costs would be
considered ‘directly attributable’ and thus capitalised, on condition that they meet the criteria
for capitalisation that are set out in IAS 23 Borrowing costs. See IAS 38.66
Directly attributable costs never include:

costs that are selling, administrative and other general overheads unless these are directly attributable to
preparing the asset for use;
costs that are due to identified inefficiencies occurring before the asset reaches its planned performance
level;
costs that represent initial operating losses incurred because the asset has not yet reached its planned
performance level;
costs of training staff how to operate the asset. Reworded from IAS 38. 67
Costs that were expensed in a previous financial period,

Development costs
because not all 6 recognition criteria were met at the time the that are expensed:
costs were incurred, may never be subsequently capitalised,
even if all 6 recognition criteria are subsequently met. because the RC are not met,
See IAS 38.71 may not be subsequently
capitalised when the RC are
met, but if
As soon as the development is complete and the development
due to an impairment, may be
asset is available for use, capitalisation of costs to this asset subsequently capitalised if and
must cease. At this point, the inflow of economic benefits when the reason for the
from the use of the developed asset can begin and thus impairment disappears!
amortisation begins. Amortisation is explained in section 5. See IAS 38.71 & IAS 36.114
462 Chapter 9
The development asset must be tested for impairments both during its development and after
its completion. Any impairment thereof should be expensed. Impairment expenses may be
subsequently capitalised if the reason for the original impairment subsequently disappears
(unless the impairment relates to goodwill, in which case the impairment may not be
subsequently capitalised). Impairment testing is explained under the section 5.
Example 9: Research and development costs

Lab Limited began researching and developing a wireless modem – one which truly did not
have any wires – something they planned to call the ‘Less-wire Wireless’. The following is
a summary of the costs that the R&D Department incurred each year:
20X1: C180 000
20X2: C100 000
20X3: C80 000
Additional information:
The costs listed above were incurred evenly throughout each year.
Included in the costs incurred in 20X1 are administrative costs of C60 000 that are not considered
to be directly attributed to the research and development process. The first two months of the year
were dedicated to research. Then development began from 1 March 20X1 but all 6 recognition
criteria for capitalisation of development costs were only met on 1 April 20X1.
Included in the costs incurred in 20X2 are administrative costs of C20 000 that are considered to
be directly attributed to the research and development process.
Included in the costs incurred in 20X3 are training costs of C30 000 that are considered to be
directly attributed to the research and development process: in preparation for the completion of
the development process, certain employees were trained on how to operate the asset.
Required: Show all journals related to the costs incurred for each of the years ended 31 December.
Solution 9: Research and development costs

20X1 Debit Credit
Administration expense (E) Given – not directly attributable 60 000
Research expense (E) (180 000 – 60 000) x 2/12 20 000
Development expense (E) (180 000 – 60 000) x 1/12 10 000
Development: cost (A) (180 000 – 60 000) x 9/12 90 000
Bank/ liability 180 000
Research and development costs incurred (capitalisation began from
1 April 20X1, being the date on which all six criteria were met; all costs
incurred before this date are expensed). Costs that were not directly
attributable to the R&D project are also expensed.
20X2
Development: cost (A) 100 000
Development costs incurred (the administration costs of C20 000 are
capitalised because they are directly attributable to the R&D project)
20X3
Training expense (E) Given – not directly attributable 30 000
Development: cost (A) (80 000 – 30 000) 50 000
Development costs incurred (training costs of C30 000 are expensed as
they are expressly not allowed to be capitalised to the intangible asset)
Comment:
Administration costs are capitalised where they are considered directly attributable (see 20X2) but are
expensed if they are not considered directly attributable (see 20X1).
Training costs are always expensed even if they are considered to be directly attributable (see 20X3).
Research costs are always expensed.
Development costs incurred before the recognition criteria are met are expensed. These development costs
expensed may not be subsequently capitalised when the recognition criteria are subsequently recognised –
they remain expensed forever.
Chapter 9 463
3.5.7.3.6 In-process research and development that is purchased

Whereas many companies do their own research and development, it is possible for a company
to simply buy another company’s research and development.
If a company buys (either separately or as part of a business combination) another company’s
‘in-process research and development’, the cost incurred must be recognised as an asset if it:
meets the definition of an asset (the basic asset definition provided in the CF);
is identifiable (i.e. is separable or arises from contractual or other legal rights). IAS 38.34
The cost of the asset is measured at the fair value on In-process R&D:
acquisition date. Interestingly, this reflects the fair value
of both the research and development, combined together. Recognised: if it:
Thus, when we buy somebody else’s research and - meets the asset definition
development we end up capitalising not only the cost of - is identifiable
development but also the cost of research (whereas Measured:
research is normally expensed)! IAS 38.33-.34 - Initial cost: FV on acquisition date
(includes research & development!)
However, subsequent costs on this purchased ‘in-process - Subsequent cost:
research and development’ project will be analysed and o Research = expense
recognised in the normal way: o Development = asset/ expense
costs that relate to research must be expensed;
costs that relate to development:
- must be expensed if all recognition criteria are not met; and
- must be capitalised if all recognition criteria are met. IAS 38.43
Example 10: In-process research and development
On 1 January 20X9, Pen Limited bought an incomplete research and development project
from Nib Limited for C300 000 (i.e. fair value).
The purchase price was analysed as follows: C
Research 50 000
Development 250 000
300 000
Subsequent expenditure has been incurred on this project as follows:
Research Further research into possible markets was considered necessary. 100 000
Development Incurred evenly throughout the year. All recognition criteria for 600 000
capitalisation as a development asset were met on 1 June 20X9.
Required: Show all journals related to the in-process research and development for 20X9.
Solution 10: In-process research and development

20X9 Debit Credit
Development: cost (A) 300 000
Purchase of ‘in-process research and development’ (no differentiation
between research and development is made) when the project was
acquired as ‘in-process R&D’ (IAS 38.34)
Research expense (E) Given 100 000
Development expense (E) 600 000 x 5/12 250 000
Development: cost (A) 600 000 x 7/12 350 000
Bank/ liability 100 000 + 600 000 700 000
Subsequent expenditure on an in-process research and development
project recognised on the usual basis: research is expensed and
development costs capitalised only if all 6 recognition criteria are met
Comment: Even though the purchased research and development contains research, which is normally never
capitalised, it is capitalised in terms of IAS 38.34 if it meets the definition of an intangible asset. However, further
research costs must be expensed as usual.
464 Chapter 9
3.5.7.4 Web site costs (SIC 32)
Creating a website is an example of the internal generation of an The 5 stages of

intangible asset. The costs incurred on a business website are creating a website:
categorised into five basic stages. Stage 1: Planning stage
Stage 1: Stage 1 is the planning stage, which typically involves Stage 2: Application &
preparing feasibility studies, defining hardware and infrastructure
software specifications etc. Stage 3: The graphical design
Stage 4: Content development
Stage 2-4: These 3 stages involve the development of the website. Stage 5: Operating stage.
- Stage 2: the application and infrastructure development stage involves, for example,
obtaining a domain name and developing server software.
- Stage 3: the graphical design stage involves, for example, designing layout &
colours.
- Stage 4: the content development stage involves, for example, writing information
about the entity and including pictures of products sold.
Stage 5: The final stage is called the operating stage and involves the maintenance and
enhancement of the aspects of the site that were developed in stages 2 – 4 (i.e.
graphics are enhanced; content is added and removed etc). In other words, the
operating stage occurs once the web-site is ready for use.
Irrespective of these 5 stages, if a company’s website is mainly involved in advertising, then

all the website costs should be expensed as advertising (since it is impossible to reliably
measure the specific future economic benefits that would flow from this advertising). On the
other hand, if the website is able to take orders, then it may be possible to identify and
measure the future economic benefits expected from the website. If the website is expected to
result in an inflow of future economic benefits, we will need to analyse the costs into the
various stages and account for them as follows:
Stage 1 costs (planning): are always expensed as research. Accounting for
Stage 2–4 costs (developing): are recognised either as a website costs:
development asset or development expense: Stage 1 (Planning):
- development asset if the six recognition criteria are met, - research expense
or Stage 2 – 4 (Development):
- development expense if the six recognition criteria are - development asset; or
not all met - development expense
Stage 5 costs (operating): are expensed unless they meet the Stage 5 (Operating):
requirements for capitalisation as subsequent costs (i.e. the - operating expenses (unless
it is a subsequent expense
definitions and the two basic recognition criteria per the CF to be capitalised)
must be met).
The development stages involve many different tasks, some of which may and some may not
meet the 6 recognition criteria. For example, content development (stage 4) could involve:
photographing products available for sale, the cost of which would be a cost of advertising
and would therefore be expensed; whereas
the acquisition of a licence to reproduce certain copyrighted information, the cost of which
would probably be capitalised (assuming the six recognition criteria are met).
Where an entity incurs website costs involved in the creation of content other than for
advertising and promotional purposes and this is a directly attributable cost that happens to
result in a separately identifiable asset (e.g. a licence or copyright) this asset should be
included in the ‘website development asset’ and should not be recognised as a separate asset.
The website asset must be amortised, as its useful life is considered to be finite. The useful
life selected should be short.
Chapter 9 465
4. Recognition of Subsequent Expenditure (IAS 38.20 and .42 - .43)
Unlike property, plant and equipment where Capitalisation of subsequent

subsequent expenditure such as replacement of parts costs:
and enhancements of parts are common, subsequent
expenditure on intangible assets does not normally Is unusual (due to the nature of IAs)
arise. However, if subsequent expenditure does arise, Occurs if the costs meet the IA:
the nature of intangible assets frequently makes it so - definition
difficult to prove that it relates to a specific intangible - recognition criteria (the basic 2)
asset rather than to the general operation of the Is not allowed if it relates to internally
business, that subsequent expenditure on intangible generated:
assets is seldom capitalised. - brands,
- mastheads,
Subsequent expenditure refers to the costs incurred - publishing titles,
after the intangible asset has been acquired or after the - customer lists, and
internal generation thereof has been completed. - items similar in substance.
The same criteria that we applied when deciding whether to recognise the initial expenditure
as an asset or expense, is also applied when accounting for this subsequent expenditure. In
other words, subsequent costs are capitalised to the carrying amount of the asset) if:
The definition of an intangible asset is met; and
The recognition criteria are met. See IAS 38.20
Where the subsequent expenditure relates to an internally generated intangible item that was
not allowed to be recognised as an intangible asset (e.g. an internally generated brand), then
this subsequent expenditure will also not be allowed to be capitalised. IAS 38.20
5. Subsequent Measurement: Amortisation and Impairment Testing (IAS 38.88 - .111)
5.1 Overview
Subsequent measurement of an intangible asset involves amortisation and impairment testing.

If the intangible asset is available for use, we need to consider both the:
- amortisation requirements, and
- impairment testing requirements;
If the intangible asset is not yet available for use: we only need to consider the:
- impairment testing requirements (these assets are not amortised but impairment testing
is more stringent than the impairment testing of assets that are available for use).
An intangible asset that is available for use may be assessed as having:

a finite useful life; or Subsequent measurement
an indefinite useful life. involves:
Whether an available for use intangible asset has a finite or Amortisation; and
Impairment testing.
indefinite life is important because it affects both the
amortisation and impairment testing of that asset:
If it has a finite useful life, it will be amortised and tested for impairment in much the
same way that property, plant and equipment is depreciated and tested for impairment;
If it has an indefinite useful life, it is not amortised but has more stringent impairment
tests than the impairment tests that apply to assets with finite lives. IAS 38.108 & IAS 36.10
Please note that indefinite does not mean infinite. If an asset We refer to indefinite
has an indefinite useful life, it means that ‘there is no useful lives.
foreseeable limit to the period over which the asset is Indefinite ≠ Infinite
expected to generate net cash inflows for the entity’. Infinite would mean there is no limit at
all to the asset’s useful life. See IAS38.91
466 Chapter 9
There are many factors to consider when assessing the useful life of the asset and whether
the useful life is finite or indefinite. Examples of some of these factors include:
possible obsolescence expected as a result of technological changes;
the stability of the industry in which the asset operates;
the stability of the market demand for the asset’s output;
expected actions by competitors;
the level of maintenance required to be assured of obtaining the expected future economic
benefits and management’s intent and ability to provide such maintenance. IAS 38.90
Summary of the subsequent measurement of intangible assets
Not yet available for use Available for use
Indefinite useful life Finite useful life

Amortisation: N/ A Amortisation: N/A Amortisation: Yes
Impairment test: Yes Impairment test: Yes Impairment test: Yes
5.2 Amortisation (IAS 38.97 - .107 and .117)

5.2.1 Overview
An asset reflects future economic benefits. As this asset is used up, these future economic
benefits are used up. This gradual reduction in the asset’s remaining future economic
benefits is reflected through the process of amortisation.
Amortisation is expensed unless the underlying intangible asset is being used to create yet
another asset, in which case it is capitalised to this other asset. This amortisation is eventually
expensed when this item is either used or sold (e.g. amortisation of an intangible asset that is
used to create inventory is first capitalised to inventory but it is eventually expensed as part of
the cost of sales when this inventory is sold).
Amortisation:
Only intangible assets with finite lives are amortised. Reflects: the usage of the IA
Recognise: normally as an exp.
There are three variables that must be estimated when Only applies to IAs that are:
calculating the amortisation: available for use & with a finite life
residual value; Does not apply to IAs:
period of amortisation; and available for use but with an indefinite
method of amortisation. life
not yet available for use
goodwill. IAS 38.97 & IAS 38.107 & IFRS 3.B69(d)
The amortisation of an intangible asset does not cease
when it is not being used – unless, of course, it has either been fully amortised or it has been
reclassified as ‘held for sale’ (i.e. it will then be accounted for under IFRS 5 Non-current
assets held for sale and discontinued operations). See IAS 38.117
5.2.2 Residual value and the depreciable amount (IAS 38.100 - .103)
The depreciable amount is: Residual value:
the cost (or fair value) of the asset Is used to calculate the:
less its residual value. IAS38.8 Depreciable amount
The residual value is defined as (just as with Should be zero unless:

property, plant and equipment): A 3rd party has committed to buying the IA at
the expected proceeds on disposal of the asset the end of its UL; OR
less expected costs of disposal The IA has an active market and
the RV can be measured from this AM and
assuming the asset to already be at the end of
it’s probable that the AM will exist at the end
its useful life (i.e. current values are of the IA’s UL.
used).IAS38.8 reworded Should be reassessed at least:
- at the end of every financial year.
Chapter 9 467
In the case of intangible assets, the residual value should always be zero unless:
a third party has committed to purchasing the asset at the end of its useful life; or
there is an active market (as defined in IRFS 13) for that asset and
- it is possible to measure the residual value using such market and
- it is probable that the market will still exist at the end of the asset’s useful life. IAS 38.100
A residual value that is anything other than zero normally suggests that the intention is to sell
the asset before the end of its total useful life.
The residual value must be assessed at least at the end of every financial year. Any change
in the residual value would be accounted for as a change in accounting estimate. IAS 38.102
5.2.3 Period of amortisation (IAS 38.88, .94 -.99 and .104)
Amortisation of an intangible asset begins on the date Amortisation period:

on which it becomes available for use (i.e. not when
we actually start to use it). See IAS 38.97 Starts:
When available for use
Amortisation must cease at the earlier of the date of: Ceases: When the asset is:
derecognition of the asset derecognised; or
reclassification of the asset to the classification of reclassified as a NCA held for sale.
‘non-current asset held for sale’. See IAS 38.97 Useful life:
Measured in years or units
The amortisation period should be the shorter of: Shorter of:
the asset’s expected economic useful life; and - useful life, or
its legal life. See IAS 38.94 - legal life, unless legal rights are
renewable & evidence suggests
Where the asset has a limited legal life (i.e. where renewal will occur at insignificant
related future economic benefits are controlled via cost.
legal rights granted for a finite period), the expected Should be reassessed at least:
economic useful life will be limited to the period of the at the end of every financial year.
legal rights, if this is shorter, unless: If an indefinite life is changed to a
the legal rights are renewable by the entity; and finite life,
- process amortisation (as a change in
there is evidence to suggest that the rights will be
estimate) and
renewed; and - check for impairments.
the costs of renewal are not significant. IAS 38.94
The asset’s expected economic useful life could be estimated either in terms of:
expected length of time that it will be used (e.g. 5 years); or
expected number of units of production, or similar (e.g. 50 000 units). See IAS 38.88
The period of amortisation must be assessed at least at the end of every financial year. Any
change in the period would be accounted for as a change in accounting estimate. IAS 38.104
Example 11: Amortisation period and renewable rights

Ace Limited, a radio broadcaster, purchased a 5 year broadcasting licence for C100 000.
Ace expects to renew the licence at the end of the 5 year period for a further 5 years.
The government has indicated that they will re-grant the licence to Ace Limited.
Required: Discuss the number of years over which the licence should be amortised, assuming that:
A. the cost of renewing the licence will be C1 000; or
B. the cost of renewing the licence will be C70 000.
Solution 11A: Amortisation period and renewable rights – insignificant cost

The useful life of the licence is 5 years, but since the legal rights are renewable, we must also consider
these. The rights are renewable at an insignificant cost (C1 000 compared to the C100 000 original cost,
(1%)), and since it is necessary for the continuation of the business and the government has indicated
that it would be renewed, we must amortise this asset over a 10 year useful life (5 yrs + 5 yrs renewal).
468 Chapter 9
Solution 11B: Renewable rights – significant cost

The useful life of the licence is 5 years, but since the legal rights are renewable, we must also consider
these. Since the rights are renewable at a significant cost (C70 000 is a significant portion of the original
cost of C100 000, (70%)), we disregard the renewal period. The asset must be amortised over a 5 year
period. (Note: the renewed licence, if and when it is acquired, must be treated a separate asset and
amortised over a useful life of 5 years).
5.2.4 Method of amortisation (IAS 38.97 - .98C and .104)
The method used should be a systematic one that reflects the pattern in which the entity
expects to use up the asset’s future economic benefits. Various methods may be possible
including:
straight-line
diminishing balance
units of production method. IAS 38.97-.98
If the pattern in which the asset is expected to be used Method of amortisation:

cannot be reliably estimated, then the straight-line
method must be used. See IAS 38.97 Methods that may be used include:
SL method
The method chosen should result in amortisation that RB method
reflects the pattern in which we expect to consume the Units of production method.
economic benefits that are contained in the intangible The method used should:
asset (i.e. it should reflect the pattern by which we reflect pattern of usage of the FEB
expect the asset will be used up). See IAS 38.97 but if you can’t determine the pattern,
you must use SL!
However, we must be absolutely sure that the method Should be reassessed at least:
used reflects how the economic benefits embodied in at the end of every financial year.
the intangible asset are being consumed (i.e. how the
asset is being used up). For example:
If our intangible asset comes with a contract that expires after 5 years, and we are able to
use the asset in any way we like during this period, then our predominant limiting factor
is time. In this example, an amortisation method based on time would be most
appropriate (e.g. if we plan to use it evenly over the 5-year period, then the straight-line
method over this time period would be the most appropriate method).
If our intangible asset comes with a contract that expires after 10 000 units have been
produced under licence, then our predominant limiting factor is units. In this example,
the useful life is 10 000 units and an appropriate method may be the units of production
method over the 10 000 units.
Notice that the method used is closely aligned to useful life.
IAS 38 clarifies that a method of amortisation that allocates the cost of the asset on the basis
of revenue (whether in terms of currency or units) would not normally be suitable. This is
because there is a concern that revenue generated from the asset would be affected by a host
of factors that have no bearing at all on how the asset is being used up (e.g. the number of
units actually sold could be affected by marketing drives or economic slumps and the unit
price could be affected by inflation or competitive pricing – or any combination thereof).
However, the assumption that revenue would be an inappropriate basis for the amortisation
method of an intangible asset is a rebuttable assumption. The fact that this assumption is
rebuttable, means that, under certain limited circumstances, we are able to argue that an
amortisation method based on revenue is, in fact, appropriate. This assumption may be
rebutted (i.e. we will be able to use revenue as the basis for the amortisation method), if:
the intangible asset is expressed as a measure of revenue; or
it can be shown that the ‘consumption of economic benefits’ is ‘highly correlated’ with
‘revenue’. See IAS 38.98B
Chapter 9 469
For example, an entity may own the right to use an asset where this right is limited based on a
revenue threshold. IAS 38 provides the example of a mining concession that expires as soon
as a certain amount of revenue has been generated (rather than as soon as a number of tons of
raw material (i.e. units) have been mined from the ground). In this case, the ‘predominant
limiting factor’ is clearly revenue (i.e. not units or time) and thus, if the contract specifies the
total amount of revenue that may be generated under the mining concession, then an
amortisation method that is based on revenue would be considered appropriate.
Amortisation methods based on revenue – a comparison between IAS 38 Intangible

assets and IAS 16 Property, plant and equipment
Please note! In case you have already studied property, plant and equipment (PPE), you
may remember a similar discussion regarding methods of depreciation based on revenue. However,
in the case of PPE, using a depreciation method that is based on revenue is never allowed whereas
in the case of intangible assets (IAs), it is what is referred to as a rebuttable assumption.
Since the amortisation method is based on an expected pattern of future benefits, it is simply
an estimate and must be reviewed at the end of each financial year. If it changes, it must be
accounted for as a change in accounting estimate (see chapter 26). See IAS 38.104
5.2.5 Annual review (IAS 38.102 and .104 and IAS 36)
Assets that are available for use and have finite useful lives are amortised. The variables of
amortisation must be assessed at the end of each financial period (i.e. the amortisation
period, amortisation method and residual value). See IAS 38.102 & .104
If any one or more of the amortisation period, Annual review:

amortisation method or residual value is to be changed,
the change should be accounted for as a change in Means reassessing the following
estimate (IAS 8). See IAS 38.102 & .104 at reporting date:
The 3 variables of amortisation:
The assessment that the useful life of an intangible - amortisation period;
asset is indefinite must be re-assessed every year to - amortisation method;
- residual value;
confirm that it is still the appropriate assessment of its
For IAs with an indefinite UL, whether
useful life. If circumstances have changed and the this is still appropriate or whether it
useful life is now thought to be finite: now has a:
process amortisation as a change in estimate (IAS 8); - finite useful life.
check for a possible impairment and record an If any of the above changes, it is
impairment loss if necessary (IAS 36). See IAS 38.109-110 accounted for as a change in estimate.
5.3 Impairment testing (IAS 36.9 -.12, .80-.99 and IAS 38.111)
5.3.1 Overview
An asset reflects the expected future economic Impairments:

benefits. If something happens to cause these expected
future economic benefits to drop (other than through Reflects: ‘damage’ to an IA
usage) the asset is considered to be impaired. The Occurs when: CA > RA
process of impairment testing involves the review of all Recognise: as an expense
aspects affecting the future economic benefits inherent Applies to: all IAs
in the asset. If the asset is found to be impaired, the carrying amount is reduced to reflect the
impairment and this impairment is recognised as an expense.
Impairment testing of an intangible asset is dictated by IAS 36 Impairment of assets and

depends on whether the intangible item:
is available for use and has:
- has a finite useful life
- has an indefinite useful life;
is not yet available for use; or
is purchased goodwill. IAS 36.10
470 Chapter 9
Impairment testing generally requires an indicator review to be performed at reporting date

to identify whether there is a possible impairment. If there appears to be a possible material
impairment, and this is not considered to be due to under-estimated amortisation in the past,
the recoverable amount is measured and compared to the carrying amount. If the carrying
amount exceeds the recoverable amount, the asset is impaired. In the case of certain
intangible assets (indefinite useful life assets, assets not yet available for use and purchased
goodwill), however, slightly more stringent impairment testing may be required.
Impairment testing of purchased goodwill is covered in section 8. Impairment testing is also
covered in detail in the chapter entitled ‘Impairment of Assets’, but the following serves as a
brief overview of the impairment testing relating to intangible assets.
5.3.2 Impairment testing of intangible assets with finite useful lives
Intangible assets that are available for use and have Impairment of IA’s that
finite useful lives are tested for impairments in the have a finite useful life:
same way as property, plant and equipment is tested
Perform an impairment indicator review
for impairment. This means that an annual indicator annually (in terms of IAS 36).
review process is followed: If there is a possible impairment that:
an indicator review is performed at reporting date to - is material; and
identify possible impairments; then - is not ‘fixed’ by processing extra
if it is possible that a material impairment exists, amortisation
- and this is not considered to be due to under- we calculate the RA at reporting date
estimated amortisation in the past, if the CA > RA = the IA is impaired
- we measure the recoverable amount and compare it to the carrying amount;
if the carrying amount exceeds the recoverable amount, the asset is impaired.
5.3.3 Impairment testing of intangible assets with indefinite useful lives
Intangible assets that are available for use and have

indefinite useful lives are tested for impairments in a Impairment of IA’s that
have an indefinite useful
slightly more stringent manner than the impairment
life:
testing applied to finite useful life assets. The same
indicator review process at reporting date that is Perform an indicator review at
followed for finite useful life assets is also performed for reporting date (this may require the
each indefinite useful life assets. However, irrespective calculation of the RA at reporting date)
of whether or not the indicator review at reporting date Calculate RA at least annually, at any
suggested that the asset may be impaired, the estimated time, but the same time every year
recoverable amount must be measured every year. This There is a situation in which a previous
can be done at any time in the year, but at the same time calculation of a RA could be used
each year. IAS 36.9-.10 instead of recalculating the RA
Example 12: Impairment test of an indefinite useful life intangible asset

An entity owns three intangible assets that have indefinite useful lives (A, B & C). This
entity has a 31 December year end. Since the accountant is very busy with the auditors in
December, it was decided that the best time to do the annual recoverable amount calculation for A was
30 September every year (the recoverable amount calculations for B & C would all be done on 30 June).
Required:
Explain what impairment testing will apply to A, referring specifically to the dates and what needs to be
done on each date and conclude how many times the recoverable amount may need to be calculated.
Suggest how one can reduce the number of recoverable amount calculations for A.
Solution 12: Impairment test of an indefinite useful life intangible asset

Since the intangible asset is an indefinite useful life asset, the asset must have:
its recoverable amount calculated every year, at the same time of the year; and
an indicator review performed for it at reporting date.
Chapter 9 471

With respect to A, it means that the entity will need to do the following:
on 30 September every year: calculate the recoverable amount for A; and
on 31 December every year: perform an indicator review for A, and if the indicator review suggests a
possible material impairment, (which is not related to underestimated amortisation that would be
fixed by way of a change in estimated amortisation), the recoverable amount of A will need to be
calculated yet again.
In conclusion, it is possible that the entity will need to calculate A’s recoverable amount twice, at:
30 September (this is a compulsory calculation) and
31 December (if the year-end indicator review suggests that the calculation is necessary).
If the entity wishes to calculate the recoverable amount only once, it will need to perform its annual
recoverable amount calculation at 31 December (i.e. not on 30 September).
It is possible to avoid calculating the recoverable The annual RA calculation

amount for an intangible asset in a particular year if a for indefinite useful life
recent and detailed estimate of the recoverable amount IAs:
was done in a preceding year, in which case this could The annual calculation of the RA may:
be used instead, but this may only be used: be avoided if 3 criteria are met...
A. if this intangible asset is part of a cash-generating unit, where the change in the values of
the assets and liabilities within the cash-generating unit are insignificant; and
B. if the most recent detailed estimate of the recoverable amount was substantially greater
than the carrying amount at the time; and
C. if events and circumstances subsequent to the calculation of the previous recoverable
amount suggest that there is only a remote chance that the current recoverable amount
would now be less than the carrying amount. IAS 36.9 -.10 & .24 reworded
The assessment that the useful life of an intangible asset is indefinite must be:
re-assessed annually to confirm that it is still an appropriate assessment; and
if circumstances have changed and the useful life is now thought to be finite:
- adjust the amortisation as a change in estimate;
- check for a possible impairment and process an impairment if necessary. IAS 38.109-110
5.3.4 Impairment testing of intangible assets not yet available for use
If the intangible asset is not yet available for use, the same indicator review process that is
applied to finite useful life assets is followed.
Impairment of IAs that
are not yet available for
However, even if this indicator review at reporting date use:
does not seem to suggest that the asset may be
impaired, the estimated recoverable amount must be Perform an indicator review at
measured every year. reporting date (this may require the
calculation of the RA at reporting date)
This recoverable amount calculation can be done at any Calculate RA at least annually, at any
time in the year, but it must always be done at the same time, but the same time every year
time each year. IAS 36.9-.10 This compulsory annual calculation may
not be avoided.
Although in the case of intangible assets that are
available for use but which have indefinite useful lives, The annual RA calculation
the annual calculation of the recoverable amount may for IAs that are not yet
be avoided in certain situations (see section 5.3.3), this available for use:
calculation may never be avoided if the intangible asset The annual calculation of the RA may:
is not yet available for use. See IAS 36.10 & .24 never be avoided!
472 Chapter 9
5.3.5 Reversing an impairment Before reversing an

impairment loss:
If the cause of the impairment in one year, then
First check whether the
‘disappears’ in a subsequent year with the result that the amortisation should not simply be
recoverable amount increases or even exceeds the decreased (change in estimate);
carrying amount once more, then the impairment may be If the CA is still too low, then process
reversed in that subsequent year. IAS 36.114 an impairment reversal;
In processing an impairment reversal,
However, care must be taken when reversing an be sure that CA is not increased above
impairment expense because the asset’s: what it would’ve been had the original
carrying amount may be lower than the recoverable impairment never been processed.
amount, not because the cause of the original impairment has subsequently disappeared
but rather because the variables of depreciation are no longer considered to be fair
estimates (e.g. the residual value, useful life or method of amortisation need to be re-
estimated), in which case the carrying amount must be adjusted upwards as a change in
estimated amortisation and not as a reversal of a previous impairment expense; and
carrying amount is not allowed to be increased above that which it would have been had
the asset never been impaired in the first place (i.e. it must never increase above the
historical carrying amount, also called the amortised historic cost). See IAS 36.113 & .117
Example 13: Impairments and reversals of an asset not yet available for use
Busy Limited has a 31 December financial year-end. In 20X7, Busy began a project
involving research and development, incurring the following costs evenly over each year:
20X7: C120 000
20X8: C100 000
20X9: C100 000
The recognition criteria for capitalisation of development costs were met on 1 September 20X7.
Since the development asset is an intangible asset not yet available for use, Busy is forced to calculate
its recoverable amount every year (at any chosen time but the same time every year) and also to do an
indicator review at reporting date. Busy decided it would be best to perform the compulsory calculation
of its recoverable amount at the same time that it performed its indicator review (i.e. at 31 December).
The recoverable amounts calculated as at 31 December were as follows:
31 December 20X7 C90 000
At no stage were the variables of amortisation in need of adjustment.
Required: Show all journals related to the costs incurred for each of the years ended 31 December.
Solution 13: Impairments and reversals of an asset not yet available for use
20X7 Debit Credit
Research expense (E) 120 000 x 8/12 80 000
Development: cost (A) 120 000 x 4/12 40 000
Bank/ liability Given 120 000
Research and development costs incurred Note 1
20X8
Development: cost (A) Given 100 000
Development costs incurred Note 2
Impairment loss: development (E) W1 or CA: 140 000 – RA: 110 000 30 000
Development: accumulated impairment loss: (-’ve A) 30 000
Impairment loss recognised Note 2
20X9
Development: cost (A) Given 100 000
Development costs incurred
Development: acc. imp. loss: (-’ve A) W1 or see Calc 4 30 000
Impairment loss reversed: development (I) 30 000
Impairment loss reversed
Chapter 9 473

W1: Summary: cost of development asset account 20X7 20X8 20X9
Opening balance 0 40 000 110 000
Current year’s cost incurred and capitalised 20X7: see calc 1 40 000 100 000 100 000
Subtotal 40 000 140 000 210 000
Compared with recoverable amount (given) 90 000 110 000 250 000
(Impairment loss)/impairment loss reversed See calc 2; 3 & 4 respectively N/A (30 000) 30 000
Closing balance 20X9: See note 4 40 000 110 000 240 000
Calculations:
1. 20X7: C120 000 x 4/12 = 40 000 (from 1/9/20X7, when all 6 criteria met)
2. 20X7: No impairment: RA > CA
3. 20X8: Impairment: CA of 140 000 – RA of 110 000 = 30 000 impairment
4. 20X9: Impairment reversal: RA of 250 000, limited to historical carrying amount: 240 000 (costs capitalised:
40 000 + 100 000 + 100 000 – amortisation: 0) – CA of 210 000 = 30 000 impairment reversal See note 3 and note 4
Notes:
1. Capitalisation began from 1 September 20X7, being the date on which all six criteria were met and thus all
costs before this date are expensed and all costs after this date are capitalised.
2. No indication is given that the six criteria are no longer met, thus we assume they are still all met and thus the
costs continue to be capitalised in 20X8 and 20X9.
3. We are told that the variables of amortisation did not need to be re-estimated and thus the entire increase in
the carrying amount in 20X9 may be ascribed to an impairment loss needing reversal.
4. The impairment loss reversed is not C40 000 but C30 000 because it is limited to the impairment loss
originally recognised. If the reversal was not limited, the balance on the development asset at 31/12/20X9
would be C250 000 and yet only C240 000 development costs were incurred:
20X7 (C120 000 x 4/12) 40 000
20X8 (given) 100 000
20X9 (given) 100 000
Total actual costs incurred: 240 000
6. Subsequent Measurement: The Two Models (IAS 38.72 - .87)
6.1 Overview
There are two alternative measurement models that may be used in the subsequent
measurement of intangible assets:
the cost model; and
the revaluation model.
These are the same two measurement models that are allowed to be used in the subsequent
measurement of property, plant and equipment (IAS 16) and the debits and credits are the
same. Thus, please see the examples in the chapter on property, plant and equipment to see
how these models are applied.
6.2 Cost model (IAS 38.74)
If an intangible asset is measured under the cost model it is Cost model

initially measured at cost and subsequently measured by
amortising the asset and testing for impairments. Thus the This model is identical
carrying amount of an asset held under the cost model is: to the model used for
cost at acquisition PPE:
Cost
less any accumulated amortisation and
Less: AA & AIL
less any accumulated impairment losses.
The measurement of an intangible asset under the cost model is identical to the cost model
used for a tangible asset (covered by IAS 16 Property, plant and equipment).
474 Chapter 9
6.3 Revaluation model (IAS 38.75 – 87 and IFRS 13: Appendix A)
If an intangible asset is measured under the cost model it is Revaluation model

initially measured at cost and subsequently measured by
amortising the asset and testing for impairments. Thus the This model is almost
carrying amount of an asset held under the cost model is: identical to the model
used for PPE:
cost at acquisition
FV at date of revaluation
less any subsequent accumulated amortisation and any
Less: Subsequent AD & AIL
accumulated impairment losses.
The only difference is that:
If the intangible asset is measured under the revaluation model, - the FV used in the RM
it is initially measured at cost but is subsequently measured at - must be measured with
its fair value. The carrying amount of an asset held under the reference to an active market if
revaluation model is thus its: dealing with IAs.
fair value at date of revaluation
less any subsequent accumulated amortisation and any accumulated impairment losses.
When using the revaluation model to subsequently measure an intangible asset, the fair value
that is used must be measured by reference to an active market. There is no such limitation in
IAS 16: Property, plant and equipment (i.e. the fair value used to revalue an item of property,
plant and equipment may be determined with reference to an active market or by other means).
An active market is defined as:

A market in which transactions for the asset or liability
take place with sufficient frequency and volume
to provide pricing information on an ongoing basis. IFRS 13: Appendix A
It is interesting to note that, due to the unique nature of most intangible assets (e.g. a brand is
unique by its very definition), an estimation of fair value in terms of an active market is
generally not possible. This is because market transactions involving these unique assets
would not take place with sufficient frequency and volume for the definition of active market
to be met. Thus, the use of the revaluation model is generally impossible for most intangible
assets. Please note that although most intangible assets do not have active markets, some
intangible assets could have active markets. Fishing licences or production quotas are
examples of intangible assets for which active markets may exist. IAS 38.78
The following intangible assets do not have active markets due to their uniqueness, with the
result that the revaluation model may never be applied to them:
brands;
newspaper mastheads;
music and film publishing rights;
patents; and
trademarks. IAS 38.78
Important for you to notice!
Although an active market is required for the subsequent measurement to fair value under the
revaluation model, this is not a requirement when determining fair value for purposes of initial
measurement. For purposes of initial measurement, IFRS 13 allows the fair value to be determined in terms of
an active market or in terms of valuation techniques. Thus even where an intangible asset is so unique that it
has no active market as defined (e.g. a brand), this asset could be initially measured at fair value (determined in
terms of a valuation technique) but would have to be subsequently measured using the cost model.
If the revaluation model is used, revaluations must be performed with sufficient regularity that
the intangible asset’s carrying amount does not differ significantly from its fair value. The
frequency of the revaluations is dependent on the:
volatility of the market prices of the asset; and
the materiality of the expected difference between the carrying amount and fair value.
Chapter 9 475
A downside to adopting the revaluation model for an asset is that all assets in that same class
must be revalued at the same time. This makes it an expensive alternative to the cost model.
If, within a class of assets measured at fair value, there is an intangible asset for which the fair
value is not reliably measurable in terms of an active market, then that asset must be measured
at cost less accumulated depreciation and impairment losses. See IAS 38.81
If the revaluation model is used but at a later stage the fair value is no longer able to be
reliably measured (i.e. there is no longer an active market), this asset should continue to be
carried at the fair value measured at the date of the last revaluation less any subsequent
accumulated amortisation and impairment losses. Thus we simply leave the fair value at the
last known fair value and continue amortising and testing for impairment. See IAS 38.82
It should be stressed, however, that if an active market ceased to exist, the possibility of an
impairment must also be considered and thus an impairment test may need to be performed
and impairment loss may need to be processed. See IAS 38.83
If, at a later date, the fair value can once again be measured in terms of an active market, then
a revaluation is performed at that date and the carrying amount thus reflects the latest fair
value less any subsequent accumulated amortisation and impairment losses. See IAS 38.84
As already mentioned, the revaluation of an intangible asset is processed in the same way as
the revaluation of a tangible asset (IAS 16 Property, plant and equipment). In summary, two
methods of journalising the revaluation adjustment are allowed (see chapter 8, section 3.9):
the gross replacement method (proportional restatement); and
the net replacement method (elimination restatement). See IAS 38.80
These two methods have no impact on the net carrying amount, but simply have an impact on
the component ledger accounts: the ‘gross carrying amount account’ and the ‘accumulated
amortisation and impairment losses account’. This obviously impacts on the note disclosure.
7. Derecognition (IAS 38.112-.117)
An intangible asset must be derecognised: Derecognition means:

on disposal; or
when no future economic benefits are expected to remove from the accounting
from its use or disposal. IAS 38.112 records.
To derecognise an asset means to remove its carrying amount from the accounting records.
The carrying amount is removed (credit cost and debit accumulated amortisation &
impairment losses) and expensed as part of profit or loss (debit the disposal account).
If, when derecognising the asset, the entity earned proceeds on the disposal, these proceeds
would be recognised as income in profit or loss (debit bank and credit disposal account). The
amount of these proceeds is measured in the same way that a transaction price is measured in
terms of IFRS 15 Revenue from contracts with customers. See IAS 38.116
The expensed carrying amount is set-off against the proceeds in the asset disposal account.
This account will thus determine whether there was any gain or loss. It is important to note
that any gain on disposal may not be classified as revenue (i.e. it is simply classified as
income in profit or loss). See IAS 38.113
If a part of an intangible asset is being disposed of and replaced, we derecognise the carrying
amount of that part and recognise the cost of the replacement part. However, if the carrying
amount of the replaced part cannot be determined, we are allowed to use the cost of the
replacement part as an indication of what the replaced part was when it was originally
acquired or internally generated. See IAS 38.116
476 Chapter 9
The date on which the disposal is recorded depends on how it is disposed of:
If disposed of via a sale and leaseback agreement, we follow IAS 17 Leases (chapter 17).
If disposed of in any other way (e.g. by way of a sale), the asset is derecognised on the
date that the recipient obtains control of the item in terms of IFRS 15 Revenue from
contracts with customers (i.e. when the performance obligations are satisfied). See IAS 38.114
8. Disclosure (IAS 38.118 - .128)
8.1 General
Information should be provided for each class of intangible asset, distinguishing between
intangible assets that have been:
internally generated; and those
acquired in another manner. IAS 38.118
The following disclosure is required for all intangible assets:
Whether the asset has an indefinite or finite useful life; IAS 38.118 (a)
‘Gross carrying amount’ and ‘accumulated amortisation and impairment losses’ at the
beginning and end of each period; IAS 38.118 (c)
A reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable:
- additions (separately identifying those acquired through internal development,
acquired separately and acquired through a business combination);
- retirements and disposals;
- amortisation;
- impairment losses recognised in the statement of comprehensive income;
- impairment losses reversed through the statement of comprehensive income;
- increases in a related revaluation surplus;
- decreases in a related revaluation surplus;
- foreign exchange differences; and
- other movements. IAS 38.118 (e)
If the asset has a finite useful life, disclosure of the following is also required:
line item in the statement of comprehensive income in which amortisation is included;
methods of amortisation; and
period of amortisation or the rate of amortisation. IAS 38.118 (a); (b) & (d)
If the asset has an indefinite useful life disclosure of the following is also required:
the reasons (and significant supporting reasons) for assessing the life as indefinite; and
the carrying amount of the asset. IAS 38.122 (a)
The following information is required but need not be categorised into ‘internally generated’
and ‘acquired in another manner’:
The existence and carrying amounts of intangible assets:
- where there are restrictions on title; or
- that have been pledged as security for a liability; IAS 38.122 (d)
Where an individual intangible asset is material to the entity’s financial statements, the
nature, carrying amount and the remaining amortisation period thereof must be disclosed.
Information relating to impaired intangible assets: should be disclosed in accordance with
the standard on impairment of assets. IAS 38.120
Information relating to changes in estimates: should be disclosed in accordance with the
standard on accounting policies, estimates and errors. IAS 38.121
Research and development costs expensed during the period must be disclosed in aggregate. IAS 38.126
Where there are contractual commitments for the acquisition of intangible assets, the amount
thereof must be disclosed. IAS 38.122 (e)
Chapter 9 477
Where the intangible asset was acquired by way of government grant and initially recorded
at fair value rather than at its nominal value,
- then its initial fair value,
- its carrying amount; and
- whether the cost or revaluation model is being used. IAS 38.122 (c)
Where intangible assets are carried under the revaluation model, the following should be
disclosed by class of asset (unless otherwise indicated):
- a reconciliation between the opening balance and closing balance of that portion of the
revaluation surplus relating to intangible assets, indicating the movement for the period
together with any restrictions on the distribution of the balance to the shareholders;
- the carrying amount of the intangible asset;
- the carrying amount that would have been recognised in the financial statements had the
cost model been applied; and
- the effective date of the revaluation. IAS 38.124
Since the following information is considered to be useful to the users, the disclosure thereof is
encouraged, but it is not required:
A description of: fully amortised intangible assets that are still being used; and
A description of: significant intangible assets that are controlled by the entity but which
were not allowed to be recognised as assets. IAS 38.128
8.2 Sample disclosure involving intangible assets (excluding goodwill)
Company name
At 31 December 20X9 (extracts)
Note 20X9 20X8
ASSETS C C
Non-current assets
Property, plant and equipment xxx xxx
Intangible assets 4 xxx xxx
Company name
Revaluation Retained
surplus earnings Total
C C C
Balance at 1 January 20X8 xxx xxx xxx
Total comprehensive income (xxx) xxx xxx
Realised portion transferred to retained earnings (xxx) xxx 0
Balance at 31 December 20X8 xxx xxx xxx
Total comprehensive income xxx xxx xxx
Realised portion transferred to retained earnings (xxx) xxx 0
Balance at 31 December 20X9 xxx xxx xxx
Company name
Notes 20X9 20X8
C C
Profit for the year xxx Xxx
Other comprehensive income for the year: xxx (xxx)
Items that may never be reclassified to profit/loss
Revaluation surplus/ (devaluation), net of tax – 24 xxx (xxx)
intangible assets
Total comprehensive income for the year xxx xxx
478 Chapter 9
Company name
2.3 Intangible assets
Amortisation is provided on all intangible assets over the expected economic useful life to
expected residual values of zero unless the intangible asset has no foreseeable limit to the
period over which future economic benefits will be generated.
The following rates and methods have been used:
Patent (purchased): 20% per annum, straight-line method
Development (internally generated): 10% per annum, straight-line method
Casino licence (purchased): indefinite
The casino licence is considered to have an indefinite life since the period of the licence is not
limited in any way other than the meeting of certain prescribed targets that have been more
than adequately met in the past and are expected to continue to be met in the future.
The casino licence is revalued annually to fair values and is thus carried at fair value less
accumulated impairment losses. All other intangible assets are carried at historic cost less
accumulated depreciation and impairment losses.
At the end of each reporting period the company reviews the carrying amount of the intangible
assets to ascertain whether there is any indication that those assets have suffered an
impairment loss. If any such indication exists, the recoverable amount of the assets is
estimated in order to measure the extent of the impairment loss.
4. Intangible assets Patent Development Licence

20X9 20X8 20X9 20X8 20X9 20X8
C C C C C C
Patent xxx xxx xxx xxx xxx xxx
Development xxx xxx xxx xxx xxx xxx
Casino licence xxx xxx xxx xxx xxx xxx
xxx xxx xxx xxx xxx xxx
Net carrying amount - opening balance xxx xxx xxx xxx xxx xx
Gross carrying amount xxx xxx xxx xxx xxx xxx
Accum amortisation & impairment losses (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Additions
- through separate acquisition xxx xxx xxx xxx xxx xxx
- through internal development xxx xxx xxx xxx xxx xxx
- through business combination xxx xxx xxx xxx xxx xxx
Less retirements and disposals (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Add reversal of previous impairment loss/ xxx (xxx) xxx (xxx) xxx (xxx)
Less impairment loss through profit or loss
Revaluation increase/ (decrease):
- through OCI xxx (xxx) xxx (xxx) xxx (xxx)
- through P/L xxx (xxx) xxx (xxx) xxx (xxx)
Less amortisation for the period (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Other movements (xxx) xxx (xxx) xxx (xxx) xxx
Net carrying amount - closing balance xxx xxx xxx xxx xxx xxx
Gross carrying amount xxx xxx xxx xxx xxx xxx
Accum amortisation & impairment losses (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
The patent has been offered as security for the loan liability (see note …).
The amortisation of the development asset is included in cost of sales.
Chapter 9 479
Company name
4. Intangible assets continued ...
The development asset is material to the entity. The following information is relevant:
Nature: Design, construction and testing of a new product
Remaining amortisation period: 7 years
The amortisation of the casino licence is included in cost of sales.
The licence is measured using the revaluation model: the last revaluation was performed on 1/1/20X9
by an independent sworn appraiser to the fair value measured in accordance with an active market.
The revaluation was recorded on a net replacement value basis.
Revaluations are performed annually. 20X9 20X8
Carrying amount had the cost model been used instead: xxx xxx

C C
- Research and development expensed xxx xxx
- Amortisation expensed xxx xxx
- Impairment losses xxx xxx
- Reversals of previous impairment losses (xxx) (xxx)
24. Other comprehensive income: revaluation surplus: intangible assets 20X9 20X8
C C
Increase/ (decrease) in revaluation surplus on intangible assets xxx (xxx)
Deferred tax on increase in revaluation surplus (xxx) xxx
Increase/ (decrease) in revaluation surplus, net of tax xxx (xxx)
Revaluation surplus on intangible assets:
Opening balance xxx (xxx)
Increase/ (decrease) in revaluation surplus, net of tax xxx (xxx)
Closing balance xxx (xxx)
There are no restrictions on the distribution of the revaluation surplus to shareholders.
35. Contractual commitments

The company is contractually committed to purchase fishing licences worth Cxxx.
9. Goodwill (IAS 38 and IFRS 3)
9.1 Overview
Goodwill is described as the synergy between the identifiable assets or individual assets that
could not be recognised as assets. There are two distinct types of goodwill:
purchased goodwill (covered by IFRS 3); and
internally generated goodwill (covered by IAS 38).
9.2 Internally generated goodwill (IAS 38.48 - .50)
Internally generated goodwill is never capitalised since: Internally generated

it is not identifiable (i.e. is neither separable from the goodwill:
business nor does it arise from contractual rights); Always expensed
it simply cannot be reliably measured; and
it is not controllable (e.g. can’t control customer loyalty) See IAS 38.49
480 Chapter 9
9.3 Purchased goodwill (IFRS 3.32 and .34)
Purchased goodwill arises on the acquisition of another Purchased goodwill:

entity. It is measured as follows:
Positive (debit): asset
Amount paid for the entity Negative (credit): income
Less net asset value of the entity = goodwill*
*or gain on bargain purchase if the net asset value of the entity exceeds the amount paid for it.
9.3.1 Positive goodwill: asset (IFRS 3.32)
Positive goodwill arises if the amount paid for the assets Positive goodwill:
exceeds the value of the assets. This is:
Recognition: asset
always capitalised;
Subsequent measurement:
never amortised; and
- NEVER amortise; but
tested annually for impairment. - Test for impairments
Impairments may NEVER be reversed.
With regard to the testing of goodwill for impairment:
the test may occur any time so long as it is done at the same time every year;
any impairment loss written off against goodwill may never be reversed.
Purchased positive goodwill is therefore held as an asset in the statement of financial position
at its carrying amount, being ‘cost less accumulated impairment losses’.
Example 14: Positive purchased goodwill: asset
Purchase price of business C100 000
Net asset value of business C80 000
Required: Journalise the acquisition (ignore any tax effects).
Solution 14: Positive purchased goodwill: asset
Debit Credit
Goodwill: cost (A) 20 000
Net assets: cost (A) 80 000
Bank 100 000
Acquisition of a business worth C80 000 for an amount of C100 000
Comment: The recoverable amount of this goodwill must be assessed at year-end and if found to be
less than C20 000, this goodwill will need to be impaired.
9.3.2 Negative goodwill: income (IFRS 3.34)
When the value of the assets acquired exceeds the amount paid for
these assets we have what is referred to as a gain on a bargain Negative goodwill:
purchase, also called purchased negative goodwill. Purchased
negative goodwill is recognised as income immediately. Recognise as: income
Negative goodwill sounds like a ‘bad thing’ and yet it is treated as income. It will make more
sense if you consider some of the situations in which negative goodwill arises (the first two
situations are obviously ‘win situations’ for the purchaser and should help to understand why
it is considered to be income):
The seller made a mistake and set the price too low
The selling price is simply a bargain price
The entity that is purchased is expecting to make losses in the future.
In the third situation above, the negative income is recognised as income in anticipation of the
future losses (i.e. over a period of time, the negative goodwill income will effectively be
eroded by the future losses).
Chapter 9 481
Example 15: Negative purchased goodwill: income

Purchase price of business C100 000
Net asset value of business C750 000
Required: Journalise the acquisition (ignore any tax effects).
Solution 15: Negative purchased goodwill: income

Debit Credit
Net assets: cost (A) 750 000
Bank 100 000
Gain on bargain purchase (I) 650 000
Acquisition of a business worth C750 000 for an amount of C100 000
Comment: Negative goodwill is a gain made on the purchase transaction and is thus recognised as income
immediately.
9.3.3 Initial recognition measured provisionally (IFRS 3.45 - .50)
When the fair value of certain assets or liabilities acquired in a business combination can only
be provisionally estimated at the date of acquisition, these assets and liabilities must be
measured at their provisional fair values and the goodwill accounted for as the difference
between the purchase price and these provisional fair values.
The provisional fair values must, however, be finalised within twelve months from acquisition
date. When the ‘provisional’ values are finalised, the comparatives must be restated from the
acquisition date, as if the asset value was known with certainty at the purchase date.
Example 16: Provisional accounting of fair values
Doc Limited purchased Nurse Limited on the 30 November 20X8 for C80 000, on which
date the following information applied:
The fair value of Nurse Limited’s plant (its only asset) could not be measured by the independent
appraiser in time for the 31 December 20X8 year end.
The fair value of the plant was provisionally measured as C36 000.
The plant’s useful life was estimated on date of acquisition to be 10 years (residual value: nil).
On 30 September 20X9 the plant’s at acquisition fair value was finally measured to be C42 000.
Required: Discuss how the acquisition should be accounted for in the financial statements of
Doc Limited for the years ended 31 December 20X8 and 20X9.
Provide journal entries where this will aid in your explanation.
Solution 16: Provisional accounting of fair values

In the 20X8 financial statements the plant must be recognised at the provisional valuation of C36 000,
and the goodwill is measured at the balancing amount of C44 000. One month depreciation would be
recorded at C300, calculated at C36 000/10 years x 1/12 months.
30 November 20X8 Debit Credit
Plant: cost (A) Given (provisional fair value) 36 000
Goodwill: cost (A) Balancing 44 000
Bank Given 80 000
Acquisition of Nurse Limited at provisional fair values
31 December 20X8
Depreciation – plant (E) 36 000 / 10 x 1 / 12 300
Plant: acc. depreciation (-A) Given 300
Depreciation of plant (acquired through acquisition of Nurse Limited)
The 20X8 financial statements would thus have included the following year-end balances/ totals:
Goodwill 44 000
Plant (Cost: 36 000 – AD: 300) 35 700
Depreciation 300
482 Chapter 9
During September 20X9 the valuation was finalised and thus the asset must be accounted for as if we
knew the true fair values at acquisition date. The following journals would thus be processed in 20X9:
30 September 20X9 Debit Credit
Plant: cost (A) Final FV: 42 000 – Provisional FV: 36 000 6 000
Goodwill (A) 6 000
Adjustment to fair values of the assets acquired through acquisition of Nurse
31 December 20X9
Retained earnings (Eq) (1) Extra depr on extra cost: 6 000 / 10 x 1 / 12 50
Plant: acc. depreciation (-A) 50
Adjustment to 20X8 depreciation of plant
(1) Notice that retained earnings are debited (not depreciation expense: this is because the adjustment relates to
the 20X8 depreciation which has already been closed off to retained earnings. The adjustment is retroactive,
which means it is an adjustment to that prior year: it must not affect this year’s profit. The comparative 20X8
financial statements would therefore be restated as follows:
Goodwill (44 000 estimate – 6 000 adjustment) 38 000

Plant 36 000 – 300 depr + Retroactive adj in 20X9 (6 000 – 50) 41 650
Depreciation (42 000/ 10 x 1/ 12) 350
Plant is depreciated in 20X9. The following journal would therefore be processed:
Depreciation – plant (E) 42 000 / 10 years x 12/12; or 4 200
Plant: acc. depreciation (-A) (42 000 – 350) / (120– 1) x 12 months 4 200
Depreciation of plant (acquired through acquisition of Nurse Limited)
The 20X9 financial statements would therefore reflect the following balances/ totals:
Goodwill Assuming no impairment necessary 38 000
Plant O/bal: 41 650 – Depr: 4 200 37 450
Depreciation 4 200
9.3.4 Adjustment in the initial accounting (IFRS 3.50)

Except for the possible need to re-measure fair values on date of acquisition (explained
above), the only other subsequent adjustments to the fair values of the acquisition of assets,
liabilities and goodwill acquired in a business combination is any correction of errors.
The correction of such an error would need to be adjusted for retrospectively and disclosed in
accordance with the standard on accounting policies, estimates and errors (IAS 8).
9.3.5 Subsequent measurement of purchased goodwill
If purchased goodwill is negative, it is recognised immediately as income and referred to as a
gain on bargain purchase. There is no subsequent measurement relating to this gain.
If the purchase goodwill is positive (a debit), it is Subsequent measurement
recognised as an asset. Subsequent measurement of the of purchased goodwill
purchased goodwill asset is as follows: asset:
it may not be amortised; Cost (Amt paid – FV of NAs acquired)
it must be tested for impairment. See IFRS 3.B69(d) Less accumulated impairment losses
Impairment testing must be done annually on purchased An impairment on goodwill:
goodwill acquired in a business combination but it may be may NEVER be reversed!
done at any time during the year, as long as it is performed at the same time every year. IAS 36.96
The entity may be able to use a recent detailed calculation of the recoverable amount of a
cash-generating unit to which goodwill has been allocated, instead of having to measure the
recoverable amount again, assuming that certain specified criteria are met. These specific
criteria are covered in more depth in the chapter on impairment of assets. IAS 36.99
An impairment of goodwill may never be reversed. IAS 36.124
Chapter 9 483
9.4 Disclosure of goodwill (IFRS 3: Appendix B.64, and .67)

9.4.1 Disclosure: positive goodwill: asset
The following information should be disclosed for goodwill:
a reconciliation between the opening and closing balances of goodwill (separately
disclosing gross carrying amount and accumulated impairment losses),
the reconciling items would include: additions, disposals, adjustments relating to changes
to the net asset value of the acquired entity, impairment losses, net exchange differences
arising during the year and any other movement during the period.
9.4.2 Disclosure: negative goodwill: income
Where we have negative goodwill (gain on a bargain purchase), we must disclose:
the line item in the statement of comprehensive income in which the negative goodwill is
recognised as income; and
the amount of the negative goodwill.
The negative goodwill income is thus normally disclosed in the profit before tax note.
9.4.3 Sample disclosure involving goodwill
Company name
At 31 December 20X9 (extracts)
ASSETS Note 20X9 20X8
Non-current Assets C C
Property, plant and equipment xxx xxx
Goodwill 7 xxx xxx
Intangible assets 8 xxx xxx
Company name
2.5 Goodwill
Goodwill arising from the acquisition of a subsidiary represents the excess of the cost of the
acquisition over the group’s interest in the net fair value of the assets, liabilities and contingent
liabilities of the acquiree. Goodwill is measured at the cost less accumulated impairment.
20X9 20X8
7. Goodwill C C
Net carrying amount - opening balance xxx xxx
Gross carrying amount - opening balance xxx xxx
Accumulated impairment losses - opening balance (xxx) (xxx)
Additions
- through business combination xxx xxx
Less: disposals of subsidiary (xxx) (xxx)
Less: Impairment (xxx) (xxx)
Net carrying amount - closing balance xxx xxx
Gross carrying amount - closing balance xxx xxx
Accumulated impairment losses - closing balance (xxx) (xxx)
Gain on a bargain purchase (xxx) (xxx)
Impairment loss on goodwill xxx xxx
484 Chapter 9
10. Black Economic Empowerment (BEE) Transactions (AC503)
In South Africa, an entity may issue equity instruments to

BEE partners with a fair value higher than the fair value of BEE equity credentials
the identifiable consideration received (cash and non-cash must be expensed
assets) in exchange for these instruments. This may arise
due to the benefits the BEE partner could provide to the company (e.g. through improving the
entity’s BEE rating) or through providing specific goods and services to the company.
A South African accounting interpretation (AC 503) was released in order to clarify how to
account for such BEE transactions. The interpretation concluded that the difference between:
the fair value of the equity instruments granted (e.g. ordinary shares); and the
the fair value of the identifiable consideration received (cash and non-cash assets)
must be expensed, and not capitalised as an intangible asset.
The reason for this conclusion was based on the fact that the entity cannot fully control the
future economic benefits of the BEE equity credentials. Competitors may also obtain BEE
credentials, over which the entity would not have control and which would thus impact the
entity’s possible future economic benefits from their own BEE credentials.
That said, the cost of acquiring BEE equity credentials may be indirectly recognised as an
intangible asset in the following two situations:
if the cost of acquiring the BEE credentials is directly attributable to the acquisition of
another intangible asset, the cost of these BEE credentials may be capitalised to the cost of
that other intangible asset; and
if the BEE credentials were obtained as part of the net assets acquired in a business
combination, the cost thereof would form part of goodwill (an asset).
Example 17: BEE Equity Credentials

Bee Limited enters into a contract with Mr Partner in order to improve the entity’s BEE
rating and thus enable it to secure certain contracts which it would otherwise not be able to
apply for. The terms of the contract granted Mr. Partner 3 000 ordinary shares, which were
currently trading at a market price of C3 each .
Required: Journalise the above assuming that, in exchange for the shares, Mr Partner provided:
A. cash of C5 000;
B. cash of C5 000 and a valuable patent to a product that he had recently developed and which
BEE Limited would put into production.
Solution 17A: BEE Equity Credentials – cash received

Debit Credit
Bank Given 5 000
BEE equity credentials (expense) Balancing 4 000
Stated capital (equity) Fair value: C3 x 3 000 9 000
BEE transaction with Mr Partner to acquire BEE credentials
Solution 17B: BEE Equity Credentials – cash and an intangible asset received
Debit Credit
Bank Given 5 000
Patent: cost (asset) Balancing 4 000
Stated capital (equity) Fair value: C3 x 3 000 9 000
BEE transaction with Mr Partner to acquire BEE credentials & a
patent.
Chapter 9 485
11. Summary
Intangible assets
Definition
IAS 38 – additional points

Framework – asset definition identifiable
(see guidance given on how to prove control) non-monetary
asset
without physical substance
Recognition
Recognise as an asset if it meets the
Definition of intangible asset (incl asset)
Recognition criteria
Initial measurement
Initially measure at cost
Internally generated Acquired
Internally generated items that may never Types of acquisition:

be recognised as assets: Separate acquisition:
goodwill Recognise as an asset if definition met
brands (recognition criteria always met)
mastheads Measure at cost: purchase price; import
publishing titles duties, non-refundable taxes; directly
customer lists attributable costs
Business combination:
If the internal generation relates to some item Recognise as an asset if definition met
other than one of the items above, then (recognition criteria always met)
separate costs into research and development: Measure at cost: FV on acquisition date
Government Grant:
Research: Recognise if definition met and recognition
Recognise as an expense criteria met
Measure at cost: FV or nominal amount plus
Development: other necessary costs
Recognise as an asset if all 6 rec. criteria can Asset exchange:
be demonstrated: Recognise as an asset if transaction has
technical feasibility of completing the IA commercial substance
intention to complete and sell/ use the IA Measure at cost:
ability to sell/ use the IA FV of the asset given up adjusted for C &
how the IA will generate future economic CE; or
benefits (e.g. prove that there is a market FV of asset acquired if more clearly
if the intention is to sell; or prove its evident; or CA of asset given up if both FV
usefulness if the intention is to use) not available
the availability of necessary resources to
complete the development and to sell/ use
the IA
the ability to reliably measure the costs of
developing the IA.
486 Chapter 9
Subsequent measurement: amortisation
Finite useful lives Indefinite useful lives
Amortise and Don’t amortise

Perform an impairment indicator test Calculate the RA at the same time every
annually (in accordance with IAS 36) year
Amortisation
Depreciable amount Method Period

Cost or FV less RV, straight-line or Start from date IA available for
where RV is zero unless: other method if use.
3rd party committed to more Shorter of its
purchase the IA at the end of appropriate UL or
its UL; or legal life unless legal rights
AM exists and RV can be renewable AND evidence
measured from this AM, and suggests renewal will occur at
probable that AM will exist at insignificant cost
the end of IA’s UL
Subsequent measurement: impairments
Finite lives Indefinite lives Not yet available for use

Perform an impairment Calculate RA at least Calculate RA at least
indicator test annually (in annually annually
accordance with IAS 36) Or whenever an impairment Or whenever an
Where there is a possible is indicated impairment is indicated
impairment that is: There is a situation in
material; and is which a previous calculation
not ‘fixed’ by could be used instead of
processing extra recalculating the RA
amortisation
calculate the RA at RD
Subsequent measurement: the two models
Cost model Revaluation model

Calculation of carrying amount: Calculation of carrying amount:
- cost - fair value
- less accumulated amortisation - less accumulated amortisation
- less accumulated impairment losses - less accumulated impairment losses
Revaluations to fair value are performed after initial
recognition at cost
The RM may only be used if a FV is reliably
measurable in terms of an AM
An active market is defined as
- a market in which transactions for the A/L take
place with sufficient frequency & volume
- giving pricing information on an ongoing basis.
Chapter 9 487
Goodwill
Purchased Internally generated

Positive: recognise as an asset and test Always expense
for impairments annually and more often
if an impairment is suspected
Negative: recognise as income
Measurement Disclosure
Positive = Asset Positive = Asset
Initial amount (cost): reconciliation of opening and closing
Amount paid balances (same as for PPE)
less value of net assets acquired
Subsequent amount:
Cost
Less accumulated impairment losses
Negative = Income Negative = Income
Amount paid amount recognised as income
Less value of net assets acquired
Clue to abbreviations:
FV = fair value
C and CE = cash and cash equivalents
CA = carrying amount
IA = intangible asset
RV = residual value
RA = recoverable amount
AM = active market
PPE = property, plant and equipment
RC = recognition criteria
RD = reporting date
NCA=non-current asset
488 Chapter 9
Gripping GAAP Investment properties
Chapter 10
Investment Properties
Reference:
IAS 40, IAS 12, IFRS 13 and IFRS15 (including any amendments to 10 December 2014)
Contents: Page
1. Introduction 491
2. Recognition of an investment property 491

491
3. Classification as investment property
491
3.1 Overview 491
3.2 Classification in general 492
Example 1: Intentions 493
3.3 Classification of joint use properties 494
Example 2: Joint use properties 494
3.4 Classification of properties held under operating leases 495
3.5 Classification of properties leased in a group context 496
Example 3: Group investment properties 496
Example 4: Group investment properties 497
3.6 Classification of properties involving ancillary services 497
Example 5: Ancillary services 497
4. Measurement 498
4.1 Overview 498
4.2 Initial measurement: cost 499
4.2.1 Overview 499
4.2.2 Costs 499
4.2.3 Cost of a property interest held under a lease 500
4.2.4 Cost of an investment property acquired via an exchange 500
4.2.5 Subsequent costs 500
Example 6: Subsequent expenditure 501
4.3 Subsequent measurement: the cost model 501
4.3.1 When the cost model is compulsory 502
4.4 Subsequent measurement: the fair value model 502
4.4.1 The fair value model in general 502
4.4.2 Fair value model: What is fair value? 502
4.4.3 Fair value model: Inability to measure the fair value 503
Example 7: Fair value cannot be reliably measured 504
4.4.4 Fair value model: When is this model compulsory? 504
Chapter 10 489
Contents continued:
5. Change in use 504

5.1 Overview 504
5.2 If the entity uses the cost model 505
5.3 If the entity uses the fair value model 505
5.3.1 Change from owner-occupied property to investment property 505
Example 8: Change from owner-occupied to investment property 506
5.3.2 Change from inventories to investment property 507
Example 9: Inventory to investment property 507
5.3.3 Change from IP to owner-occupied property or inventories 508
Example 10: Change from investment property to owner-occupied
property 508
6. Disposal 508
Example 11: Disposal 509
7. Deferred tax 509

Example 12: Deferred tax: fair value model (depreciable and deductible) 510
Example 13: Deferred tax: fair value model (depreciable and non-deductible) 513
Example 14: Deferred tax: fair value model (land and building) 515
8. Current tax 517
Example 15: Current tax: intention to keep and use (including land) 518
9. Disclosure 519
9.1 General disclosure requirements 519
9.1.1 An accounting policy note for investment properties 519
9.1.2 An investment property note 519
9.1.3 Profit before tax note 519
9.1.4 Contractual obligation note 519
9.2 Extra disclosure when using the fair value model 519
9.2.1 Investment property note 519
9.3 Extra disclosure when using the cost model 520
9.3.1 An accounting policy note for investment properties 520
9.3.2 The investment property note 520
9.4 Sample disclosure involving investment properties 521
10. Summary 522
490 Chapter 10
1. Introduction
This chapter deals with property, which is a term that refers to both land and/or buildings that
are classified as investment property. IAS 40 Investment properties, requires that the entity
differentiate between investment properties and other properties, such as:
owner-occupied property (classified as property, plant and equipment),
property held for sale in the ordinary course of business (classified as inventory), and
property leased out under a finance lease to a third party (property, plant and equipment).
For an item to be classified as investment property, it must meet the definition of investment
property. Investment property is essentially property from which the entity intends to earn
capital appreciation or rental income or both. Once an item has been classified as investment
property, we must decide whether it meets the criteria for recognition as an asset. If it does,
we will need to know what amount it will be recognised at – this is called initial measurement
(initial measurement is at cost) (section 4.2). We will then need to know how to measure it on
an ongoing basis thereafter – this is called subsequent measurement (the subsequent
measurement of an investment property involves the choice between the cost model and fair
value model) (section 4.3 and 4.4). If we have investment property at reporting date, this will
need certain disclosures. Each of the aspects of classification, recognition, measurement and
disclosure will now be discussed.
2. Recognition of an Investment Property (IAS 40.16 - .19)
Property that has been classified as an investment Investment property costs

property may only be recognised (i.e. journalised) as may only be recognised as an
an asset if it meets the basic recognition criteria: asset (i.e. capitalised) if:
they meets the recognition criteria
the expected inflow of future economic benefits
-FEB are probable
is probable; and
-Cost or value is reliably measurable
it has a cost or value that is reliably measurable.
We must question whether these recognition criteria are met whenever a cost is incurred.
This means that we would consider whether the recognition criteria are met when we incur:
the initial cost to acquire the property, and also when we incur
any related subsequent costs such as:
- costs of adding to the property (e.g. constructing a second floor to a building);
- cost of replacing parts of a property (e.g. a part of a building may need to be
reconstructed after a fire): the replaced part would need to be derecognised and the
new part would be recognised as an asset if it meets the recognition criteria (failing
which, it would be recognised as an expense); and
- costs of day-to-day servicing of the property (e.g. maintenance and minor repairs):
these costs always fail to meet the recognition criteria and are thus recognised as
expenses.
3. Classification as Investment Property (IAS 40.16 - .19)
3.1 Overview
For property to be classified as an investment property, it must meet the definition of
investment property. Deciding whether or not the definition is met is generally simple but not
always. For example, complications may arise when a property (a) has a dual purpose (i.e. a
joint use property), (b) is held under an operating lease (this may also be classified as an
investment property under certain circumstances), (c) is held by an entity within a group
context, (d) has ancillary services provided by the entity (e.g. security services) and also if (e)
its use has changed (e.g. from using it to earn rentals, in which case it was investment
property, to using it as the company head office, in which case it is property, plant and
equipment).
Chapter 10 491
All these issues of classification will now be considered in section 3, with the exception of a
change in use. Issues involving change in use are explained in section 5.
3.2 Classification in general (IAS 40.8 - .9 and .57)
To classify a property as an investment property, we Investment Property is

simply have to ensure that it meets the definition of an defined as:
investment property (see grey block alongside). land/buildings (or both, or part of a
building);
When deciding whether the investment property held by:
definition is met, we basically need to decide what the -an owner or
entity’s intention is for acquiring or holding the -a lessee under a finance lease *
property: if the intention is to earn rentals or capital to earn rentals or for capital
appreciation or both, then land and / or buildings are appreciation or both;
classified as an investment property. rather than for use in the production
or supply of goods or services or for
The following are examples of property that are administrative purposes or sale in the
ordinary course of business. IAS 40.5
classified as investment property:
* There is an exception whereby a
property held for long-term capital appreciation property held under an operating
(i.e. not a short-term sale); lease may be classified as an
a building that is leased out under an operating investment property.
lease; This exception is explained in
IAS 40.6 and section 3.4 of this
a vacant building that is held with the intention to chapter.
lease it out under an operating lease;
a property being constructed or developed for future use as an investment property;
a property that is being redeveloped for continued use as an investment property; and
land whose use is undecided (i.e. IAS 40 is saying that in this situation, you should
assume that the land is held for capital appreciation). IAS 40.8 (reworded)
The following are examples of property that are not classified as investment property:
property that is owner-occupied (this is IAS 16 Property, plant and equipment);
property that is leased out to someone under a finance lease (this is IAS 17: Leases) and
property held for sale in the ordinary course of business (this is IAS 2: Inventory)
Owner-occupied property is essentially land or Owner occupied property is

buildings that are either owned or are leased under a defined as:
finance lease and are used to produce goods or services land or buildings (or both, or part of
or used for administration purposes. Examples a building)
include: held by an owner or by a lessee
Administration buildings; under a finance lease
for use in the production or supply
Factory buildings or shops; of goods or services, or for
Employee housing; administration use. IAS 40.5
Property held for future use as owner-occupied
property;
Property that is owner-occupied and awaiting disposal. IAS 40. (reworded)
There are only two instances a property that was investment property would cease to be
classified as an investment property (i.e. transferred out of investment property).
Firstly, when the investment property becomes owner-occupied – in which case it is must
be transferred to a property, plant and equipment account.
Secondly, when there is commencement of development of the investment property with
the view to resale – in which case it must be transferred to an inventory account.
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Please note, however, that if a decision is made to There are only four
dispose of an investment property but without instances where transfers
development, this property remains classified as an occur in and out of the
investment property until disposal. This is because investment property
there are two requirements which must both be met account:
simultaneously in order for a transfer to occur from Investment property to Inventories
investment property to inventories and this involves Investment property to Owner-
development commencing at the same time as the occupied property
intention to sell the property. IAS 40.57 & 58 (reworded) Owner-occupied property to
Investment property
There are only two instances when a property that
Inventories to Investment property
was not classified as investment property would
become classified as an investment property (i.e. transferred into investment property):
when a property that was owner-occupied ceases to be occupied by the owners – in which
case it is immediately transferred from property, plant and equipment to investment
property; and
when a property that was held for sale in the ordinary course of business is rented out
under an operating lease – in which case it is immediately transferred from inventories to
investment property.
The second instance referred to above specifically mentions the reclassification to investment
property of a property that was originally held for sale in the ordinary course of business (i.e.
inventory) and which was then subsequently rented out under an operating lease instead.
What is important to notice here is that if the rental agreement constitutes a finance lease
instead of an operating lease, this property would not become classified as investment
property (it would simply be classified as a finance lease, in terms of IAS 17 Leases).
Example 1: Intentions
Pillow Limited was in the process of constructing a building to be used to earn rental income
when, due to financial difficulties, it could not complete the construction thereof.
Required:
Explain how Pillow Limited should account for the building if its intention is now to:
A. sell the building ‘as is’ (Pillow Limited sometimes sells buildings as part of its business activities);
B. hold the building ‘as is’ for capital appreciation; or
C. borrow from the bank and complete the building, then use it as the entity’s head office.
Solution 1: Intentions
Comment: This example explains how the entity’s intentions regarding the building determine the
method of accounting.
Whilst the property was being developed, it should be classified as investment property since the
entity’s intention was to earn rental income from the property. However, the recent turn of events and
change in intention would result in the following accounting treatment going forward:
A. IAS 40.57 limits the transfers in / out of investment property.
One of the possible transfers out of Investment Properties is to inventories.
However, this transfer to inventories is only allowed if there is commencement of development of
the property with a view to sell it.
If the intention is to sell the property but it is not being developed for the purposes of such a sale,
the property remains classified as investment property.
In this example, although there is an intention to sell this property, it must not be reclassified to
inventories (i.e. it remains investment property) because it is being sold ‘as is’ (i.e. it is not being
developed with the intention to sell it).
B. If the intention is to keep the building for capital appreciation, the building will remain classified
as investment property. Pillow Limited will then have the option to measure this building under
the fair value model (preferred by IAS 40) or the cost model. (See section 4.3 and 4.4)
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Solution 1: Continued...
C. If the intention is to borrow from the bank and complete the building for the purpose of future
owner-occupation, the building must be transferred to property, plant and equipment. Borrowing
costs must be capitalised if the building is a qualifying asset. If it is not a qualifying asset, the
borrowing costs must be expensed (in accordance with IAS 23: Borrowing Costs)
3.3 Classification of joint use properties (IAS 40.10 and .14)
It sometimes happens that property (i.e. land and buildings) are used for a variety of purposes
with the result that a portion of the property meets the definition of investment property and a
portion of the property meets the definition of property, plant and equipment. These
properties are referred to as joint use properties.
Joint use properties occur when:

Joint use properties are
a portion of the property is used to earn capital properties where:
appreciation and / or rental income (an investment
part appears to be IP (e.g.
property); and used to earn rent); &
a portion of the property is used in the production part appears to be PPE (e.g. used in
or supply of goods or services and / or for production of goods/ services)
administration purposes (an owner-occupied
property). IAS 40.10 (reworded)
These two portions may need to be classified separately.
Whether to classify each portion separately is determined as follows:

if each portion can be sold or leased out separately (under a finance lease), then each
portion is classified separately (one as an investment property and the other as an owner-
occupied property);
if each portion cannot be sold or leased out separately, then:
if the owner-occupied portion is an insignificant portion, then the entire property is
investment property; and
if the owner-occupied portion is the significant portion, then the entire property is
property, plant and equipment. IAS 40.10 (reworded)
IAS 40 is silent on what percentage constitutes an insignificant portion and is also silent on
whether significance should be based purely on the percentage of the physical area that is
owner-occupied or should one also consider the relative significance or insignificance of the
business carried out in the area that is owner-occupied. The IASB deliberately decided not to
provide any such guidance as this could lead to arbitrary decisions. Professional judgment is
thus required to determine whether the owner-occupied portion is insignificant and thus
whether the property qualifies as investment property. An entity must thus develop criteria so
that it can exercise its judgement consistently. IAS 40.14
Example 2: Joint use properties

Stunning Limited owns properties in Durban, Port Elizabeth, Cape Town and D’Aar.
Required: Briefly explain how Stunning Limited should classify its properties in each of these areas,
details of which are as follows:
A Durban: Stunning Limited owns two freestanding buildings on adjoining but separate sites in
Durban, South Africa: one is used by Stunning Limited for administration purposes and the other is
leased to Runodamill Limited.
B Port Elizabeth: Stunning Limited owns a twenty-storey building in Port Elizabeth: it leases out
nineteen floors (each operating lease agreement includes an option to purchase) and uses the top
floor as its head office.
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C Cape-Town: Stunning Limited owns an eight-room house in Cape Town: six rooms are used for
administration purposes and two rooms are leased to Unpleasant Limited under an operating lease.
The layout of the house makes it impossible for the rooms to be separately sold or leased under a
finance lease.
D D’Aar: Stunning Limited owns a two-storey house in D’Aar: one floor houses Stunning’s entire
business and one floor is leased to S. Kwatter under an operating lease. A single set of title deeds
exists for the house, prohibiting both the piecemeal sale of the house and the piecemeal transfer of
ownership by way of finance lease.
Solution 2: Joint use properties

Comment: This example explains how to identify joint use properties and how to classify land and
buildings that are joint use properties (IAS 40.10).
A. There are two distinct and separate buildings: owner-occupied and leased out. Since each building
is on a separate site, it is assumed that they can be sold and / or leased out separately. These
buildings, being so separate from one another would not be considered joint-use properties. The
building used for administrative purposes falls within the definition of owner-occupied property
and must therefore be disclosed as property, plant and equipment. The building leased out under
an operating lease must be disclosed as an investment property.
B. There are two portions within a single property: owner-occupied and leased out. This is thus a
joint-use property. Since each of the nineteen tenants have also been offered options to purchase,
it is clear that each of these nineteen floors are separable. Since the property is separable, the
nineteen floors that are leased out must be classified as an investment property and the remaining
one floor used as the company head office must be classified as property, plant and equipment.
C. There are two portions within a single property: owner-occupied and leased out. Since these two
portions are in one property, this is a joint-use property. The layout of the property means that the
two portions cannot be sold separately or leased out separately under a finance lease. Thus, we
must consider if the portion used as owner-occupied is significant or insignificant. Six of the eight
rooms are owner-occupied. It is submitted that this is a significant portion and thus Stunning
Limited must classify the entire house as owner-occupied (i.e. as property, plant and equipment).
D. There are two portions within a single property: owner-occupied and leased out. This is thus a
joint-use property. The title deeds prevent the building from being sold in parts and from being
leased out separately under a finance lease. Thus, we must consider if the portion used as owner-
occupied is insignificant or not. One floor is owner-occupied (property, plant and equipment) and
the other floor is leased out under an operating lease (investment property). The physical split
between owner-occupied and leased is 50:50 and thus we cannot determine ‘significance’ purely
on physical area. However, since the 50% owner-occupied portion houses the entire business, it is
submitted that the owner-occupied portion must be considered significant and thus the entire
building is classified as owner-occupied (i.e. as property, plant and equipment).
3.4 Classification of properties held under operating leases (IAS 40.6)
If the entity holds a property under an operating lease Property held under an
(leasing it from someone else), the entity may choose to operating lease can only
classify the property as an investment property if, and only be classified as
if: the definition of an investment property (discussed investment property if:
above) is met and the entity uses the fair value model to the property meets the
measure all its investment property. See IAS 40.6 definition of investment
property and ;
This option is allowed for properties held under operating the entity uses the fair value
leases on a property-by-property basis (i.e. this does not model to account for all of its
mean that all eligible operating leases must be classified as investment property.
investment properties).
What it will mean though is that once the fair value model is adopted in order to classify a
property held under an operating lease as an investment property, each and every other
investment property must now be valued using the fair value model.
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If a property held under an operating lease is classified as an investment property, the lease is
accounted for as a finance lease (not as an operating lease!). The property is then measured in
the financial statements at the lower of:
the fair value of the property, and
the present value of the minimum lease payments (see the leasing chapter). IAS 40.25 (reworded)
In this scenario, it can be seen that IAS 40 overrides IAS 17 by requiring that the lease is
accounted for as if it were a finance lease.
3.5 Classification of properties leased in a group context (IAS 40.15 and IAS 40.6)
A property leased under an operating lease within a group (i.e. the lessee is a subsidiary and
the lessor is the parent company, or vice versa), is classified:
in the lessor’s financial statements: as investment How entities in a group
property (reminder: only if it is an operating lease); context account for
in the lessee’s financial statements: either as investment properties that
an operating lease; or are held under operating
as investment property accounted for as if it leases:
were held under a finance lease (this can only Lessor: Investment property
happen if the investment property definition is Lessee: Operating lease or
met and if all the lessee’s other investment investment property accounted for
as if it were a finance lease (latter
properties are measured under the fair value can only happen if the relevant
model - see 3.4 above); and criteria are met)
in the group financial statements: as property, plant Group: PPE (As it is owner-occupied)
and equipment (since, from a group perspective, it is owner-occupied). IAS 40.15 (reworded)
Example 3: Group investment properties

Big Limited leases a building from Small Limited, a subsidiary of Big Limited, under an
operating lease. The following applies:
Small Limited purchased the building for C20 million on 1 January 20X5.
Small Limited’s accounting policy for investment properties is the fair value model.
The fair value as at 31 December 20X5 was C20 million.
The useful life of the building is expected to be 20 years with a nil residual value.
Big Limited uses the cost model for its property, plant and equipment.
Big Limited uses the fair value model to value its investment properties.
Big Limited uses the building for its administration department.
Required: Explain how the building should be accounted for in the financial statements of:
A. Small Limited’s company financial statements.
B. Big Limited’s company financial statements.
C. Big Limited’s group financial statements.
Solution 3: Group investment properties

A. In Small Limited’s financial statements as at 31 December 20X5: The building must be classified
as investment property since it meets the definition of investment property as it is earning rentals
and is not owner-occupied. It should be measured at fair value because the use of the fair value for
investment properties is Small Limited’s chosen accounting policy.
Investment property measured under the FV model, is not depreciated or tested for impairment.
B. In Big Limited’s financial statements as at 31 December 20X5: If an entity holds a property under
an operating lease, the entity may choose to recognise the property as investment property only if;
the property meets the definition of an investment property; and
the entity uses the fair value model to account for all its investment property.
Although Big Limited uses the fair value model for its investment properties, it may not choose to
recognise the leased building as an investment property because it is occupied by Big Limited for
administrative use and thus does not meet the definition of an investment property.
Since the building is not an investment property and is held under an operating lease, it will not be
recognised as an asset at all. Big Limited will recognise a lease rental expense in terms of IAS 17.
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C. In the group financial statements as at 31 December 20X5: The building must be classified as
property, plant and equipment, because, from a group perspective, it is owner-occupied.
Therefore, it must be measured at depreciated historic cost of C19 million (since the group uses the
cost model to measure property, plant and equipment) and depreciated over its 20 year useful life.
Example 4: Group investment properties

Grand Limited purchased a building from Insipid Limited, a subsidiary of Grand Limited,
on 31 March 20X5. Insipid Limited originally purchased this building on 5 January 20X5 in
order to sell it to Grand Limited as part of its ordinary business activities. Grand Limited purchased the
building from Insipid Limited with the intention of leasing it out to Insipid Limited under an operating
lease.
Required: Explain how the building should be classified in:
A. Insipid Limited’s company financial statements for the year ended 31 December 20X5.
B. Grand Limited’s company financial statements for the year ended 31 December 20X5.
C. The group financial statements for the year ended 31 December 20X5
Solution 4: Group investment properties

A. In Insipid Limited’s financial statements as at 31 December 20X5: the transaction must be
recognised as a sale of inventory. The building would have been included in inventory and
measured at its cost, and would then have been transferred to the cost of sales account upon its sale
to Grand Limited. The price at which it was then sold to Grand Limited would then have been
recognised as sales revenue, in terms of IFRS 15: Revenue from Contracts with Customers.
B. In Grand Limited’s financial statements as at 31 December 20X5: since Grand’s intention on
acquisition is to earn rental income from this property, it is classified as investment property.
C. In the group financial statements as at 31 December 20X5: the sale and cost of sale are not
recognised since, from a group perspective, the intention behind the purchase of the property was
to occupy it (i.e. owner-occupied property). Therefore, from a group perspective, the property
would have been classified as property, plant and equipment and any inter-company adjustments
and transactions need to be eliminated on consolidation.
3.6 Classification of properties involving ancillary services (IAS 40.11 - .13)
An entity may provide ancillary services to the Classification of investment

occupants of its property (such as maintenance of the properties when ancillary
building or security). In such a case, the property may services are provided:
only be classified as an investment property if these If services are insignificant:
services are insignificant or incidental to the whole Investment property
arrangement. IAS 40.11 (reworded) If services are significant:
Owner occupied property
If the services provided are considered to be
significant and / or the entity is exposed to significant variations in cash flows from the
property, then the entity can no longer be considered to be a passive investor and
classification as investment property may no longer be appropriate. IAS 40.13 (reworded)
As with partly leased out properties, the entity must develop criteria for classification
purposes so that it can exercise its judgement consistently.
Example 5: Ancillary services

Clumsy Limited owns four properties:
A. An office building which it leases out to another company under an operating lease. Clumsy
Limited provides security services to the lessee who occupies this building.
B. Hotel Mystique: Clumsy Limited leases it to Smart-Alec Limited but which it manages for a fee.
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C. Hotel D’Africa: Clumsy Limited entered into an operating lease contract with a professional hotel
management company: this contract provided for a fixed monthly rental with a 1% share in hotel
profits, which is expected to be insignificant relative to the fixed rental.
D. Hotel Brizzy: Clumsy Limited entered into an operating lease contract with a professional hotel
management company: this contract provided for a fixed monthly rental with 50% votes regarding
important decisions regarding the running of the hotel and a 25% share in hotel profits, which is
expected to be more significant than the fixed rental.
Required: Briefly explain how Clumsy Limited should account for each of these properties.
Solution 5: Ancillary services

Comment: this example shows how providing ancillary services affects the classification of a property.
A. The office building is classified as an investment property because the security services are
insignificant to the rental arrangement as a whole.
B. Hotel Mystique is classified as property, plant and equipment (i.e. in terms of IAS 16) because the
services provided by Clumsy Limited are significant to the property.
C. Hotel D’Africa is classified as an investment property since the lease contract is such that, in
substance, Clumsy Limited is simply a passive investor (IAS 40.13)
D. Hotel Brizzy is classified as property, plant and equipment since, whilst there is a lease contract
that outsources the day-to-day functions of running the hotel, Clumsy is still significantly involved
in management decisions and is exposed to significant variations in cash flows from the hotel.
(IAS 40.13)
4. Measurement (IAS 40.20 - .56)
4.1 Overview
An investment property must initially be measured at cost. How to measure cost is explained
in Section 4.2 Initial Measurement.
Subsequent measurement involves the choice between two measurement models, which must
then be applied to all its investment property. The two models allowed are the cost model and
the fair value model. These models are explained under Section 4.3 and 4.4 (being subsequent
measurement).
Cost is the amount for which
the asset was purchased. It
Although there is a choice, the standard encourages includes:
the use of the fair value model as it increases the cash equivalents paid or the fair value
relevance of the financial statements by giving a
of any other asset given;
better reflection of the true value of the property.
at the time of acquisition or
Although normally the entity may choose between construction; or
using the cost model and the fair value model, in the amount recognised as the cost of
certain circumstances one or other of the models may the asset in terms of another
be compulsory: IFRS. IAS 40.5 (reworded)
the cost model is compulsory when the fair value

is not reliably measurable on a continuing basis: Circumstances when the
models are compulsory:
once a property is forced to be measured under
the cost model, it may not be measured under the Cost model: if the fair value is not
fair value model at a later stage: this is explained reliably measurable on a continuing basis
further under section 4.3; Fair value model: property held by a
lessee under an operating lease
the fair value model is compulsory for a property
held by a lessee under an operating lease, where the lessee has elected to classify and
account for it as investment property: this is explained further under section 4.4.
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If the fair value model is chosen, it is important to remember that a subsequent change in
policy to the cost model is almost impossible, for two reasons. The reasons why we won’t be
able to change our accounting policy from the fair value to the cost model include:
We are not allowed to change from the fair value model to the cost model if and when the
fair value becomes difficult to measure. If this happens, the property is simply measured
at the last known fair value until such time that a revised fair value becomes
available. IAS 40.55 (reworded)
Although we are allowed to voluntarily change our accounting policy from the fair value
model to the cost model in terms of IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors, this will only be allowed on condition that the new accounting
policy results in reliable and more relevant information. IAS 40.31 The problem with this is
that IAS 40 states that it is highly unlikely that the cost model will result in more relevant
information than the fair value model. Thus, a change in policy from the cost model to
fair value model would seldom be possible. IAS 40.31 (reworded)
The standard requires that the fair value be measured Fair value must be
for all investment property regardless of the model measured regardless of
chosen: the model used:
if the fair value model is used, fair values will be FV model: Measurement purposes
needed for measurement purposes; Cost model: Disclosure purposes
if the cost model is used, fair values will be needed
for disclosure purposes. IAS 40.32
4.2 Initial measurement: cost (IAS 40.17 - .29)
4.2.1 Overview
An investment property is initially measured at its cost. In certain circumstances, however,

for example in the case of an investment property acquired through an asset exchange or
through an operating lease that is classified as an investment property, this initial cost could
be its fair value or the present value of future minimum lease payments. IAS 40.25 (reworded)
4.2.2 Costs (IAS 40.20 - .24)

Cost includes:
Investment property is initially measured at cost.
the purchase price;
The cost of purchased investment property comprises
any construction costs if self
its purchase price, any directly attributable developed (but excluding abnormal
expenditure and transaction costs.IAS40.21 wastage, start up costs and initial
operating losses);
The cost of self-constructed investment property any transaction costs or duties; and
would include construction costs on the basis that directly attributable expenses (for
they are directly attributable. example lawyer’s fees, transfers
( )
costs and taxes). IAS 40.21 reworded
Cost excludes:
start up costs (unless they are necessary to bring the property to the condition necessary
for it to be capable of operating in the manner intended by management);
operating losses incurred before the property achieves the planned level of occupancy;
abnormal amounts of wasted material, labour or other resources incurred in constructing
or developing the property. IAS 40.23
If the purchase price is deferred, the cost is measured at the cash price equivalent. The
difference between the amount paid and the cash price is recognised as an interest expense
over the period of credit (i.e. between the date of purchase and date of final payment). IAS 40.24
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4.2.3 Cost of a property interest held under a lease (IAS 40.25 - .26 and .34)
Properties held under a finance lease may also end up being classified as an investment
property. In this case, the property is measured at the lower of its fair value and the present
value of the future minimum lease payments. This measurement is in line with the
measurement of assets and liabilities arising under finances leases (see IAS 17.20). The
related liability (reflecting the obligation that arises under the lease) is measured at the same
amount.
Although the definition of an investment property includes properties that are held under
leases on condition that they are finance leases, IAS 40.6 allows properties that are held under
operating leases may also be classified as investment property under certain conditions (see
section 3.4). The measurement of the initial cost applies even if the property is a property that
is not held under a finance lease but is actually held under an operating lease and classified as
an investment property (i.e. in terms of the IAS 40.6 exception). Please see the leasing chapter
for more information.
Initial cost of a leased
If a property held under an operating lease is classified property is measured at the:
as an investment property, this property and all other
investment properties must all subsequently be lower of:
measured using the fair value model (i.e. the choice - The FV of the property; and
between the models no longer applies: see - the PV of the future minimum lease
section 4.4.4). IAS 40.34 (reworded) payments . IAS 40.25
4.2.4 Cost of an investment property acquired via an exchange (IAS 40.27 - .29)
If an investment property is acquired by way of an exchange for a non-monetary asset then

the cost of the investment property should be measured at the fair value of the asset given up
(or the fair value of the asset received if this is more clearly evident) unless the transaction
lacks commercial substance or it is not possible to
measure the fair value of either asset reliably, in Investment property acquired
which case, the cost is measured at the carrying through an exchange should
See IAS 40.27 & .29 be measured at:
amount of the asset given up.
The FV of the asset given up,
The fair value is considered to be reliably or
measurable if: The FV of the asset received, if this is
more clearly evident; or
the variability in the range of reasonable fair
The CA of the asset given up if:
value measurements is not significant for that
asset; or - neither fair value is reliably
measurable; or
the probabilities of the various estimates within - the exchange has no commercial
the range can be reasonably assessed and used substance. See IAS 40.27 & .29
when measuring fair value. IAS 40.29 (reworded)
4.2.5 Subsequent costs (IAS 40.18-.19)

The rules for the capitalisation of subsequent costs for investment property are identical to the
rules in IAS 16: Property, plant and equipment.
Subsequent costs can only be capitalised to the cost of the asset if it meets the two recognition
criteria which are:
it is probable that future economic benefits will flow to the entity; and
the costs are reliably measurable.
Costs incurred after the initial purchase frequently relate to day-to-day servicing (often called
repairs and maintenance) and are therefore simply expensed. IAS 40.18 (reworded)
There may, however, be occasion to incur costs on replacing parts of the property (for
instance replacing damaged walls or roofs, or building interior walls).
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In this case:
the replaced part is derecognised (see section on disposals), and
the replacement part is recognised as part of the original investment property if the
recognition criteria are met. IAS 40.19 (reworded)
Example 6: Subsequent expenditure

Flower Limited spent the following amounts on its block of flats, an investment property:
C500 000: to build an extra floor to be rented out as a penthouse flat under an operating lease;
C10 000: to replace all globes in the building that had blown in the last month;
The building’s lift was damaged due to vandalism and Flower Limited had to pay C25 000 to
replace it. The fair value of the damaged lift was C10 000.
Required: Explain how Flower Limited should account for the amounts it spent and show the journals.
Solution 6: Subsequent expenditure

Comment: this example highlights the difference between subsequent expenditure that is capitalised
and that which is expensed.
Explanation of the extra floor: The C500 000 for the extra floor is capitalised to the asset, because:
extra revenue (future economic benefits) is expected by Flower from the rental income; and
the cost is reliably measurable: C500 000.
Debit Credit
IP: Building: flats (A) 500 000
Bank/ Accounts payable (A/L) 500 000
Cost of building the penthouse
Explanation of the globes: The replacement of the globes is considered to be day-to-day servicing and
should be expensed.
Debit Credit
Maintenance (E) 10 000
Payment for the replacement of globes (minor parts)
Explanation of the lift: The lift that was destroyed due to vandalism must be impaired to zero as it was
scrapped for a nil return. The new lift must then be capitalised because:
the replacement lift will restore the expected future economic benefits; and
the cost is measurable: C25 000.
Debit Credit
Lift written off (E) 10 000
Write-off of lift destroyed through vandalism (estimated fair value)

Bank/ Creditor (A/L) 25 000
Replacement lift capitalised at cost
4.3 Subsequent measurement: the cost model (IAS 40.56)
The cost model used for investment properties is Investment property measured
the same as the cost model used for property, plant under the cost model is:
and equipment. initially measured at cost;
depreciated;
Therefore, an investment property under the cost tested for impairments; and
model is measured initially at cost, depreciated can be classified as held for sale
annually, tested for impairments (in terms of IAS 36 Impairment of assets) and can be
classified as held for sale (under IFRS 5 Non-current assets held for sale). IAS 40.56 (reworded)
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4.3.1 When the cost model is compulsory (IAS 40.53)
There is a rebuttable presumption on acquisition of an investment property that the fair value
can be reliably determined on a continuing basis, in which case the fair value model must be
used. However, if this presumption is rebutted on acquisition date, the cost model must be
used. In other words, if at the time of acquisition of a property, clear evidence can be provided
that the fair value of the property will not be measurable on a continuing basis (e.g. similar
market transactions are few and far between), then the cost model must be used for this
property. If the cost model has to be used because the presumption was rebutted on
acquisition date, the model used for this property may never subsequently be changed to the
fair value model, even if fair values subsequently become measurable.
Having to use the cost model for such a property does not prevent the entity from using the
fair value model for its other investment properties. IAS 40.53 (reworded)
This inability to determine fair value is discussed further in section 4.4.3
4.4 Subsequent measurement: the fair value model (IAS 40.33 - .55, 36.2 and IFRS 13)
4.4.1 The fair value model in general (IAS 40.33)
If the fair value model is chosen for a property, all investment properties must be measured
using this model, unless the fair value cannot be reliably measured (see section 4.4.3).
The fair value model requires that the investment

property be initially measured at cost. At the end of the Investment property
reporting period the property must be re-measured to its measured under the fair
fair value. Any subsequent gains or losses resulting from value model:
a change in the fair value of the investment property is initially measured at cost;
shall be recognised in profit or loss for the period in is re-measured to fair value at the
which they arise. See IAS 40.35 end of the reporting period;
any gains or losses arising from a
The fair value model used to measure investment change in the fair value must be
properties differs from the revaluation model used for recognised in profit or loss.
property, plant and equipment (see chapter 8).
When using the fair value model:

there is no depreciation;
there are no impairment tests;
fair value adjustments are recognised in profit or loss (not other comprehensive income).
4.4.2 Fair value model: What is a fair value? (IAS 40.40 and IFRS 13)
Fair value is a market-based value measured in

The fair value of a property
terms of IFRS 13, which must reflect, amongst
is:
other things:
the price that would be received to
rental incomes from current leases; and sell the property in an orderly
other assumptions that market participants transaction;
would use when pricing investment property between market participants;
( )
at the measurement date. IFRS 13.9 reworded
under current market conditions. IAS 40.40
The emphasis here is that the fair value is an exit price and thus, the assumptions used are
always those that a market participant would use when pricing the asset.
The standard recommends, but does not require, that this fair value be measured by an
independent and suitably qualified valuer. IAS 40.32 (reworded)
502 Chapter 10
In terms of IFRS 13, fair value is a market-based measurement and can, in fact, be measured
using a variety of valuation techniques (such as the market, cost or income approach) and can
involve a variety of inputs of varying quality. These inputs are classified into a hierarchy of
level 1 inputs through to level 3 inputs.
Level 1 inputs are ideal, being quoted prices (unadjusted) for identical assets in an active
market. These are unlikely to be found for an investment property.
Level 2 inputs are directly or indirectly observable prices for the asset. An example would
be a quoted price for a similar asset, when this has to be adjusted for the condition and
location of the asset.
Level 3 inputs are unobservable inputs. Level 3 inputs enable the entity to use
assumptions in a situation where there is little if any market activity for the asset.
It is important when measuring fair value that we do not double-count the fair value of assets
or liabilities that may have already been recognised as separate assets or liabilities. For
example, a building that includes a built-in lift would typically have a fair value that is higher
than the fair value of a building that does not have a lift. Thus, generally, the fair value of the
‘building with the lift’ will effectively have included the fair value of the lift and thus we
would need to be careful not to recognise the lift as a separate asset. See IAS 40.50
4.4.3 Fair value model: Inability to measure the fair value (IAS 40.53 - .55)
If there is clear evidence when the entity first acquires an investment property (or when it first
becomes investment property after a change in use) that the fair value will not be reliably
measurable on a continuing basis, then the entity:
must always measure this property using the cost model (in terms of IAS 16) and may
never change subsequently to the fair value model, even if fair values subsequently
become measurable, and
must always use a residual value of nil; but
must still use the fair value model for all other investment properties. IAS 40.53 (reworded)
The only exception to the above prohibition from

If the fair value is not
changing from the cost model to the fair value model is reliably measurable on a
when the investment property is a property still under continuing basis:
construction for which a fair value is not expected to be measure that property only under
reliably measurable until the property is complete. the cost model;
using a residual value of nil;
In such a case, the property under construction is regardless of whether fair values
measured at cost until either the fair value becomes can subsequently be measured.
reliably measurable, or the construction is completed (whichever happens first). See IAS 40.53
This means that, if the fair value of a property under construction becomes reliably
measurable before or on completion of construction, the measurement model will be changed
from the cost model to the fair value model. On completion, there is a rebuttable assumption
that the fair value is reliably measurable. However, if on completion of construction, there is
clear evidence that it is still not possible to reliably measure the fair value on a continuing
basis, then the presumption is rebutted and the completed property must be measured using
the cost model in terms of IAS 16 until the disposal of the property. Depreciation will be
calculated using a residual value of nil.
It should be noted that we always assume that the fair value is reliably measurable on a
continuing basis unless:
the market for comparable properties is inactive; and
alternative reliable measurements of fair value are not available. See IAS 40.53
If fair values were initially reliably measurable but are no longer so, the entity must:
continue to use the fair value model while it remains investment property, and
continue to use the last known fair value as its carrying amount until a revised fair value
becomes available (if ever). IAS 40.55 (reworded)
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Example 7: Fair value cannot be reliably measured

Clueless Limited purchased a building that it intended to hold for capital appreciation:
The building was purchased on 31 March 20X5 for C1 million.
On 31 March 20X5 it was unclear if the building’s fair value would be reliably
measurable on a continuing basis.
By the 31 March 20X6, due to a boom in the property industry, the fair value of the
building was estimated to be C15 million.
The property has an estimated useful life of 20 years.
The company’s accounting policy is to carry investment property at fair value.
Required: Calculate the carrying amount of the property at the year ended 31 March 20X5 and 20X6.
Solution 7: Fair value cannot be reliably measured

Comment: this example illustrates the measurement (initial and subsequent) of an investment property
where at the time of purchase, clear evidence can be provided that the fair value of the property will
probably not be measurable on a continuing basis.
Because it was established at the acquisition date that the fair value of the building could not be
reliably measured on a continuing basis, IAS 40.53 requires that the building be measured under the
cost model (i.e. at depreciated historic cost) throughout its life.
Even though the fair value can be measured at the next financial year end, the building must remain at
depreciated historic cost and must never be revalued to fair value.
Furthermore, if the cost model is forced to be used due to this reason, then depreciation must be
calculated using a nil residual value, even if the entity estimates another amount for the residual value.
The carrying amounts of the property would therefore be:
31 March 20X5: 1 000 000 – [(1 000 000 – 0) / 20 years x 0 yrs] = C1 000 000
31 March 20X6: 1 000 000 – [(1 000 000 – 0)/ 20 years x 1 yr] = C950 000
4.4.4 Fair value model: When is this model compulsory? (IAS 40.33-34; .53B and .55)
There are three instances where the fair value model is compulsory:
if the fair value model has been used for other properties, the fair value model becomes
compulsory for all its investment properties (unless on initial recognition it is clear that
fair values are not ascertainable);
if the property was previously measured under the fair value model, a change to the cost
model is not allowed: the fair value model is now compulsory;
if the entity classifies a specific property that is held under an operating lease as an
investment property.
5. Change in Use (IAS 40.57 - .65)
5.1 Overview
The entity may, during the current reporting period, change the use of a property. This change
in use may require that we change the classification of the property (property that was
previously not classified as investment property may become investment property or vice
versa). However, only certain transfers in and out of the investment property classification are
allowed.
Assuming that the transfer is allowed, such a transfer is measured based on whether the entity
uses the cost model or fair value model to measure its investment property.
The following two tables show under what circumstances a transfer in or out of investment
property is allowed and how to measure such transfers.
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Table 1: The transfers in and out of investment property that are allowed:
From To When such a transfer is allowed
PPE: Owner-occupied Investment property End of owner-occupation

(IAS 16) (IAS 40)
Inventories Investment property Start of an operating lease to another party
(IAS 2) (IAS 40)
Investment property PPE: Owner-occupied Start of owner-occupation
(IAS 40) (IAS 16)
Investment property Inventories Start of development with a view to sale
(IAS 40) (IAS 2)
Table 2: How to measure the transfers in and out of investment property that are allowed:
From To Transfer measured depending on model

used for investment property:
Cost model Fair value model
PPE: Owner-occupied Investment property Carrying amount Fair value *
(IAS 16) (IAS 40)
Inventories Investment property Carrying amount Carrying amount
(IAS 2) (IAS 40)
Investment property PPE: Owner-occupied Carrying amount Fair value
(IAS 40) (IAS 16)
Investment property Inventories Carrying amount Fair value
(IAS 40) (IAS 2)
* if the property is to be measured using the fair value model, the transfer is done at fair value even if
the property was previously carried under the cost model in terms of IAS 16. This complication is
explained in section 5.3.1.
5.2 If the entity uses the cost model (IAS 40.59)
If the entity uses the cost model, a change in use that results in a transfer into or out of
investment property will not involve a change in the carrying amount of the property.
5.3 If the entity uses the fair value model (IAS 40.60 - .65)
If the entity uses the fair value model then there may be measurement implications.
5.3.1 Change from owner-occupied property to investment property (IAS 40.61-.62)
Owner-occupied property is accounted for in terms of IAS 16 Property, plant and equipment.
When owner-occupied property is to be When transferring from

reclassified to investment property that will then owner-occupied property
be accounted for in terms of the fair value model, to investment property:
the entity must revalue the property to its fair account for any depreciation and impairment
value immediately before making the transfer to losses until the date of change in use and;
investment property: revalue the property to fair value (even if the
cost model has been used to measure PPE)
any change from the carrying amount to fair
value is accounted for in the same way that a revaluation would be accounted for under
the revaluation model in IAS 16, and
this revaluation is done even if the property had been measured using the cost model.
IAS 40.61 (reworded)
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The steps to follow before making the transfer from property in terms of IAS 16 to property in
terms of IAS 40 are as follows:
Depreciate and check the property for impairments up to the date of change in use;
Then revalue to fair where:
an increase in the carrying amount:
-is first credited to income (only where it reverses a previous impairment loss); and
-is then credited to other comprehensive income (revaluation surplus, as in IAS 16);
a decrease in the carrying amount:
-is first debited to other comprehensive income (if the revaluation surplus account has
a balance in it from a prior revaluation); and
-is then debited to expense (impairment loss). IAS 40.62 (reworded)
Once a property becomes investment property measured using the fair value model, it is no
longer depreciated. This creates an interesting situation if the property was previously
classified as property, plant and equipment under the revaluation model and had a revaluation
surplus at the time of reclassification to investment property.
The reason it is interesting is that, when this property becomes classified as investment
property, it is no longer possible for this revaluation surplus to be transferred to retained
earnings over the life of the asset, since the asset is longer depreciated. Thus, any revaluation
surplus relating to a property that subsequently becomes classified as investment property can
only be transferred to retained earnings on disposal of the property. This transfer from
revaluation surplus to retained earnings is not made through profit and loss: the transfer must
be made directly to retained earnings (i.e. debit revaluation surplus and credit retained
earnings). IAS 40.62(b) (ii) (reworded)
The revaluation surplus relating to investment property can only be transferred to

retained earnings on:
the disposal of the asset.
Example 8: change from owner-occupied (IAS 16) to investment property

(IAS 40)
Fantastic Limited had its head office located in De Rust, South Africa. During a ‘freak’
landslide on 30 June 20X5, a building nearby, which it owned and was renting to Sadly Limited, was
destroyed.
As Sadly Limited was a valued tenant, Fantastic Limited decided to move its own head office to another
under-utilised building nearby, which was currently also used for administrative purposes and to lease
this original head office building to Sadly Limited as a ‘replacement’. This move was considered
effective on 30 June 20X5.
Other information:
The head office was purchased on the 1 January 20X5 for C500 000 (total useful life: 5 years)
The fair value of the head office building was:
- C520 000 on 30 June 20X5 and
- C490 000 on 31 December 20X5.
Fantastic Limited uses the:
- the cost model to measure its property, plant and equipment, and
- the fair value model to measure its investment properties.
Required:
Provide the journals relating to the head office in De Rust for Fantastic Limited’s year ended
31 December 20X5.
You may use a single account to record movements in the head office’s carrying amount (i.e. do not use
a cost and accumulated depreciation account). Ignore tax.
506 Chapter 10
Solution 8: change from owner-occupied to investment property

Comment: Despite the property being measured using IAS 16’s cost model, the property must be
revalued to fair value in terms of IAS 16’s revaluation model before being transferred to investment
property. This is because the entity uses the fair value model for its investment properties.
PPE: Office building: carrying amount (A) 500 000
Purchase of head-office building(owner-occupied)
30 June 20X5
Depreciation (E) (500 000 - 0) / 5 x 6 / 12 months 50 000
Depreciation to date of change in use
Revaluation surplus (OCI) 520 000 – (500 000 – 50 000) 70 000
Revaluation of head office to fair value on date of change in use
IP: Office building: fair value (A) 520 000
Transfer head office building from PPE to IP on date of change in use
31 December 20X5
Fair value adjustment on investment property (Income: P/L) 30 000
IP: Office building: fair value (A) 30 000
Remeasurement of investment property to fair value at year-end
Notes:
1. Notice that the adjustment to the fair value of the building occurs before the transfer to investment
property thus the adjustment is credited to other comprehensive income – not to profit or loss.
2. Notice that the revaluation surplus is not reduced when the fair value drops. This revaluation surplus
will only be reversed when the property is disposed of. See IAS 40.62(b) (ii)
5.3.2 Change from inventories to investment property (IAS 40.63 - .64)

Property that is held for sale in the ordinary course of business is classified as inventories and
is measured at the lower of cost and net realisable value. If however, a property that was
initially held for sale in the ordinary course of business (i.e. inventory) is then leased to a
tenant under an operating lease, the property must be transferred from inventories to
investment properties.
The standard is not clear on how to measure this When transferring from
transfer but it makes sense to transfer the inventories to investment
inventory to investment property at the carrying property:
amount of the inventory (i.e. at the lower of cost transfer at the CA of the inventory; and
or net realisable value) and then to revalue the then revalue the property to fair value.
investment property to fair value.
If a property that was initially held for sale in the ordinary course of business (i.e. inventory)
is now to be held for capital appreciation (i.e. the intention is no longer to sell it is the short-
term as part of the ordinary course of business), the property remains classified as inventories.
Example 9: inventory to investment property
Chess Limited purchased a building on 1 January 20X5 (cost: C250 000) that it intended to
sell in the ordinary course of business.
Player Limited asked Chess Limited to lease the building to them for a period of time:
An operating lease agreement was then entered into and became effective from 1 March 20X5.
On 1 March 20X5, the building’s:
- fair value was C300 000 and
- net realisable value was C290 000.
On 31 December 20X5, the building’s fair value had grown to C340 000.
Chess Limited uses the fair value model for its investment properties.
Required: Provide the journals for Chess Limited’s year ended 31 December 20X5. Ignore tax.
Chapter 10 507
Solution 9: inventory to investment property

Comment: this example shows how to account for a change from inventory to investment property.
Building purchased with the intention of selling
1 March 20X5
IP: Building: fair value (A) 250 000
Building (previously inventory) transferred to investment property
since leased out in terms of an operating lease (no adjustment to NRV
required since the NRV is 290 000, being greater than cost)
IP: Building: fair value (A) 50 000
Fair value adjustment of investment property (Income: P/L) 50 000
Remeasuring of investment property to fair value at date of transfer
(300 000 FV – 250 000 cost)
31 December 20X5
IP: Building: fair value (A) (340 000 – 300 000) 40 000
Fair value adjustment of investment property (Income: P/L) 40 000
Investment property remeasured to fair value at year-end
5.3.3 Change from investment property to owner-occupied property or inventories (IAS40.60)

The entity must first adjust the investment property’s carrying amount to fair value on the
date of change. The resultant change must be recognised in profit or loss. The fair value on
date of transfer, measured in accordance with IAS 40, will then be deemed to be the initial
cost of the owner-occupied property or inventory. IAS 40.60 (reworded)
If the investment property is now classified as owner-occupied, it will then be measured in
terms of IAS 16: Property, plant and equipment (using either the cost model or revaluation
model) and will be depreciated over its remaining useful life.
If the investment property is now classified as inventory, it will then be measured in terms of
IAS 2: Inventories at the lower of cost (being the fair value on date of transfer) and net
realisable value.
The standard only permits a transfer a property from investment property to inventories when,
and only when, there is a change in use, evidenced by commencement of development with a
view to sale (see example 1 part A). When an entity decides to dispose of an investment
property without development, it continues to treat the property as an investment property.
Example 10: Change from investment property to owner occupied property
Super Limited owned and leased out a building in Pretoria (South Africa), which was
correctly classified as an investment property on 31 December 20X4.
During a ‘freak’ earthquake Super Limited’s head office was destroyed, forcing them to relocate to the
building in Pretoria, which forced the tenants of this building to move out from 30 June 20X5.
Super Limited’s head office moved into these premises on 1 July 20X5.
On 31 December 20X4, the fair value of the building was C200 000.
On the 30 June 20X5 the building:
had a fair value of C260 000, and
had a remaining useful life of 10 years and a nil residual value.
Super Limited uses:
fair value model for its investment property, and
cost model for its property, plant and equipment.
Required: Show the journals for Super Limited for the year ended 31 December 20X5. Ignore tax.
508 Chapter 10
Solution 10: change from investment property to owner occupied property

Comment: this example explains which accounts are affected by a change in use when an investment
property (IAS 40) becomes an owner-occupied property (IAS 16).

IP: Office building: fair value (260 000 – 200 000) 60 000
Fair value adjustment of investment property (income) 60 000
Investment property revalued to fair value on date of transfer
PPE: Office building: cost 260 000
IP: Office building: fair value 260 000
Transfer of investment property to property plant and equipment
Depreciation (260 000 / 10 x 6/12) 13 000
PPE: Office building: accumulated depreciation 13 000
Depreciation for the year
6. Disposal (IAS 40.66 - .73)
An investment property (or a part thereof) must be derecognised (eliminated from the
statement of financial position) on:
disposal (sale or finance lease); or Investment property is
permanent withdrawal from use where no future derecognised on:
economic benefits are expected from its disposal
(e.g. abandonment). IAS 40.66 Disposal or ;
Permanent withdrawal from use.
The date on which the disposal must be recorded depends
on how it is disposed of.
If the investment property is disposed of by way of a finance lease, the date will be
determined in accordance with IAS 17 Leases (see chapter 17).
If the investment property is disposed of by way of a sale, the date of disposal is the date
on which the recipient obtains control of the investment property (the recipient obtains
control when the criteria in IFRS 15 Revenue from contracts with customers are met and
indicate that the performance obligation has been satisfied). See IAS 40.67
If, when derecognising the investment property, the entity earned proceeds on the disposal,
these proceeds would be recognised as income in profit or loss. The amount of these
proceeds (also called ‘consideration’) is measured in the same way that a transaction price is
measured in terms of IFRS 15 Revenue from contracts with customers. IAS 40.70
When we retire a property (i.e. withdraw from use) or when we dispose of it, we will
generally have made a gain or incurred a loss. This gain or loss is:
measured as the difference between the net proceeds we receive for the property (if any)
and its expensed carrying amount; and
recognised in profit or loss (unless IAS 17 Leases requires an alternative treatment in the
case of a sale and leaseback). See IAS 40.69
As mentioned above, proceeds on disposal are measured in the same way that we determine
the transaction price in terms of IFRS 15. Thus, if property is disposed of by way of a sale
but the receipt of these proceeds is to be deferred, and if this deferral gives the purchaser a
significant financing benefit, these proceeds must be measured at the price that the customer
would have paid for the investment property had it been disposed of for cash. The difference
between the price that the property would have been sold for had it been sold for cash (i.e. the
notional cash price) and the actual agreed selling price must be recognised separately over the
payment period as interest revenue measured using an appropriate discount rate. See IFRS 15.60-65
It can also happen that only a part of the investment property is disposed of (for example a
roof destroyed in a storm, a lift that needs to be replaced etcetera). The carrying amount of
this replaced part needs to be derecognised.
Chapter 10 509
The following guidance is provided for cases where you find it difficult to establish the
carrying amount of the replaced part:
if the cost model is used and this part was not recognised and depreciated in a separate
account: the cost of the replacement part may be used to estimate the cost of the part on
the date that the property was purchased;
if the fair value model is used, you may either decide to:
remove an estimated fair value of the replacement part and then add the cost of the
replacement part; or
not bother removing the estimated fair value of the replacement part and add the cost
of the replacement part and then revalue the investment property as a whole to its fair
value: this option is available only if it is believed that the fair value will reflect the
changes owing to the part requiring replacement. See IAS 40.68
Compensation receivable from claims made following an impairment or giving up of a
property are considered to be separate economic transactions and are therefore accounted for
separately when the compensation becomes receivable. The compensation is recognised in
profit or loss. See IAS 40.73
Example 11: Disposal
Ashley Limited sells an investment property, with a fair value of C75 000, for C100 000.
Ashley Limited uses the fair value model.
Required: Show the journal entries for the disposal.
Solution 11: Disposal

Comment: This example shows a disposal where the fair value is known.
Debit Credit
Bank/ debtor 100 000
Investment property (asset) 75 000
Profit on sale of investment property (income) 100 000 – 75 000 25 000
Sale of investment property
7. Deferred Tax (IAS 12.15 and .51C-.D)
If the cost model is used, the deferred tax implications are the same as those arising from
property, plant and equipment measured in terms of the cost model in IAS 16 (see chapter 7).
If the fair value model is used, the carrying amount of the investment property changes each
time it is fair valued, but the tax base doesn’t change for these adjustments. The tax base will
simply reflect the tax deductions allowed, if any. The difference between the carrying amount
and the tax base will cause temporary differences.
Please note that if an asset is not deductible for tax purposes, its tax base will be nil (the tax
base of an asset being a reflection of the future tax deductions) and the resulting temporary
difference that arises on initial recognition (i.e. the difference between the carrying amount of
cost and the tax base of nil) is exempt from deferred tax. This exemption from deferred tax is
covered in more depth in chapter 6, section 6.4.
Please note a fundamental difference in the deferred tax journal entries:
fair value adjustments on property, plant and equipment may create a revaluation surplus
(which is recognised in other comprehensive income: equity): any related deferred tax
journal will be debited or credited to the revaluation surplus account (OCI); whereas
fair value adjustments on investment properties are all recognised in profit and loss: any
related deferred tax journal will be debited or credited to the tax expense account (P/L).
The general rule when measuring the deferred tax balance is to measure it based on how
management intends to recover the carrying amount of the asset (i.e. whether the entity
intends to make money from using the asset or selling the asset).
510 Chapter 10
Management intentions affect the measurement of deferred tax assuming that the way in
which the tax authorities levy tax is affected by whether income is earned through the use or
sale of the asset. In other words, if the tax authorities tax normal income (e.g. rent income) at
30% but tax capital profits differently (e.g. in SA, although a capital gain is taxed at 30%,
only 66% of it is taxable), we must build this into the estimate of our deferred tax balance.
In the case of investment property measured using the fair value model, however, there is a
rebuttable presumption that the carrying amount of the investment property will be recovered
entirely through the sale of the property rather than through the use of the property. However,
this presumption of sale is rebutted if the investment property is:
depreciable; and
held within a business model whose objective is to consume substantially all of the
economic benefits embodied in the property over time rather than through a sale. IAS 12.51C
In other words, if an investment property measured using the fair value model is land, the
related deferred tax is always based on the presumed intention to sell because the presumption
is not able to be rebutted. It is not able to be rebutted because land is an asset that is not
depreciable. However, if the investment property was a building, the presumed intention to
sell would be rebutted if it is held within a business model whose objective it is to recover
most of the carrying amount through use (since building would have been depreciated had it
been measured under the cost model).
Example 12: Deferred tax – fair value model (depreciable and deductible)
Tiffiny Limited owns a building which it leases out under an operating lease. This building originally
cost C1 500 000 (1 Jan 20X2). The total useful life of the building is 10 years.
Fair values:
31 December 20X5: C3 000 000
31 December 20X6: C3 600 000.
The company uses the fair value model to account for investment properties.
The company intends to continue leasing this property for the foreseeable future.
Allow the cost of the building to be deducted at 5% per annum.
Levy income tax on taxable profits at a rate of 30%.
Include all rent income in taxable profits.
Include capital gains in taxable profits using an inclusion rate of 50% and regard the base cost to equal the
cost price.
Required:
A. Calculate the deferred tax balance at 31 December 20X6 and provide the deferred tax adjusting journal for
the year ended 31 December 20X6.
B. Show how your answer would change, if at all, if the building falls with a business model the objective of
which is to obtain substantially all of the economic benefits embodied in the property through use rather
than sale.
Solution 12: Overview of question
This question involves presumed intentions (IAS 12.51C) and deferred tax exemptions (IAS 12.15)
This is an investment property measured under the fair value model and thus we must consider the presumed
intention to sell that is included in IAS 12.51C and whether is to be rebutted.
As the fair value model is used, the building is not depreciated and thus the useful life can be ignored.
Solution 12A: Presumed intention to sell

Comment:
In this scenario, the presumed intention to sell may not be rebutted:
- it is a building and thus considered to be a depreciable asset, but
- although the intention is to use this building, there is no evidence to suggest that it falls within a
business model the objective of which is to obtain substantially all of the economic benefits embodied
in the property through use rather than sale.
The deferred tax balance is thus measured based on the presumed intention to sell it.
Chapter 10 511
Solution 12A Continued…

The deferred tax balance at 31 December 20X6: C427 500, liability (see W1)
The deferred tax journal during 20X6 will be as follows:
Income tax expense (E) (427 500 – 315 000) 112 500
Deferred tax: income tax 112 500
(L)
Deferred tax on investment property (W1)
W1: Deferred tax calculation on investment property: intention to sell
CA TB TD DT
Balance: 1/1/20X2 0 0 0 0
(1) (4)
Purchase: 1/1/20X2 1 500 000 1 500 000 0 0
(3) (3) (3)
FV adj’s/ tax deductions: 1 500 000 (300 000) (1 800 000) (315 000) Cr DT Dr TE
X2/3/4/5
(2) (4) (5)
Balance: 1/1/20X6 3 000 000 1 200 000 (1 800 000) (315 000) Liability
(3) (3) (3)
FV adj’s/ tax deductions: X6 600 000 (75 000) (675 000) (112 500) Cr DT Dr TE
(2) (4) (5)
(1) Cost (given)
(2) Fair value (given)
(3) Balancing
(4) Tax base: 01/01/20X2: 1 500 000 (future deductions that will be allowed)
Tax base: 01/01/20X6: (1 500 000 – 1 500 000 x 5% x 4 years) = 1 200 000
Tax base: 31/12/20X6: (1 500 000 – 1 500 000 x 5% x 5 years) = 1 125 000
(5) Future tax on future economic benefits (intention to sell):
31/12/20X5 31/12/20X6
Taxable capital gain:
Selling price 3 000 000 3 600 000
Base cost (1 500 000) (1 500 000)
Capital gain 1 500 000 2 100 000
Multiplied by: X X
Inclusion rate 50% 50%
Taxable capital gain 750 000 750 000 1 050 000 1 050 000
Recoupment:
Selling price (3 000 000 or 3 600 000), limited to cost
price (1 500 000) 1 500 000 1 500 000
Tax base (1 200 000) (1 125 000)
Recoupment 300 000 300 000 375 000 375 000
Total future taxable profits 1 050 000 1 425 000
Total future tax @ 30% 315 000 427 500
Solution 12B: Presumed intention to sell is rebutted
Comment:
In this scenario, the presumption is rebutted since:
- it is a depreciable property and
- the property falls within a business model the objective of which is to obtain substantially all of the
economic benefits embodied in the property through use rather than sale.
Thus the deferred tax balance must be measured based on the actual intention to use the property.
As the fair value model is used, the building is not depreciated and thus the useful life given is irrelevant.
Income tax expense (E) W1: (742 500 – 540 000) 202 500
Deferred tax on investment property (W1)
512 Chapter 10
W1: Deferred tax calculation: Investment property: intention to keep

amount base difference taxation
(1) (2) (4)
(6) (6) (6)
Movement 600 000 (75 000) (675 000) (202 500) Cr DT Dr TE
(1) (3) (5)

(2) (1 500 000 – 1 500 000 x 5% x 4 years) = 1 200 000
(3) (1 500 000 – 1 500 000 x 5% x 5 years) = 1 125 000
(4) 1 800 000 x 30% (rental income would be taxed at income tax rates) = 540 000
(5) 2 475 000 x 30% (rental income would be taxed at income tax rates) = 742 500
(6) Balancing
Example 13: Deferred tax – fair value model (depreciable and non-deductible)
Cowie Limited owns a building which it leases out under an operating lease. This building originally
cost: C1 500 000 (1 January 20X2) and had a total useful life of 10 years and a nil residual value. The
fair values of the building were measured as follows:
31 December 20X5: C3 000 000
31 December 20X6: C3 600 000.
Tax related information:
Taxable profit will include all rent income but only 50% of a capital gain.
The base cost for purposes of calculating any taxable capital gain is equal to cost.
The cost of the building is not allowed as a tax deduction.
The company uses the fair value model to account for investment properties.
Cowie Limited intends to keep the building.
Required:
A. Calculate the deferred tax balance at 31 December 20X6 and provide the deferred tax adjusting journal for
B. Show how your answer would change, if at all, if the building falls with a business model the objective of
which is to obtain substantially all of the economic benefits embodied in the property through use rather than
sale.
Solution 13: Overview of question

Comment:
This question involves:
- presumed intentions (IAS 12.51C) and
- deferred tax exemptions (IAS 12.15).
This is an investment property that is measured under the fair value model and thus we must consider the
presumed intention to sell that is included in IAS 12.51C.
This is a property the cost of which is not deductible for tax purposes, with the result that certain of the
temporary differences are exempt from deferred tax.
Solution 13A: Presumed intention to sell and an exemption

Comment:
In this scenario, this presumed intention to sell may not be rebutted:
- it is a building and thus considered to be a depreciable asset, but
- although the intention is to use this building, there is no evidence to suggest that it falls within a business
model the objective of which is to obtain substantially all of the economic benefits embodied in the
property through use rather than sale. The deferred tax balance is thus measured based on the presumed
intention to sell it.
Chapter 10 513
Since the building is not deductible for tax purposes, the temporary difference that arises on initial
recognition of this cost is exempt from deferred tax, as are all temporary differences arising from
adjustments made to this cost, other than an adjustment that increases the carrying amount above cost.
Deferred tax will thus only arise on temporary differences caused by adjustments above cost.
Given that we must measure deferred tax based on the presumed intention is to sell and since the carrying
amount has been adjusted to a fair value that exceeds cost, we must consider the tax effect of capital gains
and exempt capital gains.
The deferred tax balance at 31 December 20X6: C315 000 liability (see W1)
Income tax expense: income tax (SOCI) W1 90 000
Deferred tax on investment property
Investment property: Carrying amount Tax Temporary Deferred taxation

intention to sell Base difference
Balance: 1/1/20X2 0 0 0 0
(1) (4) (5)
Purchase: 1/1/20X2 1 500 000 0 (1 500 000) 0 Exempt
(3) (4) (3)
FV adj’s: 20X2 – 20X5 1 500 000 0 (1 500 000) (225 000) Cr DT Dr TE
(2) (4) (6)
Balance: 1/1/20X6 3 000 000 0 (3 000 000) (225 000) Liability
Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
FV adj’s: 20X2 – 20X6 (3)
1 500 000 (4)
0 (1 500 000) (6)
(225 000) Liability
(3) (4) (3)
FV adj’s: 20X6 600 000 0 (600 000) (90 000) Cr DT Dr TE
(2) (4) (7)
Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
FV adj’s: 20X2 – 20X6 (3)
2 100 000 (4)
0 (2 100 000) (7)
(315 000) Liability
(1) Cost (given)

(3) Balancing
(4) Tax base is nil as no tax future tax deductions (e.g. wear and tear) are granted. Remember that the tax base of an asset is
defined as its future tax deductions.
(5) The temporary difference caused by the initial cost is exempt from deferred tax in terms of IAS12.15 (see chp 6). The
exemption makes sense because there would be a nil tax liability if we sold this asset for C1 500 000:
FV, limited to cost price: 1 500 000 – Tax base: 0 = Recoupment: 1 500 000 BUT
a recoupment is impossible: there were no deductions given that the tax-authority can recoup.
(6) (FV: 3 000 000 – Base cost: 1 500 000) x inclusion rate: 50% = Taxable capital gain: 750 000
The taxable capital gain is included in taxable profits and therefore taxed at 30%.
The tax is therefore 750 000 x 30% = 225 000
(7) (FV: 3 600 000 – Base cost: 1 500 000) x inclusion rate: 50% = Taxable capital gain: 1 050 000
The taxable capital gain is included in taxable profits and therefore taxed at 30%.
The tax is therefore 1 050 000 x 30% = 315 000
Solution 13B: Presumed intention to sell is rebutted and an exemption

In this scenario, this presumed intention to sell is rebutted:
- it is a building and thus considered to be a depreciable asset, and
- it falls within a business model the objective of which is to obtain substantially all of the economic
benefits embodied in the property through use rather than sale.
The deferred tax is thus measured based on the actual intention to use this asset.
514 Chapter 10

Since the building is not deductible for tax purposes, the temporary difference that arises on
initial recognition of this cost is exempt from deferred tax, as are all temporary differences
arising from adjustments made to this cost, other than an adjustment that increases the carrying
amount above cost. Deferred tax will thus only arise on temporary differences caused by
adjustments above cost.
Since the carrying amount has been adjusted to a fair value that exceeds cost, we must consider the
deferred tax effect of normal income in excess of cost being expected.

Income tax expense (E) W1 180 000

Investment property: Carrying Tax Temporary Deferred
intention to keep amount base difference taxation
Balance: 1/1/20X2 0 0 0 0
(1) (4) (5)
Purchase: 1/1/20X2 1 500 000 0 (1 500 000) 0 Exempt
(3) (4) (3)
FV adj’s: 20X2 – 20X5 1 500 000 0 (1 500 000) (450 000) Cr DT Dr TE
(2) (4) (6)
Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
FV adj’s: 20X2 – 20X6 (3)
1 500 000 (4)
0 (1 500 000) (6)
(450 000) Liability
(3) (4) (3)
(2) (4) (7)
Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
FV adj’s: 20X2 – 20X6 (3)
2 100 000 (4)
0 (2 100 000) (7)
(630 000) Liability
(1) Cost (given)

(3) Balancing
(4) Tax base is nil as no tax deductions (e.g. wear and tear) are granted
(5) The temporary difference caused by the initial cost is exempt from deferred tax in terms of
IAS12.15 (see chp 4).
(6) FV: 3 000 000 – Cost: 1 500 000 = Extra future economic benefits: 1 500 000
These extra FEB will be taxed as normal income since the intention is to keep the asset.
The future tax will therefore be: 1 500 000 x 30% = 450 000
(7) FV: 3 600 000 – Cost: 1 500 000 = Extra future economic benefits: 2 100 000
These extra FEB will be taxed as normal income since the intention is to keep the asset.
The future tax will therefore be: 2 100 000 x 30% = 630 000
Example 14: Deferred tax – fair value model: Land and Building:
Depreciable and deductible; and
Non-depreciable and non-deductible)
Cathan Limited owns a property which it is holding for rent income. The property, which is classified
as investment property and which is measured using the fair value model, consists of a building and a
large empty tract of land. The estimated split is:
40% of the cost and the fair values relate to the land, and
60% of the cost and the fair values relate to the building.
The property originally cost C1 500 000 (1 January 20X2) and had a total useful life of 10 years.
Chapter 10 515
The fair values of the property were estimated as follows:

31 December 20X5: C3 000 000
31 December 20X6: C3 600 000.
This property falls within a business model the objective of which is to obtain substantially all of the
Tax-related information:
Taxable profit will include all rent income but only 50% of a capital gain.
The base cost is equal to its original cost.
The tax authorities allow the deduction of an annual building allowance equal to 5% of the cost of
the building but do not allow deductions against the cost of land.
Required: Calculate the deferred tax balance as at 31 December 20X6 and show the deferred tax
adjusting journal for the year ended 31 December 20X6.
Solution 14: Presumed intentions (rebutted and not rebutted) and exemption
Comment:
Note: It is important to accounting for land and buildings separately wherever possible. In this regard,
the land portion is considered material enough to be recognised separately.
This question involves:
- presumed intentions (IAS 12.51C) and
- deferred tax exemptions (IAS 12.15).
We must consider the presumed intention to sell (IAS 12.51C) since this is an investment property
that is measured under the fair value model.
Certain of the temporary differences relating to land will be exempt from deferred tax because the
land is not deductible for tax purposes.
When considering the presumed intention, we apply the principle to each of the components of the
investment property: the land and the building.
In the case of the land, the presumed intention to sell may not be rebutted:
- although it falls within a business model the objective of which is to obtain substantially all of
the economic benefits embodied in the property through use rather than sale ,
- it is land and is thus not a depreciable asset.
The land thus fails the criteria for the presumption to be rebutted and thus the deferred tax must be
measured based on the presumed intention to sell this asset.
In the case of the building, this presumed intention to sell is rebutted:
- it is a building and thus considered to be a depreciable asset, and
- it falls within a business model the objective of which is to obtain substantially all of the
The deferred tax is thus measured based on the actual intention to use this asset.
The deferred tax balance at 31 December 20X6: C571 500 liability (W1: 445 500 L + W2: 126 000 L)
Income tax expense (E) (W1: 121 500 + W2: 36 000) 157 500
W1: Deferred tax calculation: Investment property: Building (keep)

(1) (3) (5)
Balance: 1/1/20X6 1 800 000 720 000 (1 080 000) (324 000) Liability
(7)
Movement 360 000 (45 000) (405 000) (121 500) Cr DT Dr TE
(2) (4) (8)
Balance: 31/12/20X6 2 160 000 675 000 (1 485 000) (445 500) Liability
516 Chapter 10

Calculations:
(1) Fair value (given): 3 000 000 x 60% = 1 800 000
(2) Fair value (given): 3 600 000 x 60% = 2 160 000
(3) (1 500 000 x 60% – 1 500 000 x 60% x 5% x 4 years)= 720 000
(4) (1 500 000 x 60% – 1 500 000 x 60% x 5% x 5 years) = 675 000
(5) 1 080 000 x 30% (all future benefits are expected to be fully taxed as rent income) = 324 000
(6) 1 485 000 x 30% (all future benefits are expected to be fully taxed as rent income) = 445 500
(7) 445 500 (L) – 324 000 (L) = 121 500 (increase in deferred tax liability)
W2: Deferred tax calculation: Land
Investment property: Carrying Tax Temporary Deferred

Land (Sell) amount base difference taxation
Balance: 1/1/20X2 0 0 0 0
(1) (4) (5)
Purchase: 1/1/20X2 600 000 0 (600 000) 0 Exempt
(3) (4) (3)
FV adj’s: 20X2 – 20X5 600 000 0 (600 000) (90 000) Cr DT Dr TE
(2) (4) (6)
Original cost (1)
600 000 (4)
0 (600 000) (5)
0 Exempt
FV adj’s: 20X2 – 20X5 (3)
600 000 (4)
0 (600 000) (6)
(90 000) Liability
(3) (4) (3)
(2) (4) (7)
Original cost (1)
600 000 (4)
0 (600 000) (5)
0 Exempt
FV adj’s: 20X2 – 20X6 (3)
840 000 (4)
0 (840 000) (6)
(126 000) Liability
(1) Cost (given): 1 500 000 x 40% = 600 000

(2) Fair value 31/12/20X5: 3 000 000 x 40% = 1 200 000
Fair value 31/12/20X6: 3 600 000 x 40% = 1 440 000
(3) Balancing
(4) No future tax deductions and thus the tax base is nil.
(5) The temporary difference arising on the initial recognition is exempt from deferred tax
(6) Future tax on future economic benefits (intention to sell):
31/12/20X5 31/12/20X6
Taxable capital gain:
Selling price (FV per W1) 1 200 000 1 440 000
Base cost: 1 500 000 x 40% (600 000) (600 000)
Capital gain 600 000 840 000
Multiplied by: X X
Inclusion rate 50% 50%
Taxable capital gain 300 000 300 000 420 000 420 000
Recoupment: not applicable (no 0 0

deductions had been given)
Total future taxable profits 300 000 420 000
Total future tax @ 30% 90 000 126 000
8. Current Tax
In most countries (including SA) the fair value gains and losses recognised in profit or loss
are not taxable for income tax purposes until they are actually realised through a sale. This
means that fair value adjustments must be reversed when converting profit before tax to
taxable profits.
Chapter 10 517
Depreciation on a building would also be ignored for tax purposes and would be replaced by
the actual tax deduction granted, if any. In other words, if converting profit before tax to
taxable profits, you need to add back the depreciation and subtract any tax deduction.
Example 15: Current tax: intention to keep and use (including land)
Faith Limited owns a property which it is holding for rent income.
Details of the property are:
The fair value was C3 000 000 on 1 January 20X6 and C3 600 000 on 31 December 20X6.
It originally cost C1 500 000 (1 January 20X2). The base cost is equal to its original cost.
The total useful life of the property is 10 years.
The property includes land and buildings: it is estimated that 40% of the cost and the fair values
relate to land with the balance relating to the building.
The property earns an annual rental of C300 000.
Faith Limited uses the fair value model to account for investment properties.
This property falls within a business model the objective of which is to obtain substantially all of the
The profit before tax and before any adjustments for the above (fair value adjustments, rental income
and depreciation) is C500 000.
The tax authorities allow the deduction of an annual building allowance equal to 5% of the cost of
the building but do not allow deductions against the cost of land.
All rent income would be included in taxable profits.
Capital gains are included in taxable profits using an inclusion rate of 50%.
The base cost for purposes of calculating the taxable capital gain is equal to the cost of
C1 500 000.
There are no temporary differences, no exempt income and no other non-deductible items other than
those evident from the above.
Required: Calculate and journalise the current income tax payable as at 31 December 20X6.
Solution 15: Current tax: intention to keep and use (including land)
Comment: The deferred tax consequences are the same as those calculated in example 14 above.
Income tax (E) W1 226 500

Current income tax payable (estimated)
W1. Current income tax Calculations C

Profit before tax and before adjustments 500 000
Add rental income 300 000
Add fair value gain - land See Ex 16: W2 (3 600 000 – 3 000 000) x 40% 240 000
Add fair value gain - building See Ex 16: W2 (3 600 000 – 3 000 000) x 60% 360 000
Less depreciation Property held under fair value model 0
Profit before tax 1 400 000
Differences between accounting profit and taxable profit:
Less fair value gain - land Taxable in future (240 000)
Less fair value gain - building Taxable in future (360 000)
Add back depreciation Not applicable: fair value model used 0
Less tax allowance on building Cost: 1 500 000 x 60% (building portion) x 5% (45 000)
Current income tax 755 000 x 30% 226 500
518 Chapter 10
9. Disclosure (IAS 40.74 - .79)
9.1 General disclosure requirements (IAS 40.75-76 and .79)
General disclosure requirements (i.e. irrespective of whether the cost model or fair value
model is used) include:
9.1.1 An accounting policy note for investment properties
The accounting policy note should disclose:

whether the fair value model or cost model is used;
the criteria used to classify property leased by the entity under an operating lease as
investment property;
where it was difficult to decide, the criteria that the entity used to determine whether a
property was an investment property, owner-occupied property or inventory. IAS 40.75 (a)-(c)
9.1.2 An investment property note
The investment property note should disclose:

whether the fair value was measured by an independent, suitably qualified valuer with
relevant experience in the location and type of property; IAS 40.75 (e)
any restrictions on the property (i.e. in terms of selling the property or on receiving the
income or proceeds on disposal); IAS 40.75 (g)
a note for investment property that shows the opening balance of the property reconciled
to the closing balance. IAS 40.76 and IAS 40.79 (d)
9.1.3 Profit before tax note
The profit before tax note should include disclosure of:

rental income earned from investment property;
direct operating expenses related to all investment property, split into:
- those that earned rental income, and
- those that did not earn rental income. IAS 40.75 (f)
9.1.4 Contractual obligations note
Contractual obligations relating to investment property must be categorised into those:

related to capital expenditure (e.g. purchase, construction or development thereof); or
general expenditure (e.g. repairs and maintenance). IAS 40.75 (h)
9.2 Extra disclosure when using the fair value model (IAS 40.76-78 & IFRS 13.91)
9.2.1 Investment property note
The investment property note should, if the fair value model was used, also disclose:
the reconciliation between the opening balance and closing balance of investment
property, showing all:
- additions (either through acquisition or a business combination);
- subsequent expenditure that was capitalised;
- transfers to and from inventories and property, plant and equipment;
- fair value adjustments;
- exchange differences;
- other changes. IAS 40.76
Chapter 10 519
if a specific property is measured using the cost model because the fair value could not be
reliably measured then the reconciliation above must be presented separately and the
following must be disclosed in relation to that property:
- a description of the property; IAS 40.78(a)
- a separate reconciliation from opening balance to closing balance;
- an explanation as to why the fair value could not be measured reliably; IAS 40.78(b)
- the range of estimates within which the fair value is highly likely to lie; IAS 40.78(c)
- if such a property is disposed of, a statement to this effect including the carrying
amount at the time of sale and the resulting gain or loss on disposal. IAS 40.78 (d)
if the valuation obtained had to be significantly adjusted to avoid double-counting assets
and liabilities recognised separately in the financial statements, then include a
reconciliation between the valuation obtained and the adjusted valuation. IAS 40.77
IFRS 13 also requires certain minimum disclosures relating to fair value. If the asset is
measured using the revaluation model, IFRS 13.91 requires disclosure of how the fair value
was measured:
the valuation techniques (e.g. market, cost or income approach); and
the inputs (e.g. quoted price for identical assets in an active market or an observable price
for similar assets in an active market).
Further minimum disclosures relating to this measurement of fair value are listed in
IFRS 13.93 and are covered in the chapter on Fair value measurement (IFRS 13).
9.3 Extra disclosure when using the cost model (IAS 40.79)
9.3.1 An accounting policy note for investment properties
If the cost model had been used, then the accounting policy note should also disclose the:
depreciation method and rates / useful lives. IAS 40.79 (a)-(b)
9.3.2 The investment property note
If the cost model had been used, then the investment property note should also disclose the:
the reconciliation between the opening balance and closing balance of investment
property must show all:
- the gross carrying amount and accumulated depreciation (at the beginning and end of
the year);
- depreciation for the current year (and in the profit before tax note);
- impairments (and reversals) for the current year (and in the profit before tax note);
- additions (either through acquisition or a business combination);
- subsequent expenditure that was capitalised;
- transfers to and from inventories and property, plant and equipment;
- exchange differences;
- other changes. IAS 40.79 (c) – (d)
the fair values of the property unless, in exceptional circumstances, these cannot be
measured, in which case also disclose:
- a description of the property
- the reasons why the fair value was considered to not be reliably measurable;
- the range of estimates within which the fair value is highly likely to lie. IAS 40.79 (e)
IFRS 13 also requires certain minimum disclosures relating to fair value:

If the asset is not measured at fair value but the fair value is disclosed in the note, certain
minimum disclosures are required. These minimum disclosures are listed in IFRS 13.97
and are covered in the chapter on Fair value measurement.
520 Chapter 10
9.4 Sample disclosure involving investment properties
Company Name
ASSETS 20X5 20X4
Non-current assets Note C C
Investment property 27 xxx xxx
Company Name
1. Statement of compliance … 20X5 20X4

.... C C
2.1 Investment property:
Investment properties are land and buildings held by the group to earn rentals and/or for
capital appreciation. Properties held for resale or that are owner-occupied are not included in
investment properties. Where investment property is occupied by another company in the
group, it is classified as owner-occupied.
Investment properties are measured using the fair value model (or the cost model).
The company uses the following criteria to identify investment properties from inventory:
…..
The criteria used to classify property leased under an operating lease as investment property:
…
27 Investment property (fair value model) 20X5 20X4

Opening balance xxx xxx
Capitalised subsequent expenditure xxx xxx
Transfers from/(to) investment property:
- from property, plant and equipment as no longer owner-occupied xxx xxx
- to property, plant and equipment as it became owner-occupied (xxx) (xxx)
- from inventory as the property is now leased under an op. lease xxx xxx
- to inventory as the property is being re-developed for resale (xxx) (xxx)
- to (or from) non-current assets held for sale (xxx) xxx
fair value adjustments xxx (xxx)
Closing balance
The investment property has been fair valued by suitably qualified and independent valuator with
recent experience in similar property in similar areas.
The valuation technique used when measuring fair value was the market approach and the inputs
involved level one inputs (quoted prices for similar properties, adjusted for condition and location).
Included in the above is a property measured at … that has been offered as security for a loan (see
Note … Loan obligations)
Included in the above is a property situated in Zimbabwe: income from rentals earned may not be
received due to exchange controls and the property may not be sold to anyone other than a
Zimbabwean national.

Profit before tax is stated after:
Income from investment properties: rental income
Fair value adjustments for the period
Investment property expenses:
- Properties not earning rentals
- Properties earning rentals
Chapter 10 521
10. Summary
Property
Owner-occupied Investment property

Land/ buildings/ both Land/ buildings/ both
Held by owner or lessee under a finance lease Held by owner or lessee under a finance lease
For use in supply of goods/ services or for To earn rentals or for capital appreciation
admin purposes
Follow IAS 16 Follow IAS 40
Recognition and measurement
Recognition Measurement
Same principle as for PPE (IAS 16): the Initial measurement: cost
property needs to meet the: Subsequent measurement: choose between
Definition and 2 models
recognition criteria Subsequent expenditure: normal
capitalisation rules (IAS 16)
Transfers in / out (4 possibilities)
Disposals / purchases (IAS 16)
Impairments (IAS 36)
Initial measurement
Initial costs:
Acquisition: Purchase price
Construction: IAS 16 costs
Leased asset: IAS 17 (lower of FV or PV of FMLP)
Exchange:
o FV of asset given up/ received (if more clearly evident) or
o CA of asset given up (if no FV’s)
Includes:
transaction costs,
directly attrib. costs, professional fees etc
Excludes:
wastage
start-up costs
initial operating losses
If payment deferred:
PV of future pmts
Subsequent costs:
Same as above but often expensed – must meet the usual recognition criteria
522 Chapter 10
Subsequent measurement
The models
Do we have a choice or is there no choice?

Generally you have the choice between:
Cost model (IAS 16)
Fair value model
But must use same model for all
An exception:
p53: on acq. date, you think FV won’t be possible for ever: use CM for this property
No choice in models if:
p34: prop held under an op lease and classified as an inv prop : use FVM for ALL investment properties
p53B and 55: properties previously measured using FV model: always measure using FVM
Fair value model

Measure at: Fair value
FV adjustments: recognised in P/L
FV is measured in terms of IFRS 13 Fair value measurement using:
- valuation techniques (e.g. market, cost or income approach) and
- inputs varying between Level 1 and Level 3 quality (ideally level one inputs, such as quoted prices for
identical assets but more likely to be level two input, such as a quoted price (adjusted) for a similar
asset, adjusted for its location and condition)
FV is an exit price based on assumptions that would be made by market participants
Fair value is ideally measured by qualified valuator with relevant experience
FV is not:
FV – CtS
VIU (i.e. not entity-specific!)
Careful of double-counting! For example:

building: equipment that is integral (e.g. a lift) is generally included in the IP
if leased out as a furnished building: furniture is generally included in the IP
if leased out and FV = DCF: lease rentals receivable are excluded because these are already reflected as
assets
If FV no longer able to be reliably measured, leave CA at the last known FV (do not change to CM)
Change in policy:
generally only from CM to FVM
Cost model
Follow:
IFRS 5: if available for sale; or
IAS 16: for all other assets, in which case measure at:
o Cost
o Less acc depreciation
o Less acc imp losses
Must still determine FV for disclosure purposes
Chapter 10 523
Change in use
Inventories IP PPE
If cost model used for IP:

No measurement complications
when transferring from one account to another
If fair value model used for IP:
Specific measurement rules
when transferring from one account to another
Only 4 instances when transfers may take place
Transfers that are allowed: Transfer measured at:

From To Cost model Fair value model
PPE (IAS 16) IP (IAS 40) Carrying amount Fair value
Inventories (IAS 2) IP (IAS 40) Carrying amount Carrying amount
IP (IAS 40) PPE (IAS 16) Carrying amount Fair value
IP (IAS 40) Inventories (IAS 2) Carrying amount Fair value
Measurement
Deferred tax
Cost model Fair value model

Deferred tax is the same as for property, plant and Deferred tax is measured based on the
equipment: deferred tax balance is measured on all presumption that the intention is to sell the
temporary differences (at income tax rates) unless investment property (IAS 12.51C)
the asset is not tax deductible, in which case the This presumption is rebutted if the investment
temporary differences will be exempt from property:
deferred tax (IAS 12.15) Is depreciable; and
Is held within a business model, the objective
of which is to recover substantially all its
carrying amount through time (use) rather
than through a sale.
Land is not depreciable and thus the presumption is
always that it will be sold.
If the asset is not tax deductible, the temporary

differences arising from the initial recognition of
the asset will be exempt from deferred tax (IAS
12.15)
524 Chapter 10
Main disclosure
General
Accounting policies
Profit before tax:
o Rental income from investment properties
o Direct expenses re IP’s that earn rental income
o Direct expenses re IP’s that do not earn rental income
o Depreciation, impairment loss & reversals (if cost model)
Investment property note:
o Reconciliation between opening and closing balance
o Fair value (if CM used, this must still be disclosed)
o How fair value measured
IP: Disclosure – for both models

which model used
whether any op lease props are recognised as IP
what criteria used to identify IP from PPE/ Inv
how FV was measured:
o Based on mkt evidence or other factors (list)
o Methods and significant assumptions applied
o Based on a valuation by professional valuer with relevant experience?
o If FVM used, a recon between such a valuation and the valuation used for FS’s
(e.g. adjustments to avoid double-counting)
o Rental income
o Direct op expenses on IP generating rent income
o Direct op expenses on IP with no rent income
Restrictions on remittance of rent income/ sale-ability
Contractual obligations
IP: Disclosure – for FV model
Recon between CA at beginning and end of period

Additions – acquisitions
Additions – subsequent expenditure
+/- assets classified as held for sale
Gain/ loss from FV adjustments
Transfers (to)/ from inventories/ PPE
Other
Show a separate recon for any property that HAD to be measured using CM and also:
Describe this property
Explain why the FV could not be measured reliably
The range of estimates in which FV is highly likely to be
When it is sold:
o Indicate that it was sold
o The CA at time of sale
o G/L recognised on sale
Chapter 10 525
IP: Disclosure – for Cost model

Recon between CA at beginning and end of period
Additions – acquisitions
Additions – subsequent expenditure
+/- assets classified as held for sale
Depreciation
Impairments or impairments reversed
+ - transfers (to)/ from inventories/ PPE
Other
FV of the properties
Summary: examples involving recognition (classification)
Property owned or held under a finance lease that is currently
Held for sale as ordinary business activity Inventories
Held for capital appreciation Investment property
Leased out under op. Lease Investment property
Leased out to 3rd party under finance lease Lease (as a lessor) (can’t be IP!)
Owner-occupied PPE
Occupied by employees PPE
Land held for unknown use Investment property
Vacant: future use = invest property Investment property
Vacant: future use = owner occupation PPE
Property owned or leased from 3rd party under a finance lease where intended use is:
Future use = investment property Investment property
Future use = owner-occupation Property, plant and equipment
Future use = for a third party Construction contracts
Future use = for sale Inventories
Property rented by a subsidiary (or parent) under an op lease
In the lessee’s books (i.e. the subsidiary) Investment property (or operating lease
expense if preferred)
In the lessor’s books (i.e. the parent) Investment property
In the group’s books (i.e. consolidated) Owner-occupied
Prop leased from 3rd party under an operating lease that is
Held for sub-leasing under operating leases (i.e. Can recognise as IP! (if other aspects of IP
investment property in all other respects) def met)
- But must use FV model – and thereafter
must use FV for all IP’s
- Select this option on a property-by-property
basis
526 Chapter 10
Gripping GAAP Impairment of assets
Chapter 11
Impairment of Assets
Reference: IAS 36 and IFRS 13 (including amendments to 10 December 2014)
Contents: Page
1. Introduction 529
2. Indicator review 530
2.1 Overview 530
2.2 External information 530
2.3 Internal information 530
2.4 Materiality 530
2.5 Reassessment of the variables of depreciation 531
Example 1: Indicator review 531
Example 2: Indicator review 533
3. Recoverable amount 535
3.1 Overview 535
Example 3: Recoverable amount and impairment loss: basic 535
3.1.1 Recoverable amounts: indefinite useful life intangible assets 535
3.1.2 Recoverable amounts: all other assets 536
3.1.3 536
3.2 Fair value less costs of disposal 537
Example 4: Recoverable amount: fair value less costs of disposal 537
3.3 Value in use 538
3.3.1 Cash flows in general 538
3.3.1.1 Relevant cash flows 538
3.3.1.2 Assumptions 538
3.3.1.3 Period of the prediction 538
3.3.1.4 Growth rate 539
3.3.1.5 General inflation 539
3.3.2 Cash flows from the use of the asset 539
3.3.2.1 Cash flows to be included 539
3.3.2.2 Cash flows to be excluded 540
3.3.3 Cash flows from the disposal of the asset 540
Example 5: Recoverable amount: value in use: cash flows 541
3.3.4 Present valuing the cash flows 541
Example 6: Value in use: discounted (present) value 542
3.3.5 Foreign currency future cash flows 542
Example 7: Foreign currency future cash flows
4. Recognising and measuring the impairment loss 543
4.1 Overview 543
4.2 Impairments and the cost model 543
Example 8: Impairment loss journal: basic 544
4.3 Impairments and the revaluation model 544
Example 9: Impairment loss journal: with a revaluation surplus 545
Example 10: Fair value and recoverable amount 546
Example 11: Fair value and recoverable amount 546
Chapter 11 527

5. Recognising a reversal of a previous impairment loss 547
5.1 Overview 547
5.2 Impairment reversals and the cost model 547
5.3 Impairment reversals and the revaluation model 548
Example 12: Revaluation model and impairment loss reversed 548
6. Impairment of cash-generating units 551
6.1 Overview 551
Example 13: Scrapping of an asset within a cash-generating unit 552
6.2 Allocation of an impairment loss to a cash-generating unit 553
Example 14: Allocation of impairment loss (no goodwill) 553
Example 15: Allocation of impairment loss (no goodwill): multiple allocation 554
Example 16: Allocation of impairment loss (with goodwill) 555
6.3 Reversals of impairments relating to a cash generating unit 556
6.3.1. Calculating impairment loss reversals relating to CGUs 556
6.3.2. Impairment loss reversals relating to CGUs – cost model 557
6.3.3. Impairment loss reversals relating to CGUs – revaluation model 557
Example 17: Impairment and reversal thereof (no goodwill) 557
Example 18: Impairment and reversal thereof (with goodwill) 559
Example 19: Impairment losses on a CGU – Impairment limited 560
Example 20: Reversal of impairment of a CGU 561
6.4 Corporate assets 564
Example 21: Corporate assets 564
7. Disclosure 566
7.1 In general 566
7.2 Impairment losses and reversals of previous impairment losses 566
7.3 Impairment testing: cash-generating units 566
8. Summary 568
528 Chapter 11
1. Introduction
The standard on impairment of assets Scope of IAS 36

(IAS 36 Impairment of assets) is designed to ensure IAS 36 applies to all assets with the
that an asset’s carrying amount does not exceed the exception of the following:
future economic benefits expected from the asset. inventories (IAS 2)
The future economic benefits that we expect from contract assets & costs to obtain/ fulfil a
an asset are referred to as the recoverable amount. contract that are recognised as assets
Since we can obtain future benefits from either (IFRS 15)
selling the asset or using it and since it is assumed deferred tax assets (IAS 12)
that an entity, being in pursuit of profit, would employee benefit assets (IAS 19)
choose to sell or use depending on which option financial assets (IFRS 9)
rendered the highest benefit, the recoverable amount investment properties measured at fair
is calculated as the higher of the benefits expected value (IAS 40)
from the use and the benefits expected from the sale certain biological assets (IAS 41)
of the asset. insurance contracts (IFRS 4)
non-current assets classified as held for
IAS 36 does not apply to all assets. See the pop-up sale (IFRS 5). IAS 36.2
outlining the scope of IAS 36. All the assets
excluded from the scope of IAS 36 are measured in terms of their own standards specifically
designed to cater for each of these asset types. This standard, IAS 36, affects all other assets,
for instance, property, plant and equipment and intangible assets.
If one looks at the definition of an asset (a resource from which future economic benefits are
expected etc), it is clear that the carrying amount of an asset reflects the future economic
benefits expected from that asset. Thus, if we calculate that our recoverable amount (being
the highest benefits that we can expect from either using or selling the asset) and find that it is
lower than our carrying amount, it means that our carrying amount is overstated and must be
reduced. This reduction is referred to as an impairment loss.
However, the conditions that led to this impairment loss may actually reverse in the future, in
which case the impairment loss may be reversed with the result that the carrying amount is
subsequently increased. This increase is referred to as an impairment loss reversal.
IAS 36 requires that an entity perform an ‘annual indicator review’ (at the end of the reporting
period) to assess whether an asset may be impaired. It is generally only if this review suggests
that an asset may be impaired that the recoverable amount is calculated. IAS 36.9 (reworded)
The annual indicator review and the calculation of the recoverable amount (when necessary),
are, although time-consuming, helpful to businesses in that it forces them to assess the most
profitable future for the asset concerned (basically one must choose whether to continue to
use an asset or dispose of it).
The purpose of IAS 36 :
The term ‘asset’ used in this chapter refers to both
individual assets and to ‘cash-generating units’ To ensure that an asset’s CA is not overstated.
(i.e. a group of assets that cannot produce cash
inflows independently of one another, but only as a part of a group). We will first explain
how to account for impairments and impairment reversals in terms of individual assets and
then we will explain these principles in context of a cash-generating unit.
We will now discuss the following issues in more detail:

what is entailed by an indicator review?
how does one calculate the recoverable amount?
how does one process an impairment loss?
how does one calculate and process and impairment loss reversal?
how does this change if we are dealing with a cash-generating unit instead of an asset?
what are the disclosure requirements when there is an impairment loss or reversal thereof?
Chapter 11 529
2. Indicator Review (IAS 36.8 - .17)
2.1 Overview (IAS 36.8 - .17)

An indicator review is:
An ‘indicator review’ must be performed at the end of the
reporting period in order to assess whether an impairment a procedure that involves looking
may have occurred. An asset is impaired if its carrying for evidence that an asset’s CA may
amount is greater than its recoverable amount. If the asset is be overstated
impaired, its carrying amount must be adjusted downwards to its recoverable amount.
The indicator review should take into consideration the Carrying amount is
following factors: defined as:
external information; the amount at which an asset is
internal information; recognised
materiality; and after deducting any:
reassessment of the variables of depreciation. - accumulated depreciation
(amortisation) and
- accumulated impairment
The recoverable amount only needs to be calculated if: losses. IAS 36.6
the indicator review suggests that the asset may be
impaired;
the asset is an intangible asset with an indefinite useful life;
the asset is an intangible asset not yet available for use; or
the asset is an intangible asset that is goodwill.
Recoverable amount is
2.2 External information (IAS 36.12 - .14) defined as:
the higher of an asset’s:
There are many examples of external information that could - fair value less costs of
indicate that an asset is impaired, including, for example: disposal (FV-CoD); and
- value in use (VIU). See IAS 36.6
a decrease in the value of the asset that is significant
relative to normal usage over time;
a significant adverse change in the market within which the asset is used (e.g. where a
new competitor may have entered the market and undercut the selling price of the goods
that the machine produces); and
the net asset value per share is greater than the market
value per share. See IAS 36.12 The recoverable
amount is only
2.3 Internal information (IAS 36.12 - .14) calculated if:
the indicator review suggests a
As with external information, there are countless examples possible material impairment
of internal information that could indicate that an asset may unless the asset is
be impaired, including, for example, knowledge of: - an intangible asset with an
significant changes adversely affecting the use of the indefinite useful life / not
asset, including planned changes; for example: yet available for use
- goodwill
- a plan to dispose of the asset at a date earlier than in which case the RA must
previously expected, ALWAYS be calculated.
- a plan that will result in the asset becoming idle,
- a plan to cease manufacturing a product line or close a factory that uses the asset
concerned, and
- the reassessment of the useful life of an asset from ‘indefinite’ to ‘finite’;
future unexpected maintenance costs that will reduce the value in use;
unusually low budgeted cash flows and profits/ losses relating to the use of the asset; and
physical damage or obsolescence. See IAS 36.12
2.4 Materiality (IAS 36.15)
We have to calculate the estimated recoverable amount if the annual indicator review suggests
that an asset may be impaired, but only if the potential impairment is expected to be material.
530 Chapter 11
However, this does not apply for intangible assets with indefinite useful lives, intangible
assets not yet available for use and goodwill - their recoverable amounts must be calculated
annually even if there is no indication of an impairment and even if a possible impairment
would not be material.
2.5 Reassessment of the variables of depreciation (IAS 36.17)

If any one of the indicators (internal or external) suggests
that the asset’s carrying amount is materially overstated, this If the CA appears
overstated:
could indicate that it may be materially impaired. If so, we
would adjust the carrying amount downwards and call this before processing an impairment
adjustment an ‘impairment loss’. However, an impairment loss; we
loss is only processed after first checking that the possibly First check that our estimated
over-stated carrying amount is not simply the result of past accumulated depreciation does
depreciation that has been under-estimated. not need to be re-estimated
In order to assess the reasonableness of the depreciation to date, we must re-evaluate the three
variables of depreciation:
estimated remaining useful life,
residual value (used to calculate depreciable amount), &
depreciation (or amortisation) method. IAS 36.17 (reworded)
Any change in the above three variables must be adjusted in accordance with the statement
governing that type of asset. For example, a change in the depreciation of property, plant and
equipment will be accounted for as a change in accounting estimate (IAS 8), since this is how
IAS 16 Property, plant and equipment requires a change in depreciation to be accounted for.
Example 1: Indicator review
Lilguy Limited owns a plant, its largest non-current asset, which:
originally cost C700 000 on 1/1/20X4; and
has a carrying amount of C350 000 at 31/12/20X8; and
is depreciated straight-line to a nil residual value over a 10 year estimated useful life.
Lilguy Limited performed an indicator review at its financial year end (31/12/20X8) to assess whether
this asset might be impaired. Initial information collected for the purpose of review includes:
Budgeted net cash inflows: these are slightly reduced because a decrease in the market demand for
the plant’s output is expected during 20X9 after which demand is expected to cease altogether.
The present value of the future net cash inflows from the plant: C230 000.
The market price per share in Lilguy Limited: C2,20 (there are 100 000 issued shares).
A summary of the totals in the statement of financial position is as follows:
Assets: 400 000
Liabilities: 100 000
Equity: 300 000
Required: Discuss whether the recoverable amount must be calculated at 31 December 20X8.
Solution 1: Indicator review

The net asset value of the company as presented in the statement of financial position is C300 000
(Assets: 400 000 – Liabilities: 100 000) and this works out to a net asset value of C3 per share
(300 000 / 100 000 shares). The fact that the market perceives the value of the company to be only
C2,20 per share or C220 000 in total suggests that the assets in the statement of financial position
may be over-valued. This difference in value appears to be material and thus suggests that there
may be a possible impairment.
The future cash flows will be reduced over the next year which suggests a possible impairment, but
the fact that the reduction is expected to be slight suggests that the impairment would be
immaterial and therefore this fact alone does not require a recoverable amount to be calculated.
Chapter 11 531

The present value of the future cash inflows from the use of the plant is C230 000. This appears to
be significantly less than the carrying amount of the plant of C350 000. This difference appears to
be material and therefore suggests that there may be a possible impairment.
There appears to be overwhelming evidence that suggests that there may be a possible impairment
and if, as in this case, the possible impairment appears likely to be material, the recoverable
amount would need to be calculated. Before doing this though, one must first reassess the variables
of depreciation, and adjust the carrying amount for any changes in estimate.
The management accountant believes that there is only 1 year of future economic benefits
remaining in the plant, which suggests that the 10 years over which the plant is being depreciated
is too long. By revising the useful life to a shorter period, the carrying amount of the plant will
decrease and may possibly decrease sufficiently such that there is no need to calculate the
recoverable amount.
Total useful life – original estimate 10 years
Used up to end of 31 December 20X8 5 years
Remaining useful life – original estimate 5 years
Remaining useful life according to latest budget 1 years
Reduction in remaining useful life (from 5 years to 5 – 1 = 4 years) 4 years
This change in useful life (decrease in total life from 10 years to 6 years: 5 past years + 1 more
year) (decrease in remaining life from 5 years to 1 year) must be recorded as a change in
accounting estimate (IAS 8). Assuming one uses the reallocation approach to calculate the effect of
the change in estimate, the change to the carrying amount is as follows:
10 year 6 year Drop in carrying
useful life useful life amount
Cost: 1/1/20X4 Given 700 000
Acc deprec: 31/12/20X7 700 000 / 10 x 4 (280 000)
Remaining useful life 10 – 4; 1 + 1 6 2
Depreciation: 20X8 420 000 / 6; (70 000) (210 000) (140 000)
420 000 / 2
Carrying amount: 31/12/20X8 350 000 210 000 (140 000)
The new carrying amount will adjust the net asset value downwards and the revised net asset value
must be compared again with the market value:
Assets per the SOFP before the change in useful life Given 400 000
Less reduction in carrying amount of plant due to extra depr. (140 000)
Assets per the SOFP after the change in useful life 260 000
Less liabilities Given 100 000
Net asset value 160 000
The revised net asset value is now less than the company’s market value of 220 000 (2.2 x
100 000) and therefore the market value no longer suggests a possible impairment.
The new reduced carrying amount is now also more in line with the present value of the future net
cash inflows per the management accountant’s budget:
Carrying amount of plant – revised 210 000

Present value of budgeted future cash inflows from plant 230 000
As the carrying amount is now less than the present value of the expected future cash inflows, the
budgeted future cash flows no longer suggest an impairment.
Conclusion: Although the review initially suggested that there were possible impairments and that
these impairments were possibly material, no recoverable amount needed to be calculated since the
revised depreciation resulted in the carrying amount being reduced.
532 Chapter 11
Debit Credit
Depreciation – plant (E) 140 000
Extra depreciation processed due to a reduction in useful life
Example 2: Indicator review

Lilguy Limited owns a plant, its largest non-current asset, that:
originally cost C700 000 on 1/1/20X1;
has a carrying amount of C350 000 at 31/12/20X5; and
is depreciated straight-line to a nil residual value over a 10 year useful life.
Lilguy Limited performed an indicator review (at 31/12/20X5) to assess if this asset may be impaired.
Initial information collected for the purpose of this review included:

The management accountant budgeted that net cash inflows will be slightly reduced over the next 3
years of usage, due to a decrease in the market demand for the plant’s output, and that there will be
no market for the plant’s output after 31/12/20X8.
The estimated fair value less costs of disposal of the plant is C250 000.
The market price per share in Lilguy Limited was C3,50 (there are 100 000 issued shares).
A summary of the totals in the statement of financial position is as follows:
Assets: 400 000
Liabilities: 100 000
Equity: 300 000
Required: Discuss whether the recoverable amount must be calculated.
Solution 2: Indicator review

The future cash flows will be reduced over the next three years which suggests a possible
impairment, but the fact that the reduction is expected to be slight suggests that the impairment
would be immaterial and therefore this fact alone does not require a recoverable amount to be
calculated.
The net asset value of the company is presented in the statement of financial position as C300 000
(Assets: 400 000 – Liabilities: 100 000) and this works out to a net asset value of C3 per share
(300 000 / 100 000 shares).
However, the market perceives the value of the company to be C3.50 per share or C350 000 in total
(C3,50 x 100 000 shares), which is more than the value reflected in the statement of financial
position (C300 000). This suggests that the assets in the statement of financial position are not
over-valued and therefore that there is possibly no impairment required.
The fact that the management accountant believes that there are only 3 years of usage left in the
plant suggests that the 10 years over which the plant is being depreciated is too long.
By revising the useful life to a shorter period, the carrying amount of the plant will be reduced and
may be reduced sufficiently such that there is no need to calculate the recoverable amount.
Total useful life – original estimate 10 years

Used up to end 31 December 20X5 5 years
Remaining useful life – original estimate 5 years
Remaining useful life according to latest budget 3 years
Reduction in remaining useful life (from 5 years to 5 – 3 = 2 years) 2 years
This change in useful life (total life of 10 years decreased to 5 + 3 = 8 years; or remaining life
changed from 5 years to 3 years) must be accounted for as a change in accounting estimate (IAS 8).
Chapter 11 533
Assuming that one uses the reallocation approach to account for the change in estimate, the change to
the carrying amount is as follows: 10 year 8 year Drop in
useful life useful life CA
Cost: 1/1/20X1 Given 700 000
Accum deprec: 31/12/20X4 700 000 / 10 x 4 (280 000)
Remaining useful life (10 – 4); (1 + 3) 6 4
Depreciation: 20X5 420 000/ 6; (70 000) (105 000) (35 000)
420 000/ 4
Carrying amount: 350 000 315 000 (35 000)
31/12/20X5
The new carrying amount will adjust the net asset value downwards and the revised net asset value
must be compared again with the market value:
Assets per the statement of financial position before the change in useful life 400 000
Less reduction in carrying amount of plant (35 000)
Assets per the statement of financial position after the change in useful life 365 000
Less liabilities 100 000
Net asset value 265 000
The revised net asset value is still lower than the company’s market value of 350 000 (3.5 x
100 000 shares) and therefore the market value still does not suggest a possible impairment.
The new carrying amount will have brought the carrying amount downwards to be more in line
with the estimated fair value less costs of disposal.
Carrying amount - revised 315 000
Fair value less costs of disposal 250 000
Although the carrying amount is reduced, it is still materially greater than the fair value less costs
of disposal, and thus these budgeted future cash flows still suggest that the asset may be impaired.
Conclusion: The depreciation journal needs to be processed:
Debit Credit
Depreciation – plant (E) 35 000
Extra depreciation processed due to a reduction in useful life
Although this extra depreciation will be processed (see above journal), there is still evidence of a
possible material impairment and therefore the recoverable amount must be calculated.
This recoverable amount must then be compared with the revised carrying amount (i.e. after
deducting the depreciation per the journal above). If the recoverable amount is less than the
carrying amount, an impairment journal would need to be processed, as follows:
Debit Credit
Impairment loss – plant (E) xxx
Plant: accumulated impairment losses (-A) xxx
Impairment of plant
534 Chapter 11
3. Recoverable Amount (IAS 36.18 - .57)
3.1 Overview
Recoverable amount is
defined as:
The recoverable amount is a calculation of the estimated
future economic benefits that the entity expects to obtain the higher of an asset’s:
from the asset. It is measured at the higher of the expected - fair value less costs of disposal
(FV-CoD); and
benefits from the entity using the asset or the entity selling
- value in use (VIU). IAS 36.6
the asset. It is important to note that recoverable amount is
thus an entity-specific measurement.
Example 3: Recoverable amount and impairment loss – basic
A company has an asset with the following details at 31 December 20X9:
Fair value less costs of disposal C170 000
Value in use C152 164
Required:
A. Calculate the recoverable amount of the asset at 31 December 20X9.
B. Calculate whether or not the asset is impaired if its carrying amount is:
i. C200 000
ii. C150 000.
Solution 3A: Recoverable amount – basic

C
Recoverable amount is the higher of the following: 170 000
Value in use 152 164
Solution 3B: Impairment loss – basic

i. If the carrying amount is C200 000, the asset is impaired: C
Carrying amount 200 000
Less recoverable amount 170 000
Impairment (carrying amount exceeded the recoverable amount) 30 000
ii. If the carrying amount is C150 000, the asset is not impaired: C
Less recoverable amount 170 000
Impairment (carrying amount less than the recoverable amount) N/A
3.1.1 Recoverable amounts: indefinite useful life intangible assets (IAS 36.24)
The recoverable amount of an intangible asset with an indefinite useful life must be estimated
annually (i.e. not only when an indicator review suggests an impairment). There is one
exception to this rule being when there is a recent detailed estimate of recoverable amount
that was made in a previous year and on condition that certain criteria are met.
If a recent detailed estimate of the recoverable amount was made in a preceding year, this
estimate may be used instead of re-calculating the recoverable amount, on condition that:
this intangible asset is part of a cash-generating unit, where the change in the values of
the assets and liabilities within the cash-generating unit are insignificant;
the most recent detailed estimate of the recoverable amount was substantially greater
than the carrying amount at the time; and
events and circumstances subsequent to the calculation of the previous recoverable
amount suggest that there is only a remote chance that the current recoverable amount
would now be less than the carrying amount. IAS 36.24 (reworded)
Chapter 11 535
3.1.2 Recoverable amounts: all other assets (IAS 36.18–22)

When faced with calculating recoverable amounts, remember that the recoverable amount
should be measured for each individual asset, unless the asset produces cash inflows in
tandem with a group of inter-dependent assets.
In this case, the recoverable amount for the group of assets is calculated rather than for an
individual asset. This group of assets is referred to as a cash-generating unit. This will be
covered later in this chapter.
Although the recoverable amount is the higher of value in use and fair value less costs of
disposal, it is not always necessary (or possible) to calculate both of these amounts:
it may be impossible to measure the fair value less costs of disposal, in which case only
the value in use is calculated;
if one of these two amounts is calculated to be greater than the carrying amount, the other
amount does not need to be calculated since this will automatically mean that the asset is
not impaired; and
if there is no indication that the value in use materially exceeds the fair value less costs of
disposal, only the fair value less costs of disposal need be calculated (this is generally
easier to calculate than value in use). See IAS 36.21
Summary:
Normal approach calculate FV-COD; and then

if FV-COD is less than CA then also:
calculate VIU (because this may be higher
than CA)
But if you know that the:
VIU> FV-COD only calculate VIU
FV-COD > VIU only calculate FV-COD
VIU = FV-COD only calculate FV-COD (easier!)
If calculation of FV-COD impossible calculate VIU
VIU = value in use FV-COD = fair value less costs of disposal CA = carrying amount
3.2 Fair value less costs of disposal (IAS 36.28 and IAS 36.53A)
Fair value is
Fair value less costs of disposal is a measurement of the defined as:
estimated net proceeds that would the price that would be
Costs of disposal
be received if we were to sell the are defined as: received to sell an asset (or
asset, after taking into account paid to transfer a liability)
are incremental costs
disposal costs. It is important to in an orderly transaction
directly attributable to the
notice that the definition of fair disposal of an asset or between market
value is a market-based cash-generating unit, participants
measurement, taking into excluding finance costs and at the measurement date.
IAS 36.6
consideration only those income tax expense. IAS 36.6
assumptions that market participants would use when pricing the asset.
The costs of disposal are the costs directly associated with the disposal (other than those
already recognised as liabilities) and may include, for example:
legal costs;
costs of removal of the asset;
costs incurred in bringing the asset to a saleable condition;
transaction taxes.
Costs to restructure (re-organise) a business may not be included as a disposal cost. IAS 36.28
(reworded)
536 Chapter 11
Example 4: recoverable amount – fair value less costs of disposal

A company has an asset with the following details at 31 December 20X9:
Expected selling price C200 000
Costs of delivery to potential customer C20 000
Legal costs involved in sale agreement C10 000
Costs to re-organise the production layout of the factory due to C15 000
disposal of asset
Required:
Calculate the fair value less costs of disposal of the asset at 31 December 20X9.
Solution 4: recoverable amount – fair value less costs of disposal

C
Expected selling price 200 000
Less the costs of disposal (C20 000 + C10 000) 30 000
Comment: The re-organisation costs may not be included in determining the costs of disposal. IAS 36.28
3.3 Value in use (IAS 36.30 – .57)

Value in use is defined
Value in use includes the net cash flows from an asset’s: as:
use and the present value of the
future cash flows expected to be
disposal after usage.
derived from
Value in use is an entity-specific measurement (whereas fair an asset or cash-generating unit.
IAS 36.6
value is a market-based measurement). This means that,
for example, a legal right or restriction that applies only to the entity and which would not
apply to market participants:
would be taken into consideration in the measurement
of value in use; but
Value in use equals:
would not be taken into consideration in the
measurement of fair value (since it is an assumption Future cash flows x Discount rate
that would not generally be available to the market
participants).
The measurement of value in use involves the calculation of a present value as follows:
estimating all future cash flows relating to the asset; and
multiplying the cash flows by the appropriate discount rate.
There are five elements involved in this process (IAS 36 Appendix A: A1):
a) future cash flows;
b) time value of money;
c) uncertainties regarding the amount and timing of the cash flows;
d) the cost of bearing the uncertainties; and
e) other factors that may affect the pricing of the cash flows (e.g. illiquidity).
An appropriate discount rate is estimated by considering the time value of money (element b).
The last three elements (elements c-d) may either be considered when estimating the future
cash flows or be considered together with the time value of money when estimating the
discount rate. Considering these elements (c-d) when estimating the future cash flows and
when estimating the discount rate would be double-counting. These elements (c-d) may only
be considered when estimating the future cash flows or estimating the discount rate - not both.
We will now discuss the calculation of the value in use under the following headings:
cash flows in general;
cash flows from the use of the asset;
cash flows from the disposal of the asset; and
present valuing the cash flows.
Chapter 11 537
3.3.1 Cash flows in general (IAS 36.33–54)

General factors to bear in mind when estimating the future cash flows include the:
relevant cash flows (cash flows to be included and excluded);
assumptions made;
period of the prediction;
growth rate used;
general inflation.
3.3.1.1 Relevant cash flows (IAS 36.39)
The cash flows that should be included in the calculation of value in use are:
From usage: the cash inflows from continuing use as Relevant cash flows
well as those cash outflows that are necessary to create include inflows &
these cash inflows; and outflows from:
From eventual disposal: the net cash flows from the Usage (inflows and outflows) &
eventual disposal of the asset. See IAS 36.39 Disposal.
3.3.1.2 Assumptions: (IAS 36.33(a), .34 and .38)

The assumptions used when making the projections should be:
reasonable;
justifiable (e.g. if an entity upgrades its plant just Assumptions must be:
before year-end, it could justify a projection of, say,
1 000 units pa even if normal output is 800 units); Reasonable
management’s best estimate (i.e. not the most Justifiable
optimistic or most pessimistic) of the future economic Mgmt’s best estimate
conditions that will exist over the useful life of the Based on past cash flows
Based mainly on past experience.
asset;
considerate of the past cash flows and past accuracy (or lack thereof) in projecting cash
flows; and be
based on mainly external evidence rather than internal evidence (since this is more
objective) wherever possible.
3.3.1.3 Period of the prediction: (IAS 36.33(b) and .35)
The projected cash flows:
should be based on the most recent budgets and forecasts that have been approved by
management (therefore budgets produced and approved after year-end would be favoured
over budgets produced and approved before year-end); and
should not cover a period of more than five years unless this can be justified (because
budgets covering longer periods become more inaccurate). See IAS 36.35
Projected cash flows should ideally not extend beyond five years since the projections usually
become increasingly unreliable. Projections may, however,
extend beyond five years if: Period of prediction:
management is confident that these projections are
should ideally be 5 years/ shorter
reliable; and should be based on most recent &
it can demonstrate its ability, based on past experience, approved budgets and forecasts.
to forecast cash flows accurately over that longer
period. See IAS 36.35
3.3.1.4 Growth rate: (IAS 36.33(c); .36 and .37)
If the projected cash flows cover a period that exceeds the period covered by the most recent,
approved budgets and forecasts (or indeed beyond the normal five year limit), then the
projected cash flows should be estimated by:
extrapolating the approved budgets and forecasts;
538 Chapter 11
using either a steady or a declining growth rate (i.e. this would be more prudent than
using an increasing growth rate), unless an increasing growth rate is justifiable, for
example, on objective information regarding the future of the product or industry; and
using a growth rate that should not exceed the long-term average growth rate of the
products, industries, market or countries in which the entity operates, unless this can be
justified (prudence once again).
For example, one should not use a future growth rate of 15% in the projections based on a
current year’s growth rate of 15%, if during the last ten years the entity experienced an
average growth rate of only 10%. This is because it is difficult to justify a growth rate that
exceeds the long-term average growth rate since a long-term average growth rate would
indicate extremely favourable conditions and of course, as soon as there are favourable
conditions, competition may increase, which will possibly decrease the growth rate in future.
The effects of future unknown competitor/s are obviously impossible to estimate.
3.3.1.5 General inflation: (IAS 36.40)
If the discount rate:
If the discount rate used:
reflects the effect of general inflation, then projected cash includes general inflation :
flows must be the ‘nominal’ cash flows (i.e. the current - use nominal cash flows
values that are not increased for the effects of inflation). excludes general inflation :
does not reflect the effects of general inflation, then - use real cash flows
projected cash flows must be the ‘real’ cash flows and must also include future specific
price increases or decreases. IAS 36.40 (reworded)
3.3.2 Cash flows from the use of the asset (IAS 36. 39–51) Cash flows from use:
Includes: cash flows relating to

3.3.2.1 Cash flows from use to be included: (IAS 36.39(a) continuing use in its existing
and (b); .41 and .42) condition (plus costs needed to
get asset to a useable condition)
Cash inflows include: Excludes: cash inflows re other
the inflows from the continuing use of the asset. assets; cash outflows already
recognised as liabilities, cash
flows relating to enhancements,
Cash outflows include all those cash outflows that are financing, tax
expected to be necessary:
for the continuing use of the asset in its current condition (and which can be directly
attributed, or allocated on a reasonable and consistent basis, to the asset); and
to bring an asset that is not yet available for use to a usable condition. See IAS 36.39
Cash flows represent the economic benefits resulting from a single asset. However, it may be
difficult to estimate the expected cash inflows from a single asset in which case it may
become necessary to evaluate the cash inflows and outflows of a group of assets (cash-
generating unit).
3.3.2.2 Cash flows from use to be excluded: (IAS 36.43 - .48, .50 and .51)
Future cash flows are estimated based on the asset’s current condition. The following
expected cash flows are thus excluded:
cash inflows that relate to other assets, (since these will be taken into account when
assessing the value in use of these other assets);
cash outflows that have already been recognised as liabilities (for example, a payment of
an accounts payable) since these outflows will have already been recognised (either as
part of the asset or as an expense); See IAS 36.43
cash inflows and outflows relating to future expenditure to enhance the asset in excess of
its current standard of performance at reporting date; See IAS 36.44
cash inflows and outflows relating to a future restructuring to which the entity is not yet
committed; See IAS 36.44
cash inflows and outflows from financing activities (since cash flows will be discounted
to present values using a discount rate that takes into account the time-value of money);
cash flows in respect of tax receipts and tax payments (because the discount rate used to
discount the cash flows is a pre-tax discount rate). See IAS 36.50
Chapter 11 539
3.3.3 Cash flows from the disposal of the asset (IAS 36.52 and .53)
The net cash flows from the future disposal of an asset is estimated as follows:
the amount the entity expects to receive from the disposal of the asset at the end of the
asset’s useful life in an arm’s length transaction between Cash flows
knowledgeable, willing parties; from disposal:
less the estimated costs of the disposal. IAS 36.52(slightly reworded)
Expected proceeds
Less expected disposal
The net cash flow from the future disposal of an asset is estimated costs
based on prices currently achieved from the disposal of similar
assets that are already at the end of their useful lives and have been used under similar
conditions. These prices are then adjusted up/down:
for general inflation (if general inflation was taken into account when estimating the cash
flows from use and the discount factor); and for
for specific future price adjustments. See IAS 36.53
Example 5: Recoverable amount – value in use – cash flows

Management’s most recently approved budget shows a machine’s future cash flows as
follows:
20X7 20X8 20X9
Future cash inflows/ (outflows): C’000 C’000 C’000
Maintenance costs (100) (120) (80)
Operational costs (electricity, water, labour etc) (200) (220) (240)
Interest on finance lease (60) (50) (40)
Tax payments on profits (16) (20) (28)
Cost of increasing the machine’s capacity (0) (220) (0)
Depreciation (80) (80) (80)
Expenses to be paid in respect of 20X6 accruals (30) (0) (0)
Basic inflows: see note 1 1 000 1 200 1 400
Extra profits resulting from the upgrade 0 20 50
Note 1: Machine Plant
Cash inflows stem from 40% 60%
The useful life of the machine is expected to last for 5 years. The growth rate in the business in 20X6
was an unusual 15% whereas the average growth rate over the last 7 years is:
in the industry 10%
in the business 8%
Required: Calculate the future net cash flows to be used in the calculation of the value in use of the
machine at 31 December 20X6 assuming that a 5-year projection is considered to be appropriate.
Solution 5: Recoverable amount - value in use – cash flows
20X7 20X8 20X9 20Y0 20Y1

Future cash inflows / (outflows) - Machine C’000 C’000 C’000 C’000 C’000
Maintenance costs (direct cost) (100) (120) (80)
Operational costs (allocated indirect costs) (200) (220) (240)
Interest on finance lease (financing always excluded) - - -
Tax payments (tax always excluded) - - -
Cost of upgrading machine (upgrades always excluded) - - -
Depreciation (not a cash flow – a ‘sunk’ cost) - - -
Payments to settle 20X6 accruals (not a future expense – - - -
already recognised in 20X6 financial statements)
Basic inflows: (only 40% relates to machine) 400 480 560
Extra profits from the upgrade (always exclude) - - -
Net cash inflows (20XY0: 240 x 1.08) (20Y1: 259 x 1.08) 100 140 240 259* 280*
* Rounded
540 Chapter 11

Comment:
The net cash inflows per year still need to be present valued and the total of the present values per year is then
totalled to give the ‘net present value’ or ‘value in use’.
It was assumed in this question that the machine would not be able to be sold at the end of its useful life and
the disposal thereof would not result in any disposal costs.
The current year growth rate of 15% seems unusual given the company’s average growth rate was only 8%.
The industry average of 10% is also greater than the business average of 8%. Prudence dictates that we should
thus use 8%.
3.3.4 Present valuing the cash flows (IAS 36.55 - .57)
The cash inflows and cash outflows relating to the use and eventual disposal of the asset must
be present valued (i.e. discounted). This means multiplying the cash flows by an appropriate
discount factor (or using a financial calculator). The discount
rate is a pre-tax discount rate. Discount rate should
be a:
The pre-tax discount rate is estimated using the: pre-tax
current market assessment of the time value of money; and mkt-related risk-free rate
Adjusted for risks specific to
the risks specific to the asset for which the future cash the asset.sks specific to the
flows have yet to be adjusted. IAS 36.55 (reworded) asset that haven’t been
adjusted for.
When an asset-specific rate is not available, a surrogate rate is used. Guidance for estimating
a surrogate rate is as follows (IAS 36 Appendix A, A16 - 18):
Estimate what the market assessment would be of:
- the time value of money for the asset over its remaining useful life;
- the uncertainties regarding the timing and amount of the cash flows (where the cash
flow has not been adjusted);
- the cost of bearing the uncertainties relating to the asset (where the cash flow has not
been adjusted);
- other factors that the market might apply when pricing future cash flows (e.g. the
entity’s liquidity) (where the cash flow has not been adjusted).
The weighted average cost of capital of the entity (using the Capital Asset Pricing
Model), the entity’s incremental borrowing rate and other market borrowing rates could
be considered although these rates would need to be adjusted for the following risks
(unless the cash flows have been appropriately adjusted):
- country risk;
- currency risk; and
- price risk.
Example 6: Value in use – discounted (present) value

An asset has the following future cash flows, estimated at 31 December 20X6:
Expected cash inflows per year (until disposal) C110 000
Expected cash outflows per year (until disposal) C50 000
Expected sale proceeds at end of year 3 C7 000
Expected disposal costs at end of year 3 C3 000
Number of years of expected usage 3 years
Present value factors based on a discount rate of 10%
Present value factor for year 1 0.909
Required: Calculate the expected value in use at 31 December 20X6.
Chapter 11 541
Solution 6: Value in use – discounted (present) value

Comment: The value in use is calculated as a net present value (NPV):
The NPV calculation below involved multiplying the net cash flows by the present value factors.
If a financial calculator had been used instead, the NPV would be C152 216 (rounded off). The
difference is because the present value factors used below were rounded to 3 decimal places.
20X7 20X8 20X9
Cash inflow for the year 110 000 110 000 110 000
Cash outflow for the year (50 000) (50 000) (50 000)
Sale proceeds 7 000
Disposal costs (3 000)
Net cash flows (NCF) 60 000 60 000 64 000
Present value factor (PVF) (discount factor) 0.909 0.826 0.751
PV of net cash flows (NCF x PVF) 54 540 49 560 48 064
Net present value (NPV) (value in use): (54 540 + 49 560 + 48 064) C152 164
3.3.5 Foreign currency future cash flows (IAS 36.54)
If the future cash flows are generated in a foreign currency, the value in use must be
calculated as follows:
the future cash flows must first be estimated in that foreign currency;
these foreign currency future cash flows must then be discounted to a present value by
using a discount rate that is appropriate for that foreign currency; and
this foreign currency present value is then translated into the local currency using the spot
rate at the date of the value in use calculation. IAS 36.54 (reworded)
Example 7: Foreign currency future cash flows
An asset belonging to a South African company, with a functional currency of Rand (R)
has the following dollar denominated future cash flows, estimated at 31 December 20X6:
Expected cash inflows per year (until disposal) $100 000
Expected cash outflows per year (until disposal) $50 000
Expected sale proceeds at end of year 3 $7 000
Expected disposal costs at end of year 3 $3 000
Number of years of expected usage 3 years
Present value factors based on a discount rate of 10% (an appropriate rate for the dollar)
PV factor for year 1 0.909
The Rand : Dollar spot exchange rate:
31 December 20X6 R6: $1
Required:
Calculate the expected value in use at 31 December 20X6.
Solution 7: Foreign currency future cash flows

Comment: The PV of cash flows would be $127 348 and R764 088 using a financial calculator.
20X7 20X8 20X9
Cash inflows for the year $100 000 $100 000 $100 000
Cash outflows for the year (50 000) (50 000) (50 000)
Sale proceeds 7 000
Disposal costs (3 000)
Net cash flows 50 000 50 000 54 000
Present value factor 0.909 0.826 0.751
PV of net cash flows 45 450 41 300 40 554
Net present value in dollars (value in use) (45 450 + 41 300 + 40 554) $127 304
Net present value in Rand (value in use) ($127 304 x R6) R763 824
542 Chapter 11
4. Recognising and Measuring the Impairment Loss (IAS 36.58 - .64 and IAS 36.5)
4.1 Overview
An impairment loss is
processed when:
When the recoverable amount of an asset (other than a
CA > RA.
cash-generating unit or goodwill) is found to be less than its
carrying amount, the carrying amount must be reduced to the recoverable amount.
After an impairment is processed, depreciation in subsequent periods must be calculated using

the new depreciable amount and using the asset’s remaining useful life.
The new depreciable amount is: An impairment loss is

the reduced carrying amount of the asset (the defined as:
recoverable amount) the amount by which the
less its residual value. carrying amount exceeds
its recoverable amount. IAS 36.6
Please note that it is not uncommon for the residual value to

be reduced and/ or for the remaining useful life to be reduced as a result of the same
circumstances that caused an impairment to be processed. Changes to the residual value and
useful life are accounted for as changes in estimate in terms of IAS 8 Accounting policies,
changes in accounting estimates and errors.
Impairments are processed whether the asset is measured using the cost model or revaluation
model. The journal entries will be slightly more complex if the revaluation model is used.
4.2 Impairments and the cost model
To process an impairment on an asset that is measured using the cost model (e.g. in terms of
IAS 16 Property, plant and equipment or IAS 38 Intangible assets):
the asset’s carrying amount is credited (reduced); and
an impairment loss expense account is debited. Cost model
impairment journal:
The carrying amount is not reduced by crediting the cost
account but rather crediting either: Dr: Impairment loss
Cr: Accumulated imp loss
accumulated impairment loss account; or
accumulated depreciation and impairment loss account (’accumulated depreciation’ is
not required to be separately disclosed from ‘accumulated impairment losses’ and thus the
two accounts can be combined).
Summary : Decreases in carrying amount using the cost model

HCA
HCA/
ACA
ACA
Imp loss Imp loss
RA RA
HCA: Historical carrying amount ACA: Actual carrying amount RA: Recoverable amount
Explanation:
If the ACA = HCA (cost less cumulative depreciation) and this ACA must be reduced to a lower RA,
this is recognised as an impairment loss expense.
If the ACA had already been reduced below the HCA and must now be reduced to a lower RA, the
treatment is the same: the decrease is recognised as an impairment loss expense.
Chapter 11 543
Example 8: impairment loss journal – basic

A plant, measured under the cost model, has the following values at 31 December 20X9:
Cost 150 000
Less accumulated depreciation to 31 December 20X9 (50 000)
Carrying amount: 31 December 20X9 100 000
Recoverable amount 40 000
Required: Journalise the impairment at the year ended 31 December 20X9.
Solution 8: impairment loss journal – basic

Impairment loss (E) 60 000
Plant: accumulated impairment losses (-A) 60 000
Impairment of plant (100 000 – 40 000)
For further examples of an impairment loss involving an asset measured under the cost model,
see chapter 7: see example 29, 31 and 32.
4.3 Impairments and the revaluation model

To process an impairment on an asset that is measured using the revaluation model (e.g. in
terms of IAS 16 Property, plant and equipment or IAS 38 Intangible assets) one must:
credit accumulated impairment losses; and
debit an impairment loss expense account, but only after first debiting (removing) any
related balance that may exist in the revaluation surplus account.
In other words, if no revaluation surplus existed, then the entire decrease in the carrying
amount is recognised as an impairment loss expense as follows:
Debit Credit
Impairment loss (E) xxx
Impairment of PPE (no revaluation surplus balance existed)
If there was a balance on the revaluation surplus, we journalise the impairment in two steps:
Step 1: first reduce the revaluation surplus account
Step 2: once the revaluation surplus account has been reduced to zero, any excess
impairment is recognised as an impairment loss expense.
Debit Credit
Revaluation surplus (OCI) xxx
Step 1: Impairment of PPE: first against existing RS balance
Impairment loss (E) xxx

Step 2: Impairment of PPE: excess impairment expensed
Note: the above journal could also be combined to show the total amount credited to
accumulated impairment losses
Notice that we credit the accumulated impairment loss account for both the:
debit to impairment loss expense, and
debit to revaluation surplus.
The effect of the above treatment is that the cost account remains reflected at fair value and
the carrying amount of the asset is thus reflected at fair value less subsequent accumulated
depreciation and impairment losses. See IAS 16.31
544 Chapter 11
Summary: Decreases in carrying amount using the revaluation model
ACA ACA HCA

Reversal Reversal
of RS of RS
NOTE 1 NOTE 1
HCA RA ACA
Imp loss Imp loss
NOTE 1
RA HCA RA
Note 1:
The summary above assumes that any revaluation surplus is transferred to retained earnings over the
life of the asset, in which case, the difference between the ACA and the HCA will reflect the
revaluation surplus balance.
If the revaluation surplus is not transferred to retained earnings over the life of the asset, the table
above does not apply since the balance in the revaluation surplus account will not be the difference
between ACA and HCA: however, the over-riding principle of first removing whatever balance exists
in the revaluation surplus account and then expensing any further impairment still applies.
In essence: any impairment is first debited against whatever balance is in the revaluation surplus
account, and any further impairment after having completely reversed the revaluation surplus balance
is then expensed as an impairment loss expense (i.e. first debit revaluation surplus and then debit
impairment loss expense with any excess).
Example 9: impairment loss journal – with a revaluation surplus

The following balances relate to plant, measured under the revaluation model at
31 December 20X9:
Carrying amount: 31 December 20X9 C100 000
Recoverable amount: 31 December 20X9 C40 000
Revaluation surplus: 31 December 20X9 C10 000
Required: Journalise the impairment at 31 December 20X9.
Solution 9: impairment loss journal – with a revaluation surplus

Comment: This example shows how:
the carrying amount is first reduced by reducing the revaluation surplus to nil, after which,
any further reduction in the carrying amount is then expensed as an impairment loss expense.
Revaluation surplus (OCI) Balance in this account: given 10 000
Impairment loss expense (P/L) (100 000 – 40 000) – 10 000 50 000
debited to revaluation surplus
Plant: accumulated impairment losses CA: 100 000 – RA: 40 000 60 000
Impairment of plant (100 000 – 40 000 = 60 000) first set-off against
the revaluation surplus balance (10 000), the rest (50 000) is expensed
When processing an impairment loss for an asset that uses the revaluation model, if a
revaluation is due to be performed during the year, we would account for the revaluation
before we account for the impairment. In other words:
Revalue the asset to fair value following the normal revaluation process (see Chapter 8)
Calculate the recoverable amount of the asset
Process an impairment loss (if the new CA exceeds the asset’s RA).
This process is based on the principle that the asset measured under the revaluation model
must be carried at its ‘fair value at the date of the revaluation less any subsequent
accumulated depreciation and impairment losses’. See IAS 16.31
Chapter 11 545
Please also remember that the carrying amount of an asset measured under the revaluation
model, must never differ materially from its current fair value at year-end. See IAS 16.31
Thus, when calculating impairment losses, we should be comparing:
the carrying amount, which should not differ materially from its current fair value; and
the recoverable amount: the higher of fair value less costs of disposal and value in use.
The difference between fair value (used in the revaluation model) and fair value less costs of
disposal (used in calculating the recoverable amount) is obviously the ‘cost of disposal’:
If the costs of disposal are negligible, the fair value less costs of disposal would be almost
the same as the fair value and thus, irrespective of what the value in use is, the asset
cannot be materially impaired (the recoverable amount will be equal to or higher than the
fair value). Thus, if the costs of disposal are negligible, the asset need not be tested for
impairment. See IAS 36.5(a) as amended by IFRS13
If the costs of disposal are not negligible, then the fair value less costs of disposal will be
less than the fair value, in which case the asset would be impaired unless the value in use
is greater than fair value. See IAS 36.5(c) as amended by IFRS13
Chapter 8, example12, is another example of the revaluation model with impairment loss.
Example 10: Fair value and Recoverable amount
An asset is revalued to fair value on 31 December 20X5. The following measurements are
provided as at this date:
Fair value Costs of disposal Value in use
Scenario A 100 000 0 100 000
Scenario B 100 000 0 60 000
Scenario C 100 000 0 120 000
Required: Determine if the asset is impaired at the financial year ended 31 December 20X5.
Solution 10: Fair value and Recoverable amount

Comment:
This example proves that if the costs of disposal are negligible (this example used an extreme
situation where the costs of disposal were actually nil, but the same principle applies if these costs
are immaterial) then the asset cannot be impaired since the fair value less costs of disposal will
almost equal the fair value and thus the recoverable amount will either be very similar to the fair
value or will be greater than fair value (e.g. if value in use is greater than fair value).
Where the costs of disposal are negligible, a revalued asset is thus not tested for impairment.

Carrying amount (FV: Given) 100 000 100 000 100 000
Less recoverable amount, higher of: (100 000) (100 000) 120 000
- Fair value less costs of disposal (100 000 – 0) (100 000) (100 000) (100 000)
- Value in use (Given) (100 000) (60 000) (120 000)
Impairment loss 0 0 N/A
Example 11: Fair value and Recoverable amount

An asset is revalued to a fair value at 31 December 20X5. The following measurements are
provided as at this date (these costs of disposal are considered significant):
Fair value Costs of disposal Value in use
Scenario A 100 000 10 000 100 000
Scenario B 100 000 10 000 60 000
Scenario C 100 000 10 000 120 000
Required: Determine if the asset is impaired at the financial year ended 31 December 20X5.
Solution 11: Fair value and Recoverable amount
Comment:
546 Chapter 11
This example proves that if the costs of disposal are not negligible then the asset could be
impaired, but only if the value in use is less than the fair value.
- Scenario A: value in use is equal to fair value: no impairment
- Scenario B: value in use is less than fair value: impaired
- Scenario C: value in use is greater than fair value: no impairment.
Where the costs of disposal are not negligible, a revalued asset must thus be tested for impairment.
Carrying amount (FV: Given) 100 000 100 000 100 000
Less recoverable amount, higher of: (100 000) (90 000) (120 000)
- Fair value less costs of (100 000 – (90 000) (90 000) (90 000)
disposal 10 000)
- Value in use (Given) (100 000) (60 000) (120 000)
Impairment loss 0 10 000 N/A
5. Recognising a Reversal of a Previous Impairment Loss (IAS 36.109 - .125)
5.1 Overview
An impairment loss
reversal is
If an asset (other than goodwill) was once impaired but, at a processed when:
later stage, it is discovered that the recoverable amount is now
RA > CA.
greater than the actual carrying amount, the impairment loss
previously recognised may be reversed. This is allowed when the circumstances that
originally caused the impairment are reversed.
An impairment loss relating to goodwill is never reversed. The reason is that an apparent
increase in the recoverable amount of goodwill probably relates to internally generated
goodwill (rather than the purchased goodwill), which is not allowed to be recognised as an
asset according to IAS 38.48 (see chapter 9 which explains Intangible Assets).
Depreciation subsequent to the reversal of an impairment loss will be calculated based on the:
increased carrying amount of the asset less its residual value
divided by the asset’s remaining useful life.
Impairment losses on
goodwill:
Please note that it is not uncommon for the remaining useful
life, for example, to be increased as a result of the change in May never be reversed!
circumstances that caused an impairment to be reversed.
Changes to the variables of depreciation are accounted for prospectively as a change in
estimate in terms of IAS 8 Accounting policies, changes in accounting estimates and errors.
Impairment reversals are processed whether the asset is measured using the cost model or
revaluation model. The journals are slightly more complex if the revaluation model is used.
5.2 Impairment reversals and the cost model

Impairment loss
When reversing an impairment, one must take care that the reversals under the
cost model:
carrying amount is not increased above the carrying amount
Dr: Accum. impairment loss
that the asset would have had had the asset never been
Cr: Impairment loss reversal
impaired. In other words, the carrying amount may never be
ILR may be limited because
increased above its historical carrying amount. IAS 36.117 (reworded) ACA must never exceed HCA
In the case of the cost model, this historical carrying amount ignores impairments and equals:
original cost
less accumulated depreciation, based on that original cost.
If the cost model is used, the increase in carrying amount is recognised as an impairment loss
reversal (income), and is calculated as follows:
Chapter 11 547
C
Recoverable amount (limited to historical carrying amount) XXX
Less the actual carrying amount (XXX)
Impairment loss reversed XXX
Summary: Increases in carrying amount using the cost model
RA HCA
Not allowed
HCA RA
Imp loss Imp loss
reversed reversed
ACA ACA
For further examples of an impairment loss reversal involving an asset measured under the
cost model, please see chapter 7: examples 30, 31 and 32.
5.3 Impairment reversals and the revaluation model
When reversing an impairment, one must take care that the carrying amount is not increased
above what the carrying amount would have been had the asset never been impaired. In other
words, in the case of the revaluation model, the carrying amount may never be increased
above its most recent fair value less subsequent accumulated depreciation.
If the revaluation model is used, the reversal of an Impairment loss

reversal under the
impairment loss may be recognised in profit or loss, other revaluation model:
comprehensive income or a combination of both.
Up to HCA:
Any reversal of an impairment loss that: - Dr Accum. impairment loss
- Cr Impairment loss reversal
increases the carrying amount up towards the historical
carrying amount (cost less accumulated depreciation) is Above HCA:
- Dr Accum. impairment loss
recognised in profit or loss as an impairment loss
- Cr Revaluation surplus
reversed (income); and
increases the carrying amount above historical carrying amount (cost less accumulated
depreciation) is recognised in other comprehensive income as a revaluation surplus (and is
therefore not an impairment reversal).
Example 12: Revaluation model and impairment loss reversed

A plant was purchased on 1 January 20X2 for C200 000.
The plant is measured under the revaluation model and was revalued to its fair value of
C270 000 on 1 January 20X3. No other revaluations have been necessary.
The asset’s recoverable amount decreased to C70 000 at 31 December 20X4 due to a
decrease in demand for the product produced by this plant. No other impairments have
been necessary.
The plant is depreciated straight-line to a nil residual value over 10 years.
Required: Show the journal entries assuming that:
A. The asset’s recoverable amount increased to C160 000 at 31 December 20X5;
B. The asset’s recoverable amount increased to C210 000 at 31 December 20X5.
Solution 12A: Revaluation model and impairment loss reversed
548 Chapter 11
Comment:
This example shows how:
- the recoverable amount exceeds the depreciated cost of C120 000 and thus the impairment loss
reversed is recognised partly in profit or loss and partly in other comprehensive income.
- because the recoverable amount does not exceed the depreciated fair value of C180 000, the
increase is not limited by this depreciated fair value.
On 31 December 20X5, the recoverable amount (RA) is C160 000.
The actual carrying amount (ACA) on 31 December 20X5 is C60 000:
- CA at 31/12/X4: 70 000 – Depr in 20X5: (70 000 – 0) / 7 yrs x 1 = 60 000.
The increase in carrying amount from C60 000 to C160 000 occurs after a previous impairment
loss had been processed (on 31/12/X4) and thus the increase on 31/12/X5 is regarded as an
impairment reversal (i.e. it is not ‘revaluation income’).
The recoverable amount of C160 000 exceeds the depreciated cost of C120 000 (W1: Cost – AD,
being the HCA) and thus part of the increase is recognised in OCI.
The recoverable amount of C160 000 does not exceed the depreciated fair value of C180 000 (W2:
FV - AD) and thus none of the increase is disallowed.

Plant: accum impairment loss (-A) 60 000
Impairment loss reversal (P/L) HCA: 120 000 (W1) – ACA: 60 000 60 000
Plant: accum impairment loss(-A) 40 000
Revaluation surplus (OCI) RA: 160 000 (not limited by the FV-AD 40 000
of 180 000 (W2)) - HCA: 120 000
Reversal of impairment on plant: RA is C160 000 and ACA is C60 000:
the IL reversal of C100 000 is recognised partly in P/L and OCI
Note: The above journal can also be combined as shown in solution 12B that follows.
W1: Historical carrying amount: 31/12/20X5 C

(i.e. cost less accumulated depreciation)
Cost: 01/01/20X2 Given, as at date of purchase 200 000
Accumulated depreciation: 31/12/20X5 (200 000 – 0) / 10yrs x 4yrs (80 000)
Historical carrying amount: 31/12/20X5 Cost – Accumulated depreciation 120 000
W2: Fair value less accumulated depreciation: 31/12/20X5

Fair value: 01/01/20X3 Given, as at date of last revaluation 270 000
Accumulated depreciation: 31/12/20X5 (270 000 – 0) / 9 remaining yrs x 3yrs (90 000)
Historical carrying amount: 31/12/20X5 Fair value – Accumulated depreciation 180 000
W3: Roll forward from purchase (01/01/X2) to reporting date (31/12/X5) (NOT REQUIRED)
Cost: 01/01/20X2 Given 200 000
Accumulated depreciation: 31/12/20X2 (200 000 – 0) / 10 yrs x 1 yr (20 000)
Carrying amount: 31/12/20X2 180 000
Revaluation surplus: 01/01/20X3 Balancing: FV: 270 000 – CA: 180 000 90 000
Depreciation: 20X3 & 20X4 (270 000 – 0) / 9 remaining yrs x 2yrs (60 000)
210 000
Revaluation surplus (OCI): 31/12/20X4 Balancing: 210 000 – HCA: 140 000 (70 000)
Historical carrying amount: 31/12/20X4 HCA: 200 000 - (200 000 – 0) / 10 x 3 140 000
Impairment loss (P/L): 31/12/20X4 Balancing: HCA: 140 000 – RA: 70 000 (70 000)
Carrying amount: 31/12/20X4 Recoverable amount: Given 70 000
Depreciation: 20X5 (70 000 – 0) / 7 remaining yrs x 1 yr (10 000)
Actual carrying amount: 31/12/20X5 ACA before the impairment is reversed 60 000
Imp loss reversed (P/L): 31/12/20X5 Balancing: ACA: 60 000 – HCA: 120 000 60 000
Historical carrying amount: 31/12/20X5 200 000 - (200 000 – 0) / 10 x 4 120 000
Revaluation surplus (OCI): 31/12/20X5 Balancing: HCA: 120 000 – RA: 160 000 40 000
Carrying amount: 31/12/20X5 Lower of: RA: 160 000 (Given), and 160 000
FV-AD: 180 000 (W2)
Chapter 11 549
Solution 12B: Revaluation model and impairment loss reversed

Comment:
This example is identical to the previous example except that it involves a recoverable amount of
C210 000 and not C160 000.
This recoverable amount exceeds the depreciated fair value of C180 000 (W2: FV - AD) and thus
the part of the intended increase is disallowed (the asset’s value is increased to C180 000 and not
to the recoverable amount of C210 000).
We are thus increasing the carrying amount to C180 000, where this amount exceeds the
depreciated cost of C120 000 (W1: Cost – AD, being the HCA) and thus this excess is recognised
in OCI. This principle was also explained in the previous example.
On 31 December 20X5, the recoverable amount (RA) is C210 000.
The actual carrying amount (ACA) on 31 December 20X5 is C60 000:
- CA at 31/12/X4: 70 000 – Depr in 20X5: (70 000 – 0) / 7 yrs x 1 = 60 000.
W1 and W2 from Part A apply to this question too.
Plant: accum impairment loss (-A) RA: 210 000, ltd to 180 000 – ACA: 60 000 120 000
Impairment loss reversal (P/L) HCA: 120 000 (W1) – ACA: 60 000 60 000
Revaluation surplus (OCI) RA: 210 000, limited by the FV-AD of 60 000
180 000 (W2) - HCA: 120 000
Impairment reversal of plant: On 31 Dec 20X5, the RA was 210 000, but
was limited to the FV-AD of 180 000, when the ACA was 60 000: an
impairment loss reversal recognised partly in P/L and partly in OCI
W1: Historical carrying amount: Cost less accumulated depreciation: 31/12/20X5
C
Cost: 01/01/20X2 Given, as at date of purchase 200 000
Accumulated depreciation: 31/12/20X5 (200 000 – 0) / 10yrs x 4yrs (80 000)
Historical CA: 31/12/20X5 Cost – Accumulated depreciation 120 000
W2: Fair value less accumulated depreciation: 31/12/20X5
C
Fair value: 01/01/20X3 Given, as at date of last revaluation 270 000
Accumulated depreciation: 31/12/20X5 (270 000 – 0) / 9 remaining yrs x 3yrs (90 000)
Historical CA: 31/12/20X5 Fair value – Accumulated depreciation 180 000
W3: Roll forward from purchase (01/01/X2) to reporting date (31/12/X5) (NOT REQUIRED)
C
Cost: 01/01/20X2 Given 200 000
Accumulated depreciation: 31/12/20X2 (200 000 – 0) / 10 yrs x 1 yr (20 000)
Carrying amount: 31/12/20X2 180 000
Revaluation surplus: 01/01/20X3 Balancing: FV: 270 000 – CA: 180 000 90 000
Depreciation: 20X3 & 20X4 (270 000 – 0) / 9 remaining yrs x 2yrs (60 000)
210 000
Revaluation surplus (OCI): 31/12/20X4 Balancing: 210 000 – HCA: 140 000 (70 000)
Historical CA: 31/12/20X4 HCA: 200 000 - (200 000 – 0) / 10 x 3 140 000
Impairment loss (P/L): 31/12/20X4 Balancing: HCA: 140 000 – RA: 70 000 (70 000)
Carrying amount: 31/12/20X4 Recoverable amount: Given 70 000
Depreciation: 20X5 (70 000 – 0) / 7 remaining yrs x 1 yr (10 000)
Actual carrying amount: 31/12/20X5 ACA before the impairment is reversed 60 000
Imp loss reversed (P/L): 31/12/20X5 Balancing: ACA: 60 000 – HCA: 120 000 60 000
Historical CA: 31/12/20X5 200 000 - (200 000 – 0) / 10 x 4 120 000
Revaluation surplus (OCI): 31/12/20X5 Balancing: HCA: 120 000 – RA: 180 000 60 000
Carrying amount: 31/12/20X5 Lower of: RA: 210 000 (Given), and 180 000
FV-AD: 180 000 (W2)
550 Chapter 11
Summary: Increases in carrying amount using the revaluation model
HCA RA RA
Not allowed
Not allowed or or
Creation of RS
(See note 1 & 2)
Increase in RS
(See note 1 & 2)
RA HCA ACA
Imp loss Imp loss
reversed reversed
(See note 3) (See note 3)
ACA ACA HCA
Note 1: If the revaluation model is used, an increase above HCA (depreciated cost) is allowed to the
extent that the new CA does not exceed the CA that the asset would have been had it not been
impaired (if an asset has been revalued, this is the depreciated fair value). See IAS 36.117
Note 2: An increase above HCA that is allowed is recognised as a revaluation surplus. See IAS 36.120
Note 3: An increase up to HCA is recognised in profit or loss. It will be called:
an impairment loss reversal if it reverses a prior impairment loss (i.e. the asset was
previously impaired to recoverable amount),
a revaluation income if it reverses a prior devaluation (i.e. the asset was previously revalued
to a lower fair value – a revaluation decrease). See IAS 36.119 read together with IAS 16.39
6. Impairment of Cash-Generating Units (IAS 36.65 – .108 and IAS 36.122 - .123)
6.1 Overview
When testing assets for impairment, the recoverable amount should ideally be estimated for
that individual asset. There are, however, instances where it is not possible to estimate the
recoverable amount of the individual asset.
A cash generating unit is
defined as:
These instances are when:
its value in use cannot be measured and this value in the smallest identifiable group of
assets
use is not estimated to be close to its fair value less
that generates cash inflows that are
costs of disposal; and
largely independent of the cash
it does not generate cash inflows from continuing use inflows from other assets or groups
that are largely independent of those from other of assets. IAS 36.6
assets (i.e. it is a part of a cash-generating unit).
Where this is the case we must decide to which cash-generating unit the asset belongs.
A cash-generating unit is essentially a grouping of assets – the smallest group of assets –

which, together as a group of assets, generate cash inflows from continuing use (i.e. not from
disposal) and where these cash inflows are generally not affected by or dependent upon other
assets or groups of assets See IAS 36.6
Please note that we identify separate cash generating units

An active market is
based on the ability of the asset or group of assets to
generate cash inflows that are independent of other assets A market in which transactions for
or groups of assets. Thus, in identifying a cash generating
the asset or liability
unit, we do not consider whether the asset or group of
take place with sufficient
assets’ cash outflows are independent. frequency and volume to
provide pricing information on an
Sometimes the output of an asset or group of assets is used ongoing basis. IFRS 13, Appendix A
partly or entirely by another asset or group of assets within
the entity. In this situation, it would seem that the cash inflows from this asset, or group of
assets, would not be independent.
Chapter 11 551
However, IAS 36 states that if it is possible for the output to be sold on an active market
instead, then this asset or group of assets is still classified as a cash generating unit even
though its output is being used internally by another group of assets. See IAS 36.70
In the case, budgets relating to this asset or group of assets may need to be adjusted to reflect
the market prices that would be achievable if the output was sold on the active market instead
of the internal prices currently achieved by using the output internally. See IAS 36.70
When checking a cash generating unit for impairment, we must calculate the recoverable
amount for the cash-generating unit as a whole and compared this to the total net carrying
amount of the assets and liabilities that make up the unit.
When calculating the carrying amount and the recoverable amount (greater of fair value less
costs of disposal and value in use) of a cash-generating unit (CGU):
include the carrying amount of only those assets that can be attributed directly, or
allocated on a reasonable and consistent basis, to the CGU and will generate the future
cash flows used in determining the CGU’s value in use; IAS 36.76 (a)
exclude all liabilities relating to the group of assets unless the recoverable amount of the
CGU cannot be measured without consideration of this liability: for example, where the
disposal of a group of assets would require the buyer to assume (accept responsibility for)
the liability, (e.g. a nuclear power station where there is a legal requirement to dismantle
it at some stage in the future); IAS 36.76 (b) (reworded)
any asset within the CGU that an entity intends to scrap is tested for impairment
separately from the remaining assets of the CGU. Obviously, if one knows that the asset
is to be scrapped, then both the value in use and fair value less costs of disposal will be
the same: the expected net proceeds from scrapping.
Example 13: Scrapping of an asset within a cash-generating unit
One of the machines (carrying amount of C40 000) in an assembly line suffered damage due
to a power surge and was immediately removed from the assembly line.
The assembly line is still operating although at 80% capacity.
The assembly line’s recoverable amount is C300 000 and its carrying amount is C240 000.
Required: Calculate and journalise the impairment of the machine assuming that:
A. the intention is to repair the machine and return it to the assembly line; and
B. the intention is to scrap the machine for C1 000.
Solution 13A: Scrapping of an asset within a cash-generating unit

The machine is part of a cash-generating unit:
the machine is thus not tested for impairment separately from the cash-generating unit.
Since the cash-generating unit’s recoverable amount exceeds its carrying amount, the cash-
generating unit is not impaired and therefore the machine is not impaired.
Therefore no journals are processed.
Solution 13B: Scrapping of an asset within a cash-generating unit

Comment: Although the machine is part of a cash-generating unit, it is to be scrapped and must
therefore be removed from the cash-generating unit and tested for impairment on its own.
Given that the machine has already been taken out of use, its value in use will be zero.
Given that the machine is to be scrapped for C1 000, its fair value less costs of disposal is C1 000
(assuming no costs of disposal).
The machine is therefore impaired as follows: C
Carrying amount: 40 000
Recoverable amount: 1 000
Impairment loss: 39 000
552 Chapter 11

Debit Credit
Machine: accumulated impairment loss (-A) 39 000
Impairment of machine
6.2 Allocation of an impairment loss to a cash-generating unit (IAS 36. 104 and 105)
Allocating an
If a cash generating unit is impaired, the impairment loss
impairment loss to
must be allocated to the individual assets within the group.
assets in a CGU:
The allocation of an impairment of a cash-generating unit to first allocate to goodwill;
its individual assets is as follows: then allocate to remaining assets
if the cash-generating unit contains goodwill, then the on a pro rata basis based on their
impairment loss is first allocated fully to goodwill; and carrying amounts
any remaining impairment loss is allocated on a pro rata basis based on the relative
carrying amounts of the individual assets within the group. IAS 36.104 (reworded)
When allocating an impairment loss, however, the The CA of each asset

individual assets’ carrying amounts may not be reduced can’t be reduced below
below the greater of their individual: the higher of its:
fair value less costs of disposal; fair value less costs of disposal
value in use; or value in use
zero. IAS 36.105 (slightly reworded) zero. IAS 36.105
Example 14: Allocation of impairment loss (no goodwill)

A cash-generating unit, measured under the cost model, which has a recoverable amount of
C10 000, includes the following assets:
Carrying amount Recoverable amount
Equipment C3 000 unknown
Vehicles 2 000 unknown
Plant 6 000 unknown
Factory building 4 000 unknown
Required: Calculate and allocate the impairment loss to this cash-generating unit and then journalise it.
Solution 14: Allocation of impairment loss (no goodwill)
W1: Impairment loss of cash-generating unit C
Carrying amount 3 000 + 2 000 + 6 000 + 4 000 15 000
Recoverable amount Given 10 000
Impairment loss 5 000
CA before Impairment CA after
W2: Impairment loss allocated to individual assets imp allocated imp
Calculation C C C
Equipment 3 000/ 15 000 x C5 000 impairment 3 000 1 000 2 000
Vehicles 2 000/ 15 000 x C5 000 impairment 2 000 667 1 333
Plant 6 000/ 15 000 x C5 000 impairment 6 000 2 000 4 000
Factory building 4 000/ 15 000 x C5 000 impairment 4 000 1 333 2 667
15 000 5 000 10 000
Journals at year-end Debit Credit
Impairment loss: equipment (E) 1 000
Equipment: accumulated impairment loss (-A) 1 000
Impairment loss: vehicles (E) 667
Vehicles: accumulated impairment loss (-A) 667
Impairment loss: plant (E) 2 000
Plant: accumulated impairment loss (-A) 2 000
Impairment loss: building (E) 1 333
Building: accumulated impairment loss (-A) 1 333
Impairment of assets within the cash-generating unit
Chapter 11 553
If a portion of the impairment loss remains unallocated, a second round of allocation must be
performed whereby any excess impairment loss is allocated to the other assets of the cash-
generating unit that have not yet been reduced below their minimum value (higher of their
value in use, fair value less costs of disposal and zero). See IAS 36.105
Example 15: Allocation of impairment loss (no goodwill) – multiple allocation

The following details apply to a cash- generating unit, measured under the cost model:
Equipment 3 000 unknown
Vehicles 2 000 unknown
Plant 6 000 5 000
Factory building 4 000 5 000
15 000 12 000
Required:
Calculate and allocate the impairment loss to this cash-generating unit
Solution 15: Allocation of impairment loss (no goodwill) – multiple allocation

W1: Impairment loss of cash-generating unit C
W2: Impairment loss allocated to individual CA before Impairment CA after

assets impairment allocated impairment
First round of allocation: C C C
Equipment 3 000/ 15 000 x C3 000 impairment 3 000 600 2 400
Vehicles 2 000/ 15 000 x C3 000 impairment 2 000 400 1 600
(1) (3)
Plant 6 000/ 15 000 x C3 000 impairment: 6 000 1 000 5 000
limited to C1000 (CA 6 000–RA 5000)
(2) (3)
Factory building 4 000/ 15 000 x C3 000 impairment: 4 000 0 4 000
limited to nil (RA exceeds its CA)
15 000 2 000 13 000
Comments:
(1) The allocated impairment initially works out to C1 200, but this would decrease the CA of the
plant to 4 800. Since we know that the RA of the plant is C5 000, we have to limit the impairment
allocation to C1 000 (C6 000 – 1 000 = 5 000). Plant is now fully impaired.
(2) Factory buildings are not allocated any of the impairment since we know that they are not impaired
(their recoverable amount is greater than their carrying amount).
(3) These assets are fully impaired since their carrying amounts are now representative of their
recoverable amounts (or less than their recoverable amounts).
impairment allocated impairment
Second round of allocations: C C C
Equipment 2 400/ 4 000 x (3 000 – 2 000) 2 400 600 1 800
Vehicles 1 600/ 4 000 x (3 000 – 2 000) 1 600 400 1 200
4 000 1 000 3 000
Comment : The apportionment base to be used in the second round of allocation consists only of the
remaining assets that can still be further impaired (i.e. equipment and vehicles)
As discussed earlier, where a cash-generating unit includes goodwill, any impairment of this
cash-generating unit must first be allocated to this goodwill. Any remaining impairment loss
is then allocated to the remaining assets within the cash-generating unit on a pro rata basis.
554 Chapter 11
Example 16: Allocation of impairment loss (with goodwill)

The following details apply to a cash- generating unit, measured under the cost model:
C C
Vehicle 4 000 2 800
Building 5 000 unknown
Goodwill 2 000 unknown
11 000 8 000
Required:
Calculate and allocate the impairment loss to this cash-generating unit
Solution 16: Allocation of impairment loss (with goodwill)

Impairment loss of cash-generating unit C
Note: The impairment of C3 000 is first allocated to the goodwill and any remaining impairment is
then allocated to the other assets within the cash-generating unit based on their carrying amounts
relative to the carrying amount of the group (reduced by the impaired goodwill).
Allocation of impairment loss Carrying Impairment Carrying

amount before allocated amount after
impairment impairment
First round of allocation: C C C
Goodwill 2 000 2 000 0
Second round of allocation:
Vehicle 4 000/ (4 000 + 5 000) x (3 000 – 2 000) 4 000 444 3 556
Building 5 000/ (4 000 + 5 000) x (3 000 – 2 000) 5 000 556 4 444
11 000 3 000 8 000
Comment:
When apportioning the remaining unallocated impairment in the second round, we must remember
that the apportionment base consists of only those assets that can still be impaired.
In the above example, only the vehicles and the buildings could still be impaired (since goodwill
was fully impaired to nil).
Thus the apportionment base was calculated to be C9 000 (vehicles: C4 000 + buildings: C5 000).
It should be noted that goodwill must be tested every year for possible impairments, even if
there is no indication that it is impaired. Whereas most other assets must be tested at year-end,
goodwill may be tested at any stage during the year so long as it is tested at the same time
every year (where goodwill is allocated across various cash-generating units, these cash-
generating units may be tested for impairment at different times).
The most recent detailed calculation made in a preceding period of the recoverable amount of
a cash-generating unit to which goodwill has been allocated may be used in the impairment
test of that unit in the current period provided all of the following criteria are met: IAS 36.99
the assets and liabilities making up the unit have not changed significantly since the most
recent recoverable amount calculation;
the most recent recoverable amount calculation resulted in an amount that exceeded the
carrying amount of the unit by a substantial margin; and
based on an analysis of the events that have occurred and the circumstances that have
changed since the most recent recoverable amount calculation, the likelihood that the
unit’s current recoverable amount is less than its current carrying amount is remote.
Chapter 11 555
6.3 Reversals of impairments relating to a cash generating unit (IAS 36.119 & 122 - .125)
6.3.1 Calculating impairment loss reversals relating to CGUs
If we find we need to reverse an impairment loss relating to a cash-generating unit (CGU),
we start by calculating the total impairment loss reversal that Allocating an
we think we need to recognise. We do this by subtracting the impairment loss
recoverable amount of the CGU from the carrying amount of reversal:
the CGU (we may not necessarily be able to recognise this Allocate first to all assets on a
total impairment loss reversal due to the limitation, which will pro rata basis (but making sure
be explained below). that the new CA doesn’t exceed
the lower of HCA & RA)
After calculating the total impairment loss reversal that we Never allocate to goodwill!
expect to recognise, we then allocate this total to each of the
assets within the CGU, (except to goodwill, because any impairment once allocated to
goodwill may never be reversed). This allocation is done on a pro rata basis using the
carrying amounts of the individual assets relative to the carrying amount of the CGU in total.
Since an impairment of goodwill may never be reversed, we leave goodwill out of this
allocation calculation entirely.
Now, when allocating the total impairment loss to the individual assets in the CGU, we must
be careful because the amount of the impairment loss reversal allocated to each of these assets
may be limited. This is because the carrying amount of each of the assets in the CGU may
not be increased above the lower of its:
Recoverable amount; and
An IL reversal is
Carrying amount, had no impairment loss been recognised
recognised:
in prior years.
in P/L if cost model is used;
- if the cost model is used, this is depreciated cost; and
in P/L, and possibly also in OCI
- if the revaluation model is used, this is depreciated (RS), if revaluation model used
fair value. See IAS 36.123
Notice that the limitation described above means that, when using the cost model, the carrying
amounts of the individual assets may not increase above depreciated cost, but if the
revaluation model is used, the carrying amounts can be increased above depreciated cost (i.e.
historical carrying amount). However, when using the revaluation model, the carrying
amounts of the individual asset may never increase above depreciated fair value. The
difference between the impairment loss reversals under the cost model and revaluation model
are described in section 6.3.2 and section 6.3.3 respectively.
If an impairment loss reversal to be allocated to a particular asset is limited (i.e. the portion
of the impairment loss reversal to be allocated to this asset could not be allocated at all or
could only be partially allocated), then the excess reversal that could not be allocated to the
asset must be allocated to the remaining assets. This is done as a ‘second round allocation’
(which may need to be followed by a third and fourth round allocation etc). For example, if
we have a total impairment loss reversal of C2 000, of which C100 is to be allocated to a
particular asset, but due to the upper limit on this asset’s carrying amount, we could only
allocate an impairment reversal of C80, then the excess reversal of C20 that could not be
allocated to the asset must be allocated to the remaining assets.
The basic principles applied when reversing an impairment loss for an individual asset also
apply to a CGU (explained in the sections below). These principles are that, when we use the:
cost model
- the impairment reversal is always recognised in profit or loss as income.
revaluation model
- the impairment reversal is recognised as income in profit or loss only to the extent
that it increases the carrying amount up to depreciated cost.
- Any remaining impairment reversal is recognised as income in other comprehensive
income (i.e. the portion that increases the carrying amount above depreciated cost).
556 Chapter 11
6.3.2 Impairment loss reversals relating to CGUs – cost model
When allocating the impairment loss reversal to each of the

Summaries in
individual assets in the CGU, we must be careful not to allow
sections :
the carrying amount increase above the lower of:
5.2 for cost model
5.3 for revaluation model
Carrying amount, had no impairment loss been recognised
in prior year: in the case of the cost model, this carrying amount is depreciated cost.
The effect of the limitation, when using the cost model, is that the carrying amounts of the
individual assets in the CGU may not increase above depreciated cost. For example:
If our actual carrying amount before the reversal is C80, the recoverable amount is C110
and the depreciated cost is C100, the impairment reversal would be limited to C20: the
CA would be increased from C80 to C100.
Conversely, if the depreciated cost was C120 (not C100), then the impairment reversal
would not be limited: the CA would be increased from C80 to C110 (i.e. the impairment
reversal would be C30).
If using the cost model, impairment loss reversals are recognised as income in profit or loss:
Debit accumulated impairment losses & Credit impairment loss reversal income (P/L).
6.3.3 Impairment loss reversals relating to CGUs – revaluation model
When allocating the impairment loss reversal to each of the individual assets in the CGU, we
must be careful not to allow the carrying amount increase above the lower of:
Carrying amount, had no impairment loss been recognised in prior year: in the case of the
revaluation model, this carrying amount is depreciated fair value.
The effect of the limitation, if the revaluation model is used, is that the carrying amounts may
be increased above depreciated cost (i.e. historical carrying amount). However, when using
the revaluation model, the carrying amounts of the individual asset may never increase above
depreciated fair value. Depreciated fair value may be higher than depreciated cost.
When using the revaluation model, an impairment loss reversal will be recognised as income
in profit or loss to the extent that it increases the carrying amount to its depreciated cost, but
increases in the carrying amount above its depreciated cost must be recognised as income in
other comprehensive income – in other words, in the revaluation surplus account:
Increasing the carrying amount up to depreciated cost:
Debit accumulated impairment losses & Credit impairment loss reversal income (P/L).
Increasing the carrying amount above depreciated cost:
Debit accumulated impairment losses & Credit revaluation surplus (OCI).
Any increase above depreciated cost (i.e. historical carrying amount) is recognised in other
comprehensive income as a revaluation surplus. Please note that we would not debit the cost
account because the cost account would currently reflect the asset’s fair value and thus a debit
to this account would result in it reflecting an arbitrary balance.
Example 17: Impairment and reversal thereof (no goodwill)
On the 31 December 20X4, as a result of a government ban on a product produced by

Banme Limited, a cash-generating unit had to be impaired to its recoverable amount of
C2 000 000.
Chapter 11 557
On this date, the details of the individual assets in the unit (each measured using the cost model) were
as follows:
Remaining Residual Carrying Recoverable
useful life value amount amount
C C C
Equipment 5 years Nil 1 000 000 unknown
Plant 5 years Nil 3 000 000 unknown
4 000 000 2 000 000
One year later, on 31 December 20X5, the ban was lifted and the cash-generating unit was brought
back into operation. Its revised recoverable amount is C3 000 000. Values on this date:
Historical carrying Recoverable
amount * amount
Equipment 800 000 unknown
Plant 2 400 000 unknown
*: the carrying amount had the assets not been impaired C3 200 000 C3 000 000
Required:
Calculate and allocate the impairment losses and reversals thereof to the cash-generating unit.
Solution 17: Impairment and reversal thereof (no goodwill)
W1: 31 December 20X4: Impairment loss of cash-generating unit C

Less: Recoverable amount (2 000 000)
Impairment loss 2 000 000
W2: 31 December 20X4: Allocation of impairment to individual assets

Equipment 1mil/ 4mil x C2mil impairment 1 000 000 (500 000) 500 000
Plant 3mil/ 4mil x C2mil impairment 3 000 000 (1 500 000) 1 500 000
4 000 000 (2 000 000) 2 000 000
W3: 31 December 20X5: Carrying amount (before reversal of impairment) C
Equipment 500 000 – (500 000 / 5 x 1 year) 400 000

Plant 1 500 000 – (1 500 000 / 5 x 1 year) 1 200 000
1 600 000
W4: 31 December 20X5: Reversal of impairment loss of cash-generating unit C
Carrying W3 1 600 000

amount
Less recoverable amount Given: unlimited: the historical CA is greater: 3 200 000 (3 000 000)
Impairment loss reversed (1 400 000)
W5: 31 December 20X5: Allocation of reversal of impairment to individual assets

impairment reversed impairment
Equipment 0.4mil/1.6mil x 1 400 000 impair. reversal 400 000 350 000 750 000
Plant 1.2mil/1.6mil x 1 400 000 impair. reversal 1 200 000 1 050 000 2 250 000
1 600 000 1 400 000 3 000 000
558 Chapter 11
Example 18: Impairment and reversal thereof (with goodwill)

On 31 December 20X4, due to a government ban on a product produced by Banme Limited,
the affected cash-generating unit must be impaired to its recoverable amount of C2 000 000.
On this date, the details of the individual assets in the unit (each measured using the cost model) were:
Remaining Residual Carrying Recoverable
useful life value amount amount
C C C
Goodwill 5 years Nil 2 000 000 unknown
Plant 5 years Nil 3 000 000 unknown
Building 5 years Nil 5 000 000 unknown
10 000 000 2 000 000
One year later, the ban was lifted and the cash-generating unit was brought back into operation. Its
revised recoverable amount is C4 000 000. On this date, the individual carrying amounts and
recoverable amounts were as follows: Historical Carrying Recoverable
carrying amount amount amount
C C C
Goodwill 2 000 000 0 Unknown
Plant 2 400 000 600 000 Unknown
Building 4 000 000 1 000 000 Unknown
8 400 000 1 600 000 4 000 000
Required: Perform the allocation of the impairment and the reversal thereof.
Solution 18: Impairment and reversal thereof (with goodwill)

W1: 31 December 20X4: Impairment loss of cash-generating unit C
Less: Recoverable amount (2 000 000)
Impairment loss 8 000 000
W2: 31 December 20X4: Allocation of impairment to individual assets
Impairment to be allocated (W1) 8 000 000
Goodwill The entire goodwill is first removed, leaving 2 000 000 (2 000 000) 0
an impairment of 6 mil still to be allocated
Impairment still to be allocated (balancing: 8mil – 2mil) 6 000 000
Plant 3mil/ (3mil + 5mil) x 6 mil impairment 3 000 000 (2 250 000) 750 000
Building 5mil/ (3mil + 5mil) x 6 mil impairment 5 000 000 (3 750 000) 1 250 000
10 000 000 8 000 000 2 000 000
W3: 31 December 20X5: Carrying amount (before reversal of impairment) C
Goodwill 0
Plant 750 000 – (750 000 / 5 x 1 year) 600 000
Building 1 250 000 – (1 250 000 / 5 x 1 year) 1 000 000
1 600 000
W4: 31 December 20X5: Reversal of impairment loss of cash-generating unit C
Carrying amount W3 1 600 000
Less recoverable amount Given – unlimited since the HCA given is greater: C6 400K* (4 000 000)
Impairment loss reversal (income) (2 400 000)
W5: 31 December 20X5: Allocation of reversal of impairment to individual assets
reversal reversed reversal
Goodwill Prior goodwill impairments may never be reversed 0 0 0
Plant 0.6mil/1.6mil x 2 400 000 impairment reversal 600 000 900 000 1 500 000
Building 1.0mil/1.6mil x 2 400 000 impairment reversal 1 000 000 1 500 000 2 500 000
1 600 000 2 400 000 4 000 000
*The impairment loss reversed is limited on an individual asset basis to what its carrying amount would
Chapter 11 559

have been if it had not previously been impaired (e.g. historical carrying amount).
There was no limit in this example to the amount of impairment reversal that could be allocated since:
Plant’s historical carrying amount was: 3 000 000 / 5 x 4 = 2 400 000
Building’s historical carrying amount was: 5 000 000 / 5 x 4 = 4 000 000
Example 19: Impairment losses on a CGU with more than one impairment
allocation – journal entries – cost model – impairment limited
A CGU has the following assets held under the cost model as at 31 December 20X9, none of which
have previously been impaired:
Carrying amount
C
Plant 100 000
Machine 200 000
Factory 300 000
Equipment 400 000
1 000 000
The recoverable amount of the unit is C900 000. The recoverable amounts of the following individual
assets are known. Recoverable amount
C
Plant 95 000
Machine 190 000
Required: Calculate and journalise the impairment losses for the year ended 31 December 20X9
Solution 19: Impairment losses on a CGU - more than one impairment allocation
W1: Impairment loss on CGU
Carrying amount: CGU 1 000 000
Recoverable amount: CGU (900 000)
W2: Allocation of the CGU impairment loss (100 000) to the individual assets
W2.1 First round Carrying Imp loss Carrying
amount before allocation amount after
Impairment to be allocated 100 000
(NOTE 1)
Plant (100 / 1 000K = 10%) 100 000 (5 000) 95 000*
(NOTE 2)
Machine (200 / 1 000K = 20%) 200 000 (10 000) 190 000*
Factory (300 / 1 000K = 30%) 300 000 (30 000) 270 000
Equipment (400 / 1 000K = 40%) 400 000 (40 000) 360 000
(NOTE 3)
1 000 000 (85 000) 915 000
Impairment still to be allocated 15 000
Note 1: 10% x 100 000 = 10 000, but the CA may not decrease below 95 000, being the plant’s own RA. We may
therefore only allocate 5 000 (100 000 – 95 000)
Note 2: 20% x 100 000 = 20 000, but the CA may not decrease below 190 000, being the plant’s own RA. We may
therefore only allocate 10 000 (200 000 – 190 000)
Note 3: Only 85 000 of the 100 000 impairment is allocated on the first round. We must now allocate the remaining
15 000 to the individual assets that have not yet reached their minimum CA: factory and equipment.
W2.2 Second round CA before Imp loss CA after
allocation
Impairment still to be allocated (W2.1) 15 000
Factory (270 / 630 = 43% *) 270 000 (6 450*) 263 550
Equipment (360 / 630 = 57%*) 360 000 (8 550*) 351 450
630 000 (15 000) 615 000
Impairment still to be allocated: 0
Carrying amounts after impairment already allocated:
Plant 95 000
Machine 190 000
Recoverable amount of CGU: 900 000
* these are rounded percentages and therefore figures have been rounded
560 Chapter 11

31/12/20X9 Debit Credit
Impairment loss : Plant (E) (W2.1) 5 000
Plant: accumulated impairment loss (-A) 5 000
Impairment loss : Machine (E) (W2.1) 10 000
Machine: accumulated impairment loss (-A) 10 000
Impairment loss : Factory (E) (W2.1: 30 000+ 36 450
Factory: accumulated impairment loss (-A) W2.2: 6 450) 36 450
Impairment loss : Equipment (E) (W2.1: 40 000 + W2.2: 48 550
Equipment: accumulated impairment loss (-A) 8 550) 48 550
Impairment loss on the CGU processed.
Example 20: Reversal of impairment of a CGU – with goodwill – some individual

recoverable amounts known: cost model and revaluation model
A CGU was impaired (for the first time) to C750 000 on 31/12/20X4, details of which are as follows:
CA before impairment CA after impairment RUL on date of impairment
Goodwill 100 000 0
Machine 200 000 190 000 5 yrs
Factory 300 000 240 000 6 years
Equipment 400 000 320 000 4 years
1 000 000 750 000
The recoverable amounts of the CGU is C900 000 on 31/12/20X5 and the recoverable amounts of the
following individual assets on this date are known: Recoverable amount
Machine 220 000
Factory 240 000
All depreciation recognised was calculated using nil residual values and using the straight-line method.
The assets in the CGU are measured as follows:
goodwill, machine, equipment: cost model;
factory building: revaluation model.
The factory building:
was originally purchased on 1/1/20X1 for 450 000.
had an original useful life of 10 years (residual value = 0) and was depreciated straight-line.
was revalued to a fair value of 350 000 on 1/1/20X4.
was revalued using the net replacement value method (see chapter 8).
The revaluation surplus is transferred to retained earnings over the asset’s useful life.
Required:
A. Calculate the impairment reversals per individual asset at 31 December 20X5.
B. Show the impairment reversal journal entries.
C. Show all journals relating to the factory from date of purchase to 31 December 20X5 (ignore tax).
Solution 20A: Impairment reversal – calculations

W1: 31/12/20X5: Carrying amount – IS
CA: Depreciation CA:
31/12/20X4 31/12/20X5
Goodwill 0 0 N/A 0
Machine 190 000 (38 000) 190K/5yrs 152 000
Factory 240 000 (40 000) 240K/6 yrs 200 000
Equipment 320 000 (80 000) 320K/4 yrs 240 000
750 000 (158 000) 592 000
W2: 31/12/20X5: Impairment loss reversed – CGU in total
Carrying amount: CGU W1 592 000
Less recoverable amount: CGU Given (900 000)
Impairment loss reversal expected * (308 000)
*This is the IL reversal we are going to try to recognise – we may not be able to recognise all of
it (and if you look ahead at W4, you will see that we only manage to recognise C108 000 of this).
Chapter 11 561

W3: Limitations per asset: lower of historical carrying amount and recoverable amount
HCA: Depreciation HCA: RA: Lower
31/12/20X4 31/12/20X5 31/12/20X5
Goodwill N/A (1& 2) 0 N/A (1) N/A (1) ? N/A (1)
(2)
Machine 200 000 40 000 200K/5yrs 160 000 220 000 160 000
Factory 300 000 (2) 50 000 300K/6yrs 250 000 240 000 240 000
(2) (3)
Equipment 400 000 100 000 400K/4yrs 300 000 ? 300 000
900 000 190 000 710 000
(1) Goodwill may never be reversed, so it is excluded from this calculation.
(2) We know that the CA given before the impairment on 31/12/20X4 is also the HCA on this date because we are
told that the impairment that then took place on 31/12/20X4 was the first impairment ever.
(3) We do not know this recoverable amount and therefore we must go with the HCA at 31/12/20X5.
W4: Allocation of the CGU impairment reversal (W2) to the individual assets in the CGU
Carrying amount Imp reversal Carrying amount
before impairment allocation after impairment
reversal reversal
(W1)
NOTE 1
Goodwill N/A N/A N/A
NOTE 2
Machine (152/592 = 25.7%*) 152 000 8 000 160 000
NOTE 3
Factory (200/592 = 33.8%*) 200 000 40 000 240 000
NOTE 4
Equipment (240/592 = 40.5%*) 240 000 60 000 300 000
NOTE 5
592 000 118 000 700 000
* These percentages have been rounded. The notes below use these rounded percentages. You could work with the
exact percentages instead, which would mean that your calculations would be slightly more accurate than the
calculations show in the notes below.
Note 1: The impairment is never reversed to goodwill, so we leave goodwill out of the calculation entirely.
Note 2: 25.7% x 308 000 = 79 156. This would increase the CA to 152 000 + 79 156= 231 156. The assets
maximum CA is 160 000 (W3), therefore the allocation is limited to 160 000 – 152 000 = 8 000
Note 3: 33.8% x 308 000 = 104 104. The CA would increase to 304 104 (200 000 + 104 104), but this asset’s
maximum CA is 240 000 (W3), thus the allocation is limited to 240 000 – 200 000 =40 000
Note 4: 40.5% x 308 000 = 124 740. The CA would increase to 364 740 (240 000 + 124 740). This asset’s
maximum CA is 300 000(W3), thus the allocation is limited to 300 000 – 240 000 =60 000
Note 5: The impairment reversal of 308 000 was limited to 118 000. There is no second round where we try to
allocate more (as is the case with an impairment loss).
Solution 20B: Impairment reversal – journals

Machine: accumulated impairment losses (-A) 8 000
Impairment loss reversed – machine (I) 8 000
Impairment of machine in 20X4 reversed (cost model)
Factory building: accumulated impairment losses (-A) 40 000
Impairment loss reversed – factory building (I: P/L) Note 1 25 000
Revaluation surplus – factory building (I: OCI) Note 1 15 000
Impairment of factory building in 20X4 reversed (reval model)
Equipment: accumulated impairment losses (-A) 60 000
Impairment loss reversed – equipment (I) 60 000
Impairment of equipment in 20X4 reversed (cost model)
Note 1:
The calculations of how much of the impairment loss reversal income is recognised in profit or loss (i.e.
presented as an impairment loss reversal income in P/L) and how much is recognised in other
comprehensive income (presented as a revaluation surplus in OCI) can be found in solution 20C.
562 Chapter 11
Solution 20C: Impairment reversal – journals for factory building (revaluation model)
Comment:
The reversal of the impairment loss relating to the machine and the equipment involved the cost
model. This means that the related carrying amounts were not allowed to increase above depreciated
cost (i.e. cost less accumulated depreciation; also known as historical carrying amount (HCA)).
The reversal of the impairment loss relating to the factory building involved the revaluation model.
This means that its carrying amount was allowed to increase above depreciated cost (i.e. HCA). The
increase above depreciated cost (i.e. HCA) is recognised in other comprehensive income as a
revaluation surplus.
To understand the impairment reversal journal for the factory building requires that you remember
how the revaluation model is applied:
Factory: cost (A) Given 450 000
Bank (A) 450 000
Factory building purchased
31/12/20X1; 31/12/20X2 and 31/12/20X3 (Jnl repeated x 3 yrs)
Depreciation – factory (E) (450 000 – 0) / 10yrs 45 000
Factory: accumulated depreciation (-A) 45 000
Factory building depreciated annually
1/1/20X4
Factory: accumulated depreciation(-A) 135 000
Factory: cost (A) 45 000 x 3 years 135 000
Accumulated depreciation netted off against cost before revaluation (NRVM)
Factory: cost (A) FV: 350 000 – HCA: 315 000 35 000
Revaluation surplus (Cost: 450 000 – AD: 135 000) 35 000
Revaluation of factory
31/12/20X4
Depreciation – factory (E) (CA: 350 000-0) / 7 remaining yrs x 1 50 000
Revaluation surplus (OCI) 35 000 / 7 remaining yrs x 1 5 000
Retained earnings (E) 5 000
Transfer of revaluation surplus to retained earnings over the life of the factory
building
Revaluation surplus (OCI) CA: 300 000 – HCA: 270 000 30 000
Impairment loss (E) HCA: 270 000 – RA: 240 000 30 000
Factory: acc. impairment (-A) CA: 300 000 – RA: 240 000 60 000
Factory building impaired –
1st step: reduce asset’s CA to depreciated cost (HCA), with impairment
recognised in OCI (revaluation surplus)
2nd step: reduce asset’s CA further, reducing from HCA to the lower
recoverable amount (RA), with impairment recognised in P/L (impairment loss
expense)
CA: (FV: 350 000 – AD: 50 000) = 300 000
HCA (depreciated cost): Cost: 450 000 – AD: (450 000 - 0) / 10 x 4yrs = 270 000 and
RA: given = 240 000
31/12/20X5
Depreciation (E) (CA: 240 000-0) / 6 remaining years x 1 40 000
Factory: acc. impairment(-A) CA: 200 000 – HCA: 225 000 (450 000 – 450 000 / 10 25 000
Impairment loss reversed(I) x 5years) 25 000
Previous impairment reversed: 1st step: increase carrying amount back up to
HCA – reversal recognised in profit or loss (impairment loss reversal income)
Factory: acc. impairment(-A) HCA: 225 000 – RA: 240 000 15 000
Revaluation surplus(OCI) 15 000
Previous impairment reversed: 2nd step: increase CA above HCA to RA: 240 000
(check not limited to depreciated FV: [FV: 350 000 - AD (350 000 – 0)/7 x 2] =
250 000): the reversal above HCA is recognised in OCI (revaluation surplus)
Chapter 11 563

Note:
If you scribble down t-accounts showing the processing of the above journals, you can do a quick check:
The cost account must reflect the fair value of C350 000 (notice that we did not debit any part of the
impairment loss reversal to ‘cost’ , even though part of the reversal is credited to revaluation surplus –
the entire IL reversal is debited to ‘Acc IL’).
The revaluation surplus reverses to zero at end 20X5.
The total of the AD account and AIL account on 31 December 20X5 is C110 000 (AD: 90 000 + AIL:
20 000 = 110 000).
This correctly reflects the total of the AD and AIL that would have been processed had we not
impaired on 31 December 20X4. We would have depreciated the fair value by C50 000 in 20X4 and in
20X5 (i.e.by total of C100 000) thus reducing the CA from C350 000 to C250 000 and would have then
found that we have a RA of C240 000, so would have impaired the CA by C10 000. So the total of the
AD and AIL accounts would have been C110 000 (AD: 100 000 + AIL: 10 000).
6.4 Corporate assets (IAS 36.100 - .102)
Corporate assets are
When testing a cash-generating unit for impairment, one defined as:
must include any corporate assets that are capable of assets other than goodwill
being allocated on a reasonable and consistent basis to that contribute to the future cash
that unit. flows
The primary characteristics of corporate assets (e.g. head of both the:
office buildings) are that: - cash generating unit under review
and
‘they do not generate cash flows independently of the - other cash generating units. IAS 36.6
other assets or groups of assets; and
their carrying amounts cannot be fully allocated to the cash-generating unit under review’.
IAS 36.100 (extract)
It may be possible to allocate the corporate assets to the cash generating units on a reasonable
basis, using, for example, the carrying amounts of the various cash generating units to pro-
rata the corporate assets to these units.
If the entity owns corporate assets that are unable to be allocated to its cash-generating units
on a reasonable basis, further impairment test/s are performed from the bottom-up.
Essentially this means that we must:
first test the smallest CGU for impairment (excluding the corporate assets);
then test a group of CGUs to which the corporate assets (or portion thereof) can be
allocated on a reasonable and consistent basis for impairment (example: two CGUs with
one corporate asset);
then test a bigger group of CGUs for impairment; and so on until the corporate assets are
completely included in a CGU/s (example: 3 CGUs with 2 corporate assets). The final
group of CGUs is often the business as a whole. See IAS36.102
Example 21: Corporate assets
The reporting entity has 3 cash-generating units (toothpaste, wire brushes and rubber tyre
production lines) and 3 corporate assets (a building, phone system and a computer platform).
The building and phone system support all cash-generating units while the computer platform supports
the toothpaste and wire-brush units only. The following are measurements as at 31 December 20X5:
CA RA
Cash-generating units excluding corporate assets: C C
Toothpaste unit 1 000 000 600 000
Wire-brush unit 2 000 000 1 500 000
Rubber tyre unit 4 000 000 3 200 000
7 000 000 5 300 000
Corporate assets:
Building 700 000
Phone system 350 000
Computer platform 1 050 000
2 100 000
Summary of carrying amounts:
Cash generating units excluding corporate assets 7 000 000
Corporate assets 2 100 000
Total carrying amount 9 100 000
564 Chapter 11
Required: Calculate the amount of the impairment to be allocated to the entity’s assets, assuming that:
A. the corporate assets can be allocated to the relevant cash-generating units. The appropriate method
of allocation is based on the carrying amount of the cash-generating unit’s individual assets as a
percentage of cash-generating unit’s total assets excluding corporate assets to be allocated.
B. the corporate assets cannot be allocated to the relevant cash-generating units.
Solution 21A: Corporate assets are able to be allocated
W1. Calculation of impairment loss per unit Cash-generating units
Toothpaste Wire-brushes Rubber tyres
Without corporate assets 1 000 000 2 000 000 4 000 000
Building 1 000K / 7 000K x 700 000 * 100 000 200 000 400 000
2 000K / 7 000K x 700 000 *
4 000K / 7 000K x 700 000 *
Phone system 1 000K / 7 000K x 350 000 * 50 000 100 000 200 000
2 000K / 7 000K x 350 000 *
4 000K / 7 000K x 350 000 *
Computer platform 1 000K / 3 000K x 1 050 000 ** 350 000 700 000 0
2 000K / 3 000K x 1 050 000 **
Total 1 500 000 3 000 000 4 600 000
Recoverable amount 600 000 1 500 000 3 200 000
Impairment 900 000 1 500 000 1 400 000
*: 1 000 000 + 2 000 000 + 4 000 000 = 7 000 000
**: 1 000 000 + 2 000 000 = 3 000 000
Note: these three impairment losses are then allocated and journalised to the individual assets within each cash
generating unit (as has been done in the previous CGU examples).
Solution 21B: Corporate assets not able to be allocated

The impairment testing of this entity’s assets, where its corporate assets were incapable of being
allocated to its three cash-generating units, involves three levels of testing, as follows:
W1: First test: without any corporate assets: Cash-generating units
Toothpaste Wire-brushes Rubber tyres
Carrying amount before first impairment 1 000 000 2 000 000 4 000 000
Recoverable amount 600 000 1 500 000 3 200 000
First impairment 400 000 500 000 800 000
W2: Second test: toothpaste and wire-brush units with computer platform C
Cash-generating unit toothpaste 1 000 000 – 400 000 first impairment 600 000
Cash-generating unit wire-brushes 2 000 000 – 500 000 first impairment 1 500 000
Computer platform (supports only the toothpaste and wire-brush unit) 1 050 000
Carrying amount before level 2 impairment 3 150 000
Recoverable amount 600 000 + 1 500 000 2 100 000
Second impairment 1 050 000
W3: Third test: all cash-generating units with all corporate assets: C
Toothpaste, wire-brushes and computer platform 3 150K – 1050K second impairment 2 100 000
Cash-generating unit: rubber tyres 4000K – 800K first impairment 3 200 000
Building (supports all 3 units) 700 000
Phone system (supports all 3 units) 350 000
Carrying amount before level 3 impairment 6 350 000
Recoverable amount 600 000 + 1 500 000 + 3 200 000 (5 300 000)
Third impairment 1 050 000
W4: Total impairment: C
First impairment 400 000 + 500 000 + 800 000 1 700 000
Second impairment 1 050 000
Third impairment 1 050 000
Total impairment allocated 3 800 000
W5: Total revised carrying amount of all assets: C
Carrying amount before impairment 9 100 000
Impairment 3 800 000
Carrying amount after impairment 5 300 000
Chapter 11 565
7. Disclosure (IAS 36.126– .137)
7.1 In general
The following information must be disclosed for each class of asset:

For any impairment losses:
The amount debited to expenses and which line item includes the impairment loss,
(e.g. profit before tax);
The amount debited against equity (i.e. the revaluation surplus account).
For any reversals of impairment losses:
The amount credited to income and which line item includes this impairment reversal,
(e.g. profit before tax);
The amount credited to equity (i.e. revaluation surplus). See IAS 36.126
These disclosures may be included in a note supporting the calculation of profit or loss (e.g.
‘profit before tax’ note) or in the note supporting the asset (e.g. the ‘property, plant and
equipment’ note in the reconciliation of carrying amount).
7.2 Impairment losses and reversals of previous impairment losses (IAS 36.130 - .131)
For every material impairment loss or impairment loss reversal, the entity must disclose:
the events and circumstances that led to the impairment loss or reversal thereof;
the nature of the asset (or the description of a cash-generating unit);
the amount of the impairment loss or impairment loss reversed;
if applicable, the reportable segment in which the individual asset or cash-generating unit
belongs (i.e. if the entity reports segment information);
if the recoverable amount is fair value less costs of disposal or value in use. See IAS 36.130
For impairment losses and impairment loss reversals that are not disclosed as above, indicate
the main class of assets affected; and
the main events and circumstances that led to the recognition or reversal of the
impairment losses. IAS 36.131( reworded)
7.3 Impairment testing: cash-generating units (IAS 36.130, and .134)
Additional disclosure is required when impairment testing is performed on ‘cash-generating

units’ instead of ‘individual assets’. This additional disclosure is listed below:
a description of the cash-generating unit (e.g. a product line or geographical area);
the amount of the impairment loss recognised or reversed by class for assets and, if the
entity reports segment information, by reportable segment;
if the aggregation of assets for identifying the cash-generating unit has changed since the
previous estimate of the cash-generating unit’s recoverable amount, a description of the
current and former way of aggregating assets and the reasons for changing the way the
cash-generating unit is identified.
If a cash-generating unit includes goodwill or an intangible asset with an indefinite useful life
and the portion of the carrying amount of that goodwill or intangible assets that is allocated to
the unit is significant in relation to the total carrying amount of goodwill or intangible assets
with indefinite useful lives of the entity (as a whole), then we also need to disclose:
the carrying amount of the allocated goodwill;
the carrying amount of intangible assets with indefinite useful lives;
the recoverable amount of the unit and the basis for calculating the recoverable amount of
the cash-generating unit (either its fair value less costs of disposal or value in use);
566 Chapter 11
where the recoverable amount is based on value in use:

- each key measurement assumption on which management based cash flow projections;
- a description of how management measured the values assigned to each key
assumption, whether those values reflect past experience or external sources of
information or both, and if not, why and how they differ from past experience or
external sources of information;
- the period over which management has projected cash flows based on financial
budgets approved by management and, when a period of more than five years is used
for a cash-generating unit, an explanation of why that longer period is justified;
- the growth rate used to extrapolate cash flow projections beyond the period covered
by the financial budgets and the justification for using a growth rate that exceeds the
long-term average growth rate; and
- the discount rate applied to cash flow projections;
where the recoverable amount is based on fair value less costs of disposal, state that this
value has been measured using a quoted price for an identical unit (or group of units),
unless this isn’t the basis, in which case disclose:
- each key measurement assumption on which management has estimated the fair value
less costs of disposal;
- a description of how management measured the values assigned to each key
assumption, whether those values reflect past experience and external sources of
information, and if not, why and how they differ from past experience or external
sources of information;
- the level of fair value hierarchy (see IFRS 13), ignoring observability of disposal costs;
- if there have been changes to the valuation techniques the reason(s) for these changes;
- if the fair value less costs of disposal has been measured using cash flow projections,
the following must also be disclosed:
- The period over which the projected cash flows have been estimated;
- The growth rate used to extrapolate the cash flows over this period; and
- The discount rate used.See IAS 36.134
If a cash-generating unit includes goodwill or an intangible asset with an indefinite useful life
and the portion of the carrying amount of that goodwill or intangible assets that is allocated to
the unit is insignificant in relation to the total carrying amount of goodwill or intangible assets
with indefinite useful lives of the entity (as a whole), then we must also disclose:
the aggregated carrying amount of allocated goodwill;
the aggregated carrying amount of allocated intangible assets with indefinite useful lives;
the key assumptions
a description of how management measured the values assigned to each key assumption,
whether those values reflect past experience or external sources of information or both,
and if not, why and how they differ. See IAS 36.135
Whether allocated goodwill or intangible assets with indefinite lives is significant or

insignificant, where a key assumption that was used in the determination of the recoverable
amount might reasonably be expected to change such that the recoverable amount decreases
below the carrying amount then disclose:
the amount by which the recoverable amount currently exceeds the carrying amount;
the value assigned to the key assumption;
the amount by which this value would have to change in order for the recoverable amount
to equal the carrying amount. See IAS 36.135(e)
Chapter 11 567
8. Summary
Impairment of Assets
There should be an annual 'indicator review' with the purpose of identifying

possible impairments.
Calculate the:
carrying amount (CA) and recoverable amount (RA);
If the CA>RA = impairment
Carrying amount Recoverable amount Impairment loss

Per statement of financial Greater of: ACA – RA:
position: value in use or
cost or fair value fair value less costs of first debit RS: ACA>HCA
less ‘accumulated disposal
depreciation and then debit IL: HCA>RA
impairment losses’ Calculated if:
indicator review suggests
material impairment
intangible asset that:
- has indefinite useful life
- is not available for use
- is goodwill
Fair value less costs of disposal Value in use

The price that would be received to sell an The present value of estimated future cash
asset (or paid to transfer a liability) flows (pre-tax) from:
in an orderly transaction Use and
between market participants Disposal at end of useful life
at the measurement date Exclude the following cash flows:
Less Disposal costs Financing
Tax
Outflows in respect of obligations already
recognised as liabilities
Estimated future cash flows Appropriate discount rate

Use cash flows based on managements’ best Pre-tax
estimated projections: Market-related risk-free rate
Short-term projections (less than 5 yrs): Adjusted for risks specific to the asset
approved budgets only
Long-term projections (beyond 5 years):
extrapolate the approved budget using a
justifiable growth rate (generally a stable/
declining growth rate)
ACA = actual carrying amount

HCA = historical carrying amount
RA = recoverable amount
RS = revaluation surplus
IL = impairment loss
568 Chapter 11
Indicator Review
External information Internal information

Significant decrease in value Obsolescence
Significant adverse current/ future changes in Physical damage
the market in which the asset is used Adverse current/ future changes in usage of
Increase in market interest rates (decreases the asset
value in use) Actual profits and/ or cash flows worse than
Carrying amount of business net assets > budgeted
market capitalisation etc Net cash outflows or losses become apparent
when looking at figures in aggregate (e.g. past
+ current; current + future; past + current +
future)
Recognition of adjustments
Impairment loss Reversal of impairment loss

If cost model used: If cost model used:
debit: debit:
impairment loss (expense) accumulated impairment losses
credit: credit:
accumulated impairment losses reversal of impairment loss (income: P/L)
Limit to HCA (i.e. Cost – AD)
or or
If revaluation model used: If revaluation model used:

up to HCA: up to HCA:
debit: debit:
impairment loss (expense: P/L) accumulated impairment losses
credit: credit:
accumulated impairment losses reversal of impairment loss (income: P/L)
above HCA (where there is a revaluation surplus) above HCA:

debit: debit:
revaluation surplus (to the extent of the balance accumulated impairment losses
therein) (OCI) credit:
credit: revaluation surplus (income: OCI)
accumulated impairment losses Limit to FV - AD
if the decrease in value exceeds the revaluation

surplus balance:
debit: impairment loss (expense) (with any excess)
and
credit: accumulated impairment losses
Depreciation thereafter: Depreciation thereafter:

a new depreciable amount is calculated (after a new depreciable amount is calculated (after
deducting the accumulated impairment loss) deducting the remaining accumulated impairment
which must be depreciated over the remaining useful loss)
life of the asset which must be depreciated over the remaining
useful life of the asset
Chapter 11 569
Gripping GAAP Non-current assets held for sale and discontinued operations
Chapter 12
Non-current Assets Held for Sale and Discontinued Operations
Main reference: IFRS 5 (including any amendments to 10 December 2014)
CHAPTER SPLIT:
This chapter covers IFRS 5, which is the standard that explains the topics of:
Non-current assets held for sale - a term that refers to both:
- individual assets held for sale, which we will refer to as NCAHFS, and
- disposal groups held for sale, which we will refer to as DGHFS; and also
Discontinued operations (DO).
Although the concepts in the first topic do have a bearing on the second topic, these topics can be studied separately.
Thus the chapter is separated into these two separate topics as follows:
PARTS: Page
PART A: Non-current assets held for sale 572
PART B: Discontinued operations 624
PART A:
Non-Current Assets Held for Sale
Contents: Page
A: 1 Overview 572
A: 2 Scope 573
A: 2.1 Non-current assets held for sale: scoped-out non-current assets 573
A: 2.2 Disposal groups held for sale: scoped-out items 574
A: 3 Classification: as ‘held for sale’ or ‘held for distribution’ 574
A: 3.1 What happens if something is classified as HFS or HFD? 574
A: 3.2 The classification criteria in general 574
A: 3.2.1 Overview 574
A: 3.2.2 Classification as held for sale 575
A: 3.2.2.1 The core criterion 575
A: 3.2.2.2 The further supporting criteria 575
A: 3.2.2.3 Meeting the criteria 576
A: 3.2.2.4 An intention to sell may be an indication of a possible impairment 576
A: 3.2.3 Classification as held for distribution 576
A: 3.2.3 Comparison of the classification as held for sale and held for distribution 577
A: 3.3 Criteria when a completed sale is expected within one year 577
A: 3.4 Criteria when a completed sale is not expected within one year 578
A: 3.5 Criteria when an NCA or DG is acquired with the intention to sell 579
A: 4 Measurement: individual non-current assets held for sale 579
A: 4.1 Overview 579
A: 4.2 Measurement if the sale is expected within one year 580
A: 4.3 Measurement when the NCA is not expected to be sold within one year 581
A: 4.4 Measurement when the NCA is acquired with the intention to sell 581
A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD 581
A: 4.5.1 Initial measurement (on the date of classification) 581
A: 4.5.2 Subsequent measurement (after the date of classification as held for sale ) 582
A: 4.6 Measurement principles specific to the cost model 583
A: 4.6.1 The basic principles when the cost model was used 583
Example 1: Measurement on date classified as HFS (previously: cost model) 583
Example 2: Re-measurement after classified as HFS: impairment loss 585
reversal limited
Example 3: Measurement on date classified as a NCAHFS and re- 587
measurement of NCAHFS: reversal of impairment loss 591
limitation (previously: cost model) 591
A: 4.6.2 The tax effect when the cost model was used
Example 4: Tax effects of classification as NCAHFS and the cost model
570 Chapter 12
A: 4.7 Measurement principles specific to the revaluation model 592

A: 4.7.1 The basic principles when the revaluation model was used 592
Example 5: Measurement on date classified as HFS (was revaluation model) 592
Example 6: Re-measurement of a NCAHFS: (was revaluation model): further
impairments and reversals of impairments 594
Example 7: Re-measurement of a NCAHFS (was revaluation model): prior
revaluation expenses may not be reversed 597
A: 4.7.2 The tax effect when the revaluation model was used 599
Example 8: Tax effect of reclassification and the revaluation model 599
A: 4.8 Measurement implications of a change to a plan to sell / distribute 603
A: 4.8.2 If a NCAHFS subsequently fails to meet the HFS or HFD classification criteria 603
A: 4.8.3 If a NCAHFS subsequently becomes a NCAHFD, or vice versa 603
Example 9: Re-measurement of assets no longer classified as ‘held for sale’ 604
A: 4.9 Measurement involving ‘scoped-out non-current assets’ 604
Example 10: Asset falling outside the measurement scope of IFRS 5 605
A: 5 Disposal groups held for sale 605
A: 5.1 Overview of disposal groups 605
A: 5.2 Identification of disposal groups 606
A: 5.3 Classification, presentation and disclosure of disposal groups held for sale or distribution 606
A: 5.4 Measurement of disposal groups in general 606
A: 5.4.1 Initial measurement of disposal groups 607
Example 11: Disposal group held for sale – impairment allocation 608
Example 12: Disposal group held for sale – initial impairment 609
A: 5.4.2 Subsequent measurement of a disposal group 611
Example 13: Disposal group held for sale – subsequent impairment 612
Example 14: Disposal group held for sale – subsequent impairment reversal 613
A: 5.5 Measurement of disposal groups that are not expected to be sold within one year 615
A: 5.6 Measurement of disposal groups acquired with the intention to sell 615
A: 5.7 Measurement of disposal groups when there is a change to the plan to sell or distribute 616
A: 5.7.2 If a DG subsequently fails to meet the HFS or HFD classification criteria 616
A: 5.7.3 If a DGHFS subsequently becomes a DGHFD, or vice versa 617
A: 6 Presentation and disclosure: non-current assets (or disposal groups) held for sale or distribution 617
A: 6.1 Overview 617
A: 6.2 In the statement of financial position 618
A: 6.3 In the statement of financial position or notes thereto 618
A: 6.4 In the statement of other comprehensive income 618
A: 6.5 Comparative figures 618
A: 6.6 Other note disclosure 618
A: 6.6.1 General note 618
A: 6.6.2 Change to a plan of sale 618
A: 6.6.3 Events after the reporting period 619
Example 15: Disclosure of non-current assets held for sale 619
A: 7 Summary 621
PART B:
Discontinued Operations
B: 1 Introduction to discontinued operations 624
B: 2 Identification of a discontinued operation 624
B: 3 Measurement of a discontinued operation 625
B: 4 Disclosure of a discontinued operation 625
B: 4.1 Profit or loss from discontinued operation 625
B: 4.2 Cash flows relating to a discontinued operation 627
B: 4.3 Comparative figures 627
B: 4.4 Changes in estimates 627
B: 4.5 Other note disclosure 627
B: 4.5.1 Components no longer held for sale 627
B: 4.5.2 If the discontinued operation also meets the definition of ‘held for sale’ 628
B: 5 Summary 628
Chapter 12 571
INTRODUCTION
This standard (IFRS 5 Non-current assets held for sale and discontinued operations) covers
both non-current assets held for sale (NCAHFS) and discontinued operations (DO):
Non-current assets held for sale will be explained in this part: Part A.
Discontinued operations are explained in Part B.
PART A:
Non-current Assets Held for Sale
A: 1 Overview
Although half of the title of IFRS 5 refers to non-current Part A explains how to
assets held for sale, this term actually refers to: classify, measure, present
individual ‘non-current assets held for sale’ and disclose:
(NCAHFS); and Individual assets held for sale
(NCAHFS); and
a group of items held for sale, where this group
Disposal groups (groups of assets)
sometimes includes not only non-current assets but held for sale (DGHFS)
also current assets and directly related liabilities,
referred to as a ‘disposal group held for sale’ (DGHFS); and
individual ‘non-current assets held for distribution to owners’ or ‘disposal groups held for
distribution to owners’ (as opposed to being held for sale) (NCAHFD and DGHFD).
This can possibly be better understood by looking at the following diagrammatic summary:
The term ‘non-current assets held for sale’ actually refers to:
Individual non-current assets: Disposal groups:

held for sale (NCAHFS) held for sale (DGHFS)
held for distribution (NCAHFD) held for distribution (DGHFD)
We will first look at how to account for an individual non-current asset that is held for sale
(NCAHFS) and then how to account for a disposal group that is held for sale (DGHFS).
The method of accounting for an individual non-current asset held for sale applies almost
100% to an individual non-current asset that is held for
distribution instead. Similarly, the method of accounting Important definitions:
for a disposal group held for sale applies almost 100% to
a disposal group that is held for distribution instead. A non-current asset is defined as:
An asset that is not a CA. IFRS 5 App A
For this reason, we will not discuss individual non- A current asset is defined:
current assets or disposal groups held for sale and held in the CF (please see the CF/ chp 2)
IFRS 5 Appendix A
for distribution separately. Instead, you may assume that
wherever this chapter refers to something as being held A disposal group is defined as:
for sale, that the principles will apply equally if it were a group of assets
held for distribution – unless stated otherwise. to be disposed of, by sale or
otherwise,
When we talk about how to account for items that are together as a group in a single
held for sale (or held for distribution), we are talking transaction,
about their: and liabilities directly associated with
Classification; those assets that will be transferred
Measurement; in the transaction.
IFRS 5 App A
Presentation; and
Disclosure.
572 Chapter 12
Classification refers to the process involved in deciding whether or not an item should be
classified as held for sale (and also whether or not an item should be held for distribution).
The process of classification as held for sale/ distribution is the same whether we are looking
at an individual non-current asset or a disposal group. The process of classifying as held for
sale differs very slightly from the process of classifying as held for distribution.
The measurement of items held for sale follow the basic principle that the item must be
measured at the lower of carrying amount and fair value less costs to sell. The measurement
of items held for distribution follow a similar basic principle that the item must be measured
at the lower of carrying amount and fair value less costs to distribute.
Certain non-current assets that are held for sale (or held for distribution) are not affected by
the measurement requirements stipulated in IFRS 5. I refer to these non-current assets as
‘scoped-out non-current assets’. These are listed in section A:2.
Although the basic measurement principles mentioned above are always the same, there are
further complexities when the item being measured is a disposal group rather than an
individual non-current asset. This is because a disposal group could include:
a variety of assets (current and non-current, some of which may be scoped out) as well as
directly related liabilities.
Measurement of disposal groups held for sale (or held for distribution) is thus made more
complex because the measurement requirements of IFRS 5 only apply to certain non-current
assets – they do not apply to current assets, scoped-out non-current assets or liabilities. Due to
this extra complexity, the measurement of individual non-current assets held for sale (or held
for distribution) will be explained separately from the measurement of disposal groups held
for sale (or held for distribution):
measurement of individual non-current assets held for sale/ distribution: section A.4;
measurement of disposal groups held for sale/ distribution: section A.5.
The presentation and disclosure requirements for items that are classified as held for sale are
the same as those for items that are classified as held for distribution – and these requirements
are the same whether we are dealing with an individual non-current asset or a disposal group.
The rest of Part A of this chapter is laid out as follows:
Section A:2 explains what assets are scoped out of IFRS 5 and what this means.
Section A:3 explains how to classify NCAs & DGs as held for sale or held for distribution;
Section A:4 explains how we measure individual NCAs held for sale/ held for distribution;
Section A:5 explains how we measure DGs held for sale/ held for distribution
Section A:6 explains how to present and disclose NCAs & DGs held for sale/distribution.
A: 2 Scope (IFRS 5.2 - .5)
A: 2.1 Non-current assets held for sale: scoped-out non-current assets (IFRS 5.5)
The IFRS 5 measurement requirements do not apply to The IFRS 5 measurement
the following non-current assets: requirements do not apply
to the following NCAs
Assets already measured at fair value with (scoped-out NCAs):
movements recognised in profit or loss: Assets measured at FV with
- Financial assets within the scope of IFRS 9 movements recognised in P/L (e.g. IP
measured at FV)
(IFRS 9 Financial instruments) Assets for which FV may be difficult
- Non-current assets measured under the fair value to determine (e.g. DT assets)
model (IAS 40 Investment property)
- Non- current assets measured at fair value less costs to sell (IAS 41 Agriculture)
Assets for which fair values may be difficult to determine:
- Deferred tax assets (IAS 12 Income taxes)
- Assets relating to employee benefits (IAS 19 Employee benefits)
- Contractual rights under insurance contracts (IFRS 4 Insurance contracts). See IFRS 5.5
Chapter 12 573
Please note that these non-current assets are scoped-out only from the measurement
requirements of IFRS 5. Thus, if these assets are considered to be non-current assets held for
sale, they would thus still be subject to the classification, presentation and disclosure
requirements of IFRS 5. See IFRS 5.2
A: 2.2 Disposal groups held for sale: scoped-out items
Disposal groups are simply groups of assets, or The IFRS 5 measurement

sometimes groups of assets and related liabilities, that requirements do not apply
are to be disposed of in a single transaction. Thus, it is to (scoped-out items):
important to realise that a disposal group may actually Scoped-out non-current assets
not contain any non-current assets. However, as its Current assets
name suggests, IFRS 5 will not apply to a disposal group Liabilities.
that does not contain any non-current assets.
Conversely, if a disposal group contains a mixture of items (e.g. it contains non-current assets
and/ or current assets and possibly even related liabilities), then IFRS 5 will apply to this
disposal group if it contain just one non-current asset. However, although IFRS 5 would then
apply to this disposal group, we must remember that IFRS 5’s measurement requirements do
not apply to all non-current assets – some non-current assets are scoped out from the IFRS 5
measurement requirements.
Apart from the specific non-current assets that are scoped out from IFRS 5’s measurement
requirements (see section A: 2.1), all current assets and all liabilities are also scoped-out from
IFRS 5’s measurement requirements.
Please notice that these items (scoped-out non-current assets, all current assets and all
liabilities) are scoped-out only from the measurement requirements of IFRS 5. This means
that if a disposal group held for sale (or distribution) includes any of these items, the
measurement requirements would not apply to these specific items ... but all items in the
disposal group would still be subject to the classification, presentation and disclosure
requirements of IFRS 5.
A: 3 Classification as ‘Held For Sale’ or ‘Held for Distribution’ (IFRS 5.6 - .14)
A: 3.1 What happens if something is classified as HFS or HFD? (IFRS 5.6 - .14)
If a non-current asset (NCA) or disposal group (DG) meets the criteria to be classified as
‘held for sale’ (HFS) or ‘held for distribution’ (HFD), this individual NCA or DG must be:
measured in terms of IFRS 5 (unless it is a ‘scoped-out asset’ – see section 1);
separately presented in the statement of financial position as ‘held for sale’ and presented
under ‘current assets’ (i.e. a machine that is held for sale will no longer be presented as
part of property, plant and equipment); and
disclosed in the notes to the financial statements.
A: 3.2 The classification criteria in general (IFRS 5.6 - .14)
A: 3.2.1 Overview
When to classify a non-current asset (NCA) or disposal group (DG) as held for sale depends
on whether certain criteria are met. Similarly, when to classify a non-current asset (NCA) or
disposal group (DG) as held for distribution depends on whether certain criteria are met.
The criteria relating to classification as held for sale and classification as held for distribution
differ (though they are very similar) and thus we will discuss each separately. At the end of
this discussion, you will find a summary that compares these two set of criteria.
574 Chapter 12
A: 3.2.2 Classification as held for sale
A: 3.2.2.1 The core criterion A NCA/ DG is classified as

HFS when we expect that:
The core criteria driving the classification of a non- its carrying amount
current asset (NCA) or disposal group (DG) as ‘held for will be recovered principally through
sale’ is that it may only be classified as held for sale a sale transaction rather than
when most of its carrying amount is expected to be through continuing use. IFRS 5.6
recovered through the inflows from the sale of the NCA P.S. There are more criteria to be met
or DG rather than from the use thereof. See IFRS 5.6 before we can say we expect the CA to
be recovered mainly through sale.
If we look at this classification requirement carefully, we can see a non-current asset (NCA)
or disposal group (DG) may continue to be used by the entity and yet still be classified as
‘held for sale’. The important issue is whether the inflows from the sale of the asset are
greater than from the use of the asset: if the inflows from the sale of the asset are greater, then
the asset is classified as held for sale.
If we look at this classification requirement again, we can also see that a non-current asset
(NCA) or disposal group (DG) that is to be abandoned could not possibly be classified as
‘held for sale’ because an abandonment means no sale and thus none of its carrying amount
would be recovered through a sale.
Abandonment means just that – the non-current asset

(NCA) or disposal group (DG) will be discarded, Abandoned assets can
dumped, ditched, discontinued – there is no future sale never be classified as HFS
involved. Its carrying amount will therefore be
recovered through future use (until date of abandonment) after which it will not be sold but
will be thrown away instead. IFRS 5.13
Non-current assets (NCAs) or disposal groups (DGs) to be abandoned include:

non-current assets (or DGs) that are to be used to the end of their economic life; and
non-current assets (or DGs) that are to be closed rather than sold.
Please note that assets that have been permanently taken out of use and for which there is no
plan to sell (e.g. the entity plans to drop the asset off at the local dump) would be considered
to be abandoned. Assets that have simply been temporarily taken out of use are not
accounted for as abandoned assets. See IFRS 5.14
A: 3.2.2.2 The further supporting criteria The CA of the NCA/DG

will be said to be
Now, look at the core criterion again (see above). recovered mainly through a
Before we may conclude that the carrying amount of the sale transaction if:
NCA or DG is expected to be recovered mainly through it is available for immediate sale
the sale rather than through the use thereof, the following - in its present condition
two criteria must also be met: - subject only to terms that are usual
and customary for sales of such
the asset must be available for sale immediately, in NCAs or DGs and
its present condition and based on terms that are its sale must be highly probable.
considered to be normal, and IFRS 5.7
the sale must highly probable of occurring. See IFRS 5.7
To prove that the sale is highly probable, a further set of criteria must be met:
the appropriate level of management must be committed to the plan to sell;
an active programme to try and sell the asset has begun;
it must be actively marketed at a selling price that is reasonable relative to its fair value;
the sale is expected to be complete within one year from date of classification as held for
sale (unless the situation facing the entity allows an exception to this rule: see
section A:3.4); and
the remaining actions needed to complete the sale must suggest that the plan to sell will
not need to be withdrawn or significantly changed. See IFRS 5.8
Chapter 12 575
A: 3.2.2.3 Meeting the criteria
It is quite difficult to meet all these criteria and thus a non-current asset (NCA) or disposal
group (DG) that is intended to be sold will often fail to be classified as ‘held for sale’.
However, if both these criteria are met before reporting date, the non-current asset (NCA) or
disposal group (DG) must be classified as a ‘held for sale’ in those financial statements.
If these criteria are met, but only after the reporting period (i.e. after the financial year has
ended) but before the financial statements are issued, the non-current asset (NCA) or disposal
group (DG) is not classified as ‘held for sale’ in that set of financial statements, but certain
disclosures are still required. This is covered in the section on disclosure. IFRS 5.12
A more thorough discussion of all these criteria outlined above appears in section A: 3.3.
One of the criteria when proving that a sale is highly probable of occurring requires that this
sale must be expected to be complete within one year from date of classification. However,
an asset whose sale is not expected to be complete within a year could still be classified as
held for sale if further specified criteria are met. This is discussed in section A: 3.4.
Yet a further variation to the criteria that need to be met arises when a non-current asset is
acquired with the sole intention of being sold. This is discussed in section A: 3.5.
A: 3.2.2.4 An intention to sell may be an indication of a possible impairment
If there is an intention to sell an asset – even if it is not

The mere intention to sell
classified as such – we must bear in mind that the mere a NCA or DG may be
intention to sell the non-current asset may be an considered to be:
indication of a possible impairment. an indication of a possible impairment
If the intention to sell is considered to be an indication of a possible impairment, we would be

required to calculate the recoverable amount. See IAS 36.9
If the recoverable amount is calculated and found to be less than the carrying amount, an
impairment loss would need to be recognised.
A: 3.2.3 Classification as held for distribution (IFRS 5.12A)
A non-current asset (NCA) or disposal group (DG) may

A NCA/ DG is classified as
only be classified as ‘held for distribution’ if we can
HFD if:
confirm that the entity is committed to the distribution
thereof to the owners of the entity. the entity is committed
to distribute the NCA/DG
to the owners. IFRS 5.12A (reworded)
We can only confirm that the entity is committed to the
P.S. There are more criteria to be met
distribution of the NCA or DG if: before we can say the entity is
it is ‘already available for immediate distribution’ in committed to the distribution.
its present condition and that
it is highly probable that the distribution will occur.
A distribution is highly probable if: The entity is committed to

the actions taken to complete the distribution have the distribution if the:
begun and NCA/DG is available for immediate
the distribution is expected to be completed within a distribution in its present condition;
and
year of the classification as held for distribution and the distribution is highly probable.
the remaining actions necessary to complete the IFRS 5.12A (slightly reworded)
distribution suggest that it is unlikely that:

- the distribution will be withdrawn or that
- there will be any significant changes to the distribution.
576 Chapter 12
A: 3.2.4 Comparison of the classification as held for sale and held for distribution
The following diagrammatic summary may be helpful in seeing how the process of
classifying a non-current asset or disposal group as held for sale differs from classifying it as
held for distribution.
Classification
See IFRS 5.6-.7

Held for sale: Held for distribution: See IFRS 5.12A
A NCA/DG is classified as HFS if its CA is A NCA/DG is classified as HFD if the entity is
expected to be recovered mainly through a sale committed to distributing it to the owners.
of the asset than through use of the asset.
We prove the above if these criteria are met: We prove the above if these criteria are met:
the asset is available for immediate sale (in the asset is available for immediate
its present condition and at normal terms); & distribution (in its present condition); &
the sale thereof is highly probable. the distribution thereof is highly probable.
Highly probable sale: See IFRS 5.8 Highly probable distribution:

A sale is highly probable if: A distribution is highly probable if:
the appropriate level of mgmt is committed to it; actions to complete the distribution have begun
an active programme to sell has begun; the distribution is expected to be concluded
it must be actively marketed at a reasonable price within 1 yr of the date of classification as HFD
relative to its FV; actions required to complete the distribution
the sale is expected to be concluded within 1 yr of should suggest that it is unlikely that:
the date of classification as HFS (unless a longer - significant changes to the distribution will be
period is permitted in terms of IFRS 5.9) made; or that
actions required to complete the sale should - the distribution will be withdrawn
suggest that it is unlikely that:
- significant changes to the plan to sell will be
made; or that
- the plan to sell will be withdrawn.
A: 3.3 Criteria when a completed sale is expected within one year (IFRS 5.7 - .8)
For a non-current asset (NCA) or disposal group (DG) To prove that a CA will
to be classified as ‘held for sale’ the carrying amount be recovered mainly via a
of the asset is to be recovered mainly through a sale sale, ALL the following
transaction than through continuing use. criteria must be met:
the NCA is immediately available for
In order to prove this, we must meet all of the sale in its present condition and on
normal terms:
following criteria listed in IFRS 5: See IFRS 5.7-8 - Mgmt must have intention & ability
to complete this sale
The non-current asset (NCA) or disposal group The sale must be highly probable:
(DG) must be available for immediate sale: - Must be commitment to the sale
from appropriate level of mgmt;
- in its present condition - Active programme to find a buyer &
complete the sale must’ve begun
- subject only to terms that are usual and - Sale expected within 1 year of
customary for sales of such assets; IFRS 5.7 classification
- selling price reasonable compared to
For an asset to be available for immediate sale, the its FV
- Unlikely to be significant changes
entity must currently have ‘the intention and made to the plan of sale.
ability to transfer the NCA (or DG) to a buyer in See IFRS 5.7 & 8
its present condition’.
For example, an entity intending to sell its factory where any outstanding customer orders
would be transferred to and completed by the buyer would meet this criteria, but an entity
intending to sell its factory only after completing any outstanding customer orders first
would not meet this criteria (since the delay in timing of the sale of the factory, which is
imposed by the seller, means that the factory is not available for immediate sale in its
present condition). IFRS 5: Implementation Guidance
Chapter 12 577
The sale must be highly probable: IFRS 5.7 Highly probable is

For the sale to be considered highly probable, there are five defined as:
sub-criteria to be met: significantly more likely than
Probable. IFRS 5 App A
- The appropriate level of management must have
committed itself to a sales plan: Probable is defined as:
Management, with the necessary authority to approve more likely than
not. IFRS 5 App A
the action, must have committed itself to a plan to sell:
this often requires the board of directors to have committed themselves to the plan,
but on occasion, further approval must also be sought, for example shareholder
approval may also be required before it can be said that there is an appropriate level
of commitment to the plan;
- An active programme must have begun to find a buyer and complete the sale:
This simply means that the asset (or DG) must be actively marketed;
- The sale must be expected to happen within one year:
The sale must be expected to qualify for recognition as a completed sale within one
year from the date of classification as ‘held for sale’, (periods longer than one year
are allowed under certain circumstances: these are discussed below);
- The selling price must be reasonable in relation to its current fair value; and
- It must be unlikely that significant changes to the plan will be made:
The actions required to complete the plan must indicate that it is unlikely that
significant changes to the plan will be made or that the plan will be withdrawn.
If all the criteria above are met before reporting date, the non-current asset (or DG) must be
separately classified as a ‘non-current asset held for sale’.
If the entity is committed to a plan that involves the loss of control of a subsidiary and if the
above criteria are met, all the subsidiary’s assets and liabilities must be classified as held for
sale, even if we retain a non-controlling interest in it. Reworded IFRS 5.8A
A: 3.4 Criteria when a completed sale is not expected within one year (IFRS 5.9 & App B)
On occasion, an asset may be classified as ‘held for sale’ A NCA/ DG may still be
even though the sale may not be completed and classified as HFS even if
recognised as a sale within one year. This happens when: the sale is not expected
the delay is caused by events or circumstances within 1 year on condition that:
beyond the entity’s control; and the delay is beyond the entity’s
control; and
there is sufficient evidence that the entity remains
there is sufficient evidence that the
committed to its plan to sell the asset. entity is still committed to the sale.
Certain extra criteria must be met
There are three different scenarios that IFRS 5 identifies depending on the scenario.
as possibly leading to a sale taking longer than one year. See IFRS 5.9 & IFRS 5 App B
For each of these scenarios, certain additional criteria

need to be met for the one-year requirement to fall away. See IFRS 5 App B
Scenario 1: The entity initially commits to selling a non-current asset (or disposal group), but
it has a reasonable expectation that someone other than
the buyer will impose conditions that will delay the A firm purchase
completion of the sale. commitment is defined as:
an agreement with a third party,
In this scenario, the NCA (or DG) must be classified as binding on both parties and usually
held for sale if: legally enforceable, that:
- specifies all significant terms,
the entity is unable to respond to these expected (incl the price and timing); and
conditions until a firm purchase commitment is - includes a disincentive for non-
actually obtained, and performance that is large enough
that performance is highly
a firm purchase commitment is highly probable probable.
within one year. Reworded IFRS 5 Appendix A
578 Chapter 12
Scenario 2: On the date that an entity obtains a firm purchase commitment, someone
unexpectedly imposes conditions that will delay the completion of the sale of the non-current
asset (or disposal group) that was previously classified as held for sale. In this scenario, the
NCA (or DG) must continue to be classified as held for sale if:
the entity has timeously taken the necessary actions to respond to the conditions, and
the entity expects that the delaying conditions will be favourably resolved.
Scenario 3: A non-current asset (or disposal group) that was initially expected to be sold
within one year remains unsold at the end of this one-year period due to unexpected
circumstances that arose during the one-year period. In this scenario, the NCA (or DG) must
continue to be classified as held for sale if:
the entity took the necessary actions during that year to respond to the change in
circumstances,
the entity is actively marketing the non-current asset (or disposal group) at a reasonable
price bearing in mind the change in circumstances, and
the criteria in paragraph 7 (i.e. the asset must be available for immediate sale and the sale
must be highly probable) and paragraph 8 (i.e. the criteria for the sale to be highly
probable) are met.
A: 3.5 Criteria when an NCA or DG is acquired with the intention to sell (IFRS 5.11)
It may happen that an entity acquires a non-current asset
(or disposal group) exclusively with the view to its A NCA/ DG acquired with
subsequent disposal. In this case, the non-current asset the intention to sell must
must be classified as ‘held for sale’ immediately on be classified as HFS if:
acquisition date if: the sale is expected within 1 yr; and
the one-year requirement is met (unless a longer any criteria in para 7 & para 8 that
aren’t met on date of acquisition will
period is allowed by paragraph 9 and the related be met within a short period (+-3m).
appendix B – see section A: 3.3 above); and See IFRS 5.11
it is highly probable that any criteria given in para 7

and para 8 that are not met on the date of acquisition, are expected to be met within a
short period (usually three months) after acquisition.
A: 4 Measurement: Individual Non-Current Assets Held for Sale (IFRS 5.15 - .25)
Assets classified as HFS or

A: 4.1 Overview HFD will have been
measured as follows:
There are two phases to the life of an individual non- before classification:
current asset (NCA) that is classified as held for sale - measured in terms of its previous
(HFS) or held for distribution (HFD): standard;
from date of classification:
before the date of classification (clearly irrelevant to measured in terms of IFRS 5:
newly acquired assets) when it is measured in terms - initial measurement
of its previous relevant standard (e.g. IAS 16); and - subsequent measurement.
from the date of classification when it is measured in
terms of IFRS 5.
Before the asset is classified as held for sale (or held for distribution), the NCA is simply
measured in terms of its previous relevant IFRS. For example, if the NCA was an item of
property, plant and equipment, the NCA will have been measured in terms of
IAS 16 Property, plant and equipment, which will mean that:
on initial acquisition, the asset will have been recorded at cost; and
subsequently, the asset will have been measured either under the:
- Cost model: depreciated and reviewed annually for impairments, or
- Revaluation model: depreciated, reviewed annually for impairments and revalued to
fair value on a regular basis.
Chapter 12 579
From the date the NCA is classified as held for sale (or held for distribution) the measurement
principles in IFRS 5 must be followed. These measurement principles can be separated into:
initial measurement; and
subsequent measurement (depreciation and amortisation ceases).
Essentially, initial measurement of a NCA that is Fair value is defined as:
classified as held for sale (i.e. on the date that it is
the price that would be received
classified as such) is at the lower of its: to sell an asset (or paid to
carrying amount (CA) and its transfer a liability)
fair value less costs to sell (FV-CtS). See IFRS 5.15 between market participants
at the measurement date.
Similarly, initial measurement of a NCA that is classified IFRS 5 Appendix A
as held for distribution (i.e. on the date that it is
classified as such) is at the lower of its:
carrying amount (CA) and its
fair value less costs to distribute (FV-CtD). See IFRS 5.15A
The subsequent measurement of a NCA from the date that it is classified as held for sale or
held for distribution involves ceasing all depreciation and amortisation. See IFRS 5.25
Apart from the cessation of depreciation and amortisation, subsequent measurement of a NCA
held for sale (NCAHFS) involves remeasuring it on each subsequent reporting date to the
lower of its carrying amount (CA) and its latest fair value less costs to sell (FV-CtS).
Similarly, subsequent measurement of a NCA held for distribution (NCAHFD) involves
remeasuring it on each subsequent reporting date, to the lower of its carrying amount (CA)
and its latest fair value less costs to distribute (FV-CtD).
We will first explain the measurement principles in
Costs to sell are defined as:
terms of the normal situation where the asset is expected
to be sold within one year. the incremental costs
After this we will look at how these principles may need disposal of an asset (or disposal
to be modified if the asset held for sale is expected to be group),
excluding finance costs and
sold after one year from date of classification or if the income tax expense.
asset is acquired with the intention to sell. IFRS 5 Appendix A
Thereafter, we will look at the detailed steps involved in the initial measurement and
subsequent measurement of a non-current asset held for sale.
A: 4.2 Measurement if the sale is expected within one year (IFRS 5.15; 17; .25)
Non-current assets (or disposal groups) that are classified as held for sale are measured on
date of classification and then on subsequent reporting dates at the lower of its:
carrying amount (CA), and
fair value less costs to sell (FV-CtS). IFRS 5.15 Measurement of a NCAHFS:
Assets that are held for sale are not depreciated (nor the lower of:
- carrying amount; and
amortised). This is because their carrying amount is - FV less costs to sell.
principally made up of the future income from the sale of depreciation/ amortisation ceases. .
the asset rather than the use thereof (note: depreciation is See IFRS 5 15 & .25
a reflection of this usage). Since the usage is considered to be relatively minimal,

depreciation is not reflected. IFRS 5.25
When re-measuring a non-current asset held for sale after the date on which it has been
classified as held for sale, (i.e. if the asset had not yet been sold at year-end):
further impairment losses may be recognised, but
any impairment loss reversal would be limited to the cumulative impairment losses
recognised, both in terms of IFRS 5 and IAS 36 Impairment of assets. IFRS 5.20 -21
580 Chapter 12
A: 4.3 Measurement when the NCA is not expected to be sold within one year
(IFRS 5.17)
If, in the unusual instance a sale is expected beyond one If the sale is not
year, it may be necessary (depending on materiality) to expected within 1 year:
measure the ‘costs to sell’ at their present value. The the costs to sell may need to be
gradual increase in the present value due to the passage present valued. See IFRS 5.17
of time shall be recognised as a financing expense in
profit or loss. IFRS 5.17
A: 4.4 Measurement when the NCA is acquired with the intention to sell (IFRS 5.16)
The measurement of NCAs that are acquired with the NCAs acquired with the
intention to sell follows the same measurement intention of being sold are
principles as described above, but with a slight measured:
using the same principles = lower of:
modification. The modification is that, instead of - carrying amount; and
recognising and measuring the asset as, for example, an - FV less costs to sell.
item of property, plant and equipment, and then where the CA is what it would have
reclassifying and remeasuring it as a NCA held for sale, been if it wasn’t classified as HFS.
the acquisition of the asset is immediately recognised Thus it is effectively measured at:
and measured as a held for sale asset. As a result, the FV-CtS See IFRS 5.15 & .25
NCA must be immediately measured on its initial
recognition at the lower of its:
carrying amount had it not been classified as held for sale (e.g. its cost), and
fair value less costs to sell. IFRS 5.16 reworded slightly
In other words, in the case of a NCA that is acquired with the sole purpose of selling it, it will
not be initially recognised and measured at cost and then reclassified to held for sale and
remeasured at fair value less costs to sell. Instead, it will immediately be recognised as a held
for sale asset and will thus be immediately measured at the lower of what its carrying amount
would have been on this date if it had not been classified as held for sale and its fair value less
costs to sell.
Since the asset’s purchase cost is typically equal to its fair value on date of purchase, it means
that, if the asset is acquired with the intention of selling it, this asset will effectively be
measured at fair value less costs to sell – it would not be initially measured at cost as is
normal practice on the initial recognition of an asset. This is because selling costs are
normally expected in order to sell an asset and thus fair value less costs to sell would
normally be lower than its carrying amount (cost) (i.e. carrying amount on date of purchase
had the item not been classified as HFS = cost = fair value and thus fair value less costs to
sell will be the lower amount).
A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD (IFRS 5.18 -

5.21 & 5.25)
A: 4.5.1 Initial measurement (on the date of classification)
There are 3 steps to measuring the non-current asset on the date of the classification:
Before reclassifying the asset to ‘held for sale/ distribution’ (i.e. before transferring it to a
HFS/ HFD account): Measure the asset one last time in terms of its previous IFRS.
For example: if the asset was previously an item of property, plant and equipment (PPE)
that was measured using IAS 16’s:
- Cost model: we would depreciate to date of classification and then check for any
indication of an impairment; or
- Revaluation model: we would depreciate to date of reclassification, revalue to its fair
value if materially different and check for any indication of an impairment. See IFRS 5.18
Chapter 12 581
Transfer the asset from its previous classification to Steps to initial

‘held for sale’ measurement:
For example: transfer the asset from property, plant Before reclassifying: measure the
and equipment to ‘held for sale’. asset one last time in terms of its
previous IFRS
After transferring (i.e. classifying) to ‘held for sale’: Reclassify (i.e. transfer this asset
Measure the asset in terms of IFRS 5, which to a new HFS (or HFD) account)
requires measuring it at the lower of: After reclassifying: measure the
asset to the lower of
- Carrying amount (CA), and - CA and
- Fair value less costs to sell (FV-CtS). IFRS 5.15 - FV-CtS (or FV – CtD)
Remember, that there are certain non-current assets that, although are subjected to IFRS 5
classification and presentation requirements, will not be subjected to IFRS 5’s measurement
requirements. These are referred to as the scoped-out non-current assets.
Worked example: If the non-current asset held for sale was previously investment
property that was measured under the fair value model:
it will be reclassified to ‘held for sale’, and
it will be presented and disclosed as ‘held for sale’, but
IFRS 5’s measurement principles will not apply to this property and it will continue to
be measured under IAS 40’s fair value model. IFRS 5.5
A: 4.5.2 Subsequent measurement (after the date of classification as held for sale)
The measurement principles after classification as ‘held
Steps to subsequent
for sale’ are quite simple: measurement:
The asset is no longer depreciated or amortised. Stop depreciating/ amortising
The asset continues to be periodically re-measured Re-measure to lower of
- CA and
to the lower of carrying amount and its latest fair - FV-CtS
value less costs to sell. See IFRS 5.15 & .25
Subsequent re-measurement could
The re-measurements may result in either: result in an:
impairment loss; or
an impairment loss, or impairment loss reversal.
an impairment loss reversal.
The impairment loss reversed may need to be limited
Impairment losses reversed
since impairment losses reversed must not exceed the are limited to:
cumulative impairment losses that have previously been
the cumulative impairment losses
recognised, both: recognised in terms of:
in terms of IAS 36 Impairment of assets; and - IAS 36 (i.e. prior to
classification as HFS); plus
in terms of IFRS 5 Non-current assets held for sale - IFRS 5. IFRS 5.21
and Discontinued operations. See IFRS 5.21
See IASPlus Guide on IFRS 5: 2008, example 4.1F
What is meant by ‘carrying amount’?
IFRS 5 does not define ‘carrying amount’ and thus there are a number of interpretations as to how
to apply the measurement rule of ‘lower of carrying amount and fair value less costs to sell’.
This text has adopted the following Deloitte interpretation:
the measurement rule ‘lower of CA and FV-CtS’ means that the NCAHFS may not be re-measured to ‘FV-
CtS’ if this is greater than the
‘carrying amount that the plant would have had
- on the date it was classified as held for sale
- assuming no prior impairment loss had ever been recognised under IAS 36’,
- i.e CA = Cost – Accumulated depreciation to the date of the classification
By way of explanation, let us now consider examples involving an item of ‘property, plant
and equipment’ that is now to be reclassified as a ‘held for sale’. Under IAS 16 Property,
plant and equipment, this plant could have been measured using either the:
Cost model; or
Revaluation model.
582 Chapter 12
A: 4.6 Measurement principles specific to the cost model

A: 4.6.1 The basic principles when the cost model was used
If an asset measured under the cost model is classified as ‘held for sale’:
immediately before classifying the asset as ‘held for sale’, the asset must be measured
using its previous cost model in terms of IAS 16:
depreciate it to date of classification, and
test for impairments;
then transfer it to NCAHFS;
immediately after reclassifying the asset as ‘held for sale’, the asset must be measured in
terms of IFRS 5:
Measure it to the lower of:
- Carrying amount (CA), and
- Fair value less costs to sell (FV-CtS); IFRS 5.15
Stop depreciating it; IFRS 5.25 and
Periodically re-measure to ‘fair value less costs to sell’ whenever appropriate. This
may require the recognition of an impairment loss or an impairment loss reversal.
Impairment losses are always recognised as expenses in profit or loss whereas impairment
losses reversed are recognised as income in profit or loss.
Impairment loss reversals are limited to the asset’s cumulative impairment losses, in other
words the impairment losses previously recognised in terms of IAS 36 plus the impairment
losses recognised in terms of IFRS 5. IFRS 5.20-21 & IFRS 5.37
Furthermore, when recognising an impairment loss reversal, we must remember that the
NCAHFS must always be measured at the lower of its CA (i.e. interpreted to mean the
depreciated cost, see interpretation in section A: 4.5.2) and its FV-CtS.
Costs to sell (IFRS 5) versus disposal costs (IAS 36)?
Have you noticed that:
IFRS 5 measures assets held for sale at the lower of:
- carrying amount and fair value less costs to sell, whereas
IAS 36 measures recoverable amount at the higher of:
- value in use and fair value less costs of disposal.
The term cost of disposal (IAS 36) is a wider term than costs to sell (IFRS 5) because IAS 36 refers to not
only disposal by way of sale, but to any form of disposal (e.g. abandoning or scrapping).
It is submitted that, when referring to an asset that is expected to be sold:
the costs to sell (IFRS 5) will be the same as the cost of disposal (IAS 36)
Thus we will use the terms costs to sell and costs of disposal interchangeably in the following examples (i.e.
you may assume that they are the same amounts).
Example 1: Measurement on date classified as HFS (previously: cost model)

All criteria for classification of a plant as a ‘held for sale’ asset were met on
1 January 20X3, when the asset had the following account balances:
Cost: 100 000 and
Accumulated depreciation: 20 000 (the asset has never been impaired).
This plant had been measured using the cost model in IAS 16.
Required: Journalise the re-classification of plant (PPE) to HFS assuming that on 1 January 20X3:
A. the fair value is C70 000, the expected costs to sell are C5 000 and the value in use is C90 000;
B. the fair value is C70 000, the expected costs to sell are C5 000 and the value in use is C72 000;
C. the fair value is C70 000, the expected costs to sell are C5 000 and the value in use is C60 000.
You may assume that the expected costs to sell (used for measuring the NCAHFS) were a fair
indication of expected costs of disposal (used for impairments).
Chapter 12 583
Solution 1: Measurement on date classified as HFS (previously: cost model)

Comment: Remember the following:
The asset’s carrying amount (CA) must be checked for impairments by comparing to its
recoverable amount (RA) before transferring to NCAHFS.
The recoverable amount (RA) is the greater of:
value in use (VIU); and
fair value less costs of disposal (FV-CoD).
If the CA before transfer is greater than the RA, then the asset is impaired in terms of ‘IAS 36
Impairment of assets’. If this RA is represented by VIU (i.e. VIU > FV-CoD), then this asset could
be further impaired after classification (i.e. if the CA transferred is greater than FV-CtS).
Compare A, B and C: These examples show how an impairment can be recognised under IAS 36
(while still PPE), under IFRS 5 (when classified as HFS) or under both IAS 36 and IFRS 5.
A: the CA of the PPE is less than its RA and therefore the PPE is not impaired, but the CA
transferred to NCAHFS is greater than its FV-CtS and thus the NCAHFS is impaired.
B: the CA of the PPE is greater than its RA and thus the PPE is impaired, and the CA
transferred to NCAHFS is greater than its FV-CtS and thus the NCAHFS is also impaired.
C: the CA of the PPE is greater than its RA and thus the PPE is impaired, but the CA
transferred to NCAHFS was less than its FV-CtS and thus the NCAHFS is not impaired.
Workings: A B C
W1: Impairment of plant before classification: (i.e. measured as PPE: IAS 16 & IAS 36)
PPE: carrying amount Cost: 100 000 – Acc depr: 20 000 80 000 80 000 80 000
PPE: Recoverable amount Higher of: (90 000) (72 000) (65 000)
FV-CoD: 70 000 – 5 000 = 65 000 and:
A: VIU:90 000; thus RA=90 000
B:VIU: 72 000; thus RA=72 000
C:VIU: 60 000; thus RA=65 000
PPE: Impairment IAS 36 Impairment of PPE on 1 January 20X3 0 8 000 15 000
Plant transferred at Lower of CA and RA 80 000 72 000 65 000
W2: Impairment of plant after classification: (i.e. measured as NCAHFS: IFRS 5)
NCAHFS: CA Transfer at the PPE CA calculated in W1 80 000 72 000 65 000

NCAHFS: FV-CtS A, B & C: FV-CtS: 70 000 – 5 000 (65 000) (65 000) (65 000)
IFRS 5
NCAHFS: Impairment Impairment of NCAHFS on 1 Jan 20X3 15 000 7 000 0
Journals: A B C
Debit/ Debit/ Debit/
1 January 20X3 (Credit) (Credit) (Credit)
Impairment loss – PPE (E) W1 N/A 8 000 15 000
PPE: Plant: acc impairment loss (-A) N/A (8 000) (15 000)
Impairment loss before classification as ‘HFS’
PPE: Plant: acc depreciation (-A) Given 20 000 20 000 20 000

PPE: Plant: cost (A) Given (100 000) (100 000) (100 000)
NCAHFS: Plant: Cost-AD W1 80 000 80 000 80 000
PPE: Plant: acc impairment loss O/bal : 0 + IL (W1) N/A 8 000 15 000
NCAHFS: Plant: acc imp loss N/A (8 000) (15 000)
Transfer of plant to non-current asset held for sale
Impairment loss – NCAHFS (E) W2 15 000 7 000 N/A

NCAHFS: accumulated impairment loss (-A) (15 000) (7 000) N/A
Impairment loss after classification as ‘held for sale’
584 Chapter 12
Note:
Depreciation on this asset stops from the date it is classified as HFS (i.e. it is now measured in
terms of IFRS 5)
IFRS 5 does not require you to separate the NCAHFS ledger accounts into the following:
its old carrying amount, being calculated as ‘cost – accumulated depreciation’, and
any accumulated impairment losses relating to the asset
However. This is considered a good idea because any future reversals of impairment losses on a
NCAHFS are limited to these accumulated impairment losses (total of accumulated impairment
losses in terms of IAS 36 + IFRS 5)
In all three scenarios, the NCAHFS is measured at 65 000 and the total impairment is 15 000 but
the difference is that this impairment is recognised:
A: under IFRS 5 only,
B: under both IAS 36 and IFRS 5 , and
C: under IAS 36 only.
Example 2: Re-measurement after classification as HFS (previously: cost model)

reversal of impairment loss is limited
A plant met all criteria for classification as ‘held for sale’ on 1 January 20X3, when:
Cost: C100 000 and
Accumulated depreciation: C20 000 (the asset has never been impaired).
The following values were established on this date:
Fair value C70 000
Costs to sell C5 000 (these were a fair indication of the estimated costs of disposal)
Value in use C72 000.
Required: Journalise the re-measurement of the non-current asset held for sale at year-end
30 June 20X3 (i.e. 6 months after re-classification from PPE to NCAHFS) assuming that:
A. on 30 June 20X3: fair value is C70 000 and expected costs to sell are C2 000;
B. on 30 June 20X3: fair value is C90 000 and expected costs to sell are C5 000.
Solution 2: Re-measurement after classified as HFS: impairment loss reversal is limited

Comment:
This example continues from example 1B where on date of classification as held for sale (HFS):
the PPE was impaired for the very first time immediately before reclassification, and
the NCAHFS was impaired immediately after reclassification.
This example explains the limit to the reversal of an impairment loss. The essence is simply that if
the fair value less costs to sell (FV-CtS) subsequently increases:
recognise a ‘reversal of impairment loss’ (income) – but remember that this reversal is limited
in two ways:
- the reversal is limited to the previous accumulated impairment losses on the asset,
whether they arose in terms of IAS 36 or IFRS 5! (let’s call this the ‘first limit’)
- the new carrying amount of the NCAHFS must continue to be measured at the lower of
the CA and FV-CtS (let’s call this the ‘second limit’).
Workings: A B
W1: Subsequent re-measurement of plant after classification as NCAHFS: IFRS 5.15 and 5.20-.21
W1.1: Subsequent increase in FV - CtS

FV-CtS: 30/06/X3 A: 70 000 – 2 000 = 68 000 68 000 85 000
B: 90 000 – 5 000 = 85 000
Less:
Lower of CA & FV-CtS:01/01/X3 See example 1B: (65 000) (65 000)
Increase in value: 3 000 20 000
Chapter 12 585
W1.2: First limit:

Subsequent increase in value is limited to prior accumulated impairment losses: IFRS 5.21
A B
Increase in value: W1.1 3 000 20 000
Limited to prior cumulative PPE impairment: 8 000 + NCAHFS (15 000) (15 000)
impairment losses impairment: 7 000 (See example 1B)
Excess disallowed N/A 5 000
Increase in value after first A: not limited (3 000 – excess: N/A) * 3 000 15 000
limitation*: B: limited (20 000 – excess: 5 000)
(20 000 Increase > 15 000 AIL) *
* Note: The prior cumulative impairment loss recognised on this asset was 15 000 before the
reversal, and thus:
A. The reversal of 3 000 is not limited (the previous cumulative impairment losses of 15 000 is
bigger than 3 000). A further 12 000 may be reversed in future if necessary.
B. The reversal of 20 000 is limited (the balance on the previous accumulated impairment losses is
only 15 000 (less than 20 000), and thus limits, the potential reversal of 20 000). No further
reversals are possible in the future.
W1.3: Second limit:
New carrying amount is limited to carrying amount of PPE on date of classification: IFRS 5.15
A B
NCAHFS: CA on 01/01/X3 was: See example 1B: 65 000 65 000
Plus planned impairment loss reversal: 30/06/X3 W1.2 above 3 000 15 000
NCAHFS: CA on 30/06/X3 would be: 68 000 80 000
Limited to: CA of the PPE on date it was Cost: 100 000 – AD: 20 000 (80 000) (80 000)
classified ignoring imp losses: 01/01/X3
Excess disallowed There is no excess N/A N/A
Therefore, impairment loss reversal *: Not limited – see note below 3 000 15 000
* Note:
W1.1 calculates whether the FV-CtS has increased/ decreased since the prior measurement date.
W1.2 ensures that any increase does not exceed the prior accumulated impairment losses (whether
recognised in terms of IAS 36 and/ or IFRS 5).
W1.3 checks that the new CA of the NCAHFS (i.e. after reversing the proposed impairment loss)
will not exceed the CA of the PPE on date of classification ignoring IAS 36 impairment losses (i.e.
cost – accumulated depreciation).
The following is an alternative layout combining W1, W2 and W3:
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS: IFRS 5.15 &.20-.21
A B
Lower of CA: 01/01/X3 & FV-CtS: 30/06/X3 68 000 80 000
CA on date classified but A&B: Cost: 100 000 – AD: 20 000 80 000 80 000
ignoring imp losses: 01/01/X3
FV - CtS: 30/06/X3 A: 70 000 – 2 000 = 68 000 68 000 85 000
B: 90 000 – 5 000 = 85 000
Less:
Lower of CA & FV-CtS: 01/01/X3 See example 1B: (65 000) (65 000)
Impairment loss reversal: 3 000 15 000
Proof: The impairment loss reversal may not exceed the prior cumulative impairment losses IFRS 5.21
Impairment loss reversal Above 3 000 15 000
Limited to prior cumulative PPE impairment: 8 000 + NCAHFS (15 000) (15 000)
impairment losses impairment: 7 000 (See example 1B)
Excessive reversal disallowed See note overleaf N/A N/A
Note:
586 Chapter 12
This alternative layout of W1 will automatically limit any impairment loss reversal to prior cumulative
impairment losses and thus the comparison of the planned impairment loss reversal to prior cumulative
impairment losses in the above table is only a ‘proof’ on your workings.
Journals: A B
30 June 20X3 Dr/(Cr) Dr/(Cr)
NCAHFS: accumulated impairment losses (-A) 3 000 15 000
Impairment loss reversed – NCAHFS (I) (3 000) (15 000)
Reversal of impairment loss: on re-measurement of ‘NCA held for sale’
Example 3: Measurement on date classified as a NCAHFS and Re-measurement

of NCAHFS (previously: cost model):
reversal of impairment loss limitation
Light Limited owns a plant, measured using the cost model, and which had a carrying amount of
C64 000 on 31 December 20X2:
Cost: 100 000 (purchased on 1 January 20X1)
Accumulated impairment loss: 18 000 (processed on 31 December 20X1)
Accumulated depreciation: 18 000 (depreciation at 10% pa straight line to nil residual values).
On 5 January 20X3, the company that originally supplied the plant to Light Limited announced the
release of an upgraded version of the plant that could decrease processing costs by nearly 20%. On this
date, management placed an order for the new plant and decided that the plant on hand would be sold.
All criteria for classification as a ‘non-current asset held for sale’ are met on 8 January 20X3 on which
date the following values were established:
Value in use: 75 000
Fair value less costs to sell (IFRS 5) & Fair value less costs of disposal (IAS 36): 60 000
Required:
A. Journalise the re-classification from PPE to NCAHFS on 8 January 20X3 (depreciation for the
period 01/01/X3 – 08/01/X3 is considered insignificant and must be ignored);
B. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 75 000;
C. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 82 000;
D. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 85 000.
Solution 3: NCAHFS impairment losses reversed are limited

Comment on parts A, B, C and D:
This example also explains the limit to the reversal of an impairment loss when subsequently re-
measuring the non-current asset held for sale (NCAHFS), but it differs slightly.
It differs in that it shows how to apply the limit to the reversal of the impairment loss when an item
of PPE already had a balance on its accumulated impairment loss from impairments processed in
the years before the date on which it is classified as held for sale.
Part A shows the initial measurement on date of classification as a NCAHFS.
Part B, C and D show three different scenarios regarding the re-measurement of the NCAHFS after
the date of classification as a NCAHFS.
Part B, C and D show that an impairment loss reversal on a NCAHFS is limited to the prior
cumulative impairment losses and the carrying amount of a NCAHFS may not exceed the carrying
amount calculated as if it had never been impaired/ classified as HFS, in other words, measure at
the lower of:
carrying amount, calculated as: cost – accumulated depreciation; and
fair value less costs to sell.
Solution 3A: Measurement on date classified as HFS (previously: cost model)
Comment on Part A: This example reflects a situation where, on date of classification, the PPE is not
further impaired, but the NCAHFS is impaired (a similar example can be found in Example 1A).
Chapter 12 587
Immediately before the transfer to NCAHFS (8 January 20X3), the plant is measured one last time
as PPE. In terms of IAS 16 and IAS 36, the CA of C64 000 is less than its RA of C75 000 (VIU:
C75 000 is higher than FV-CoD: C60 000) and thus there is no impairment of the plant whilst it is
classified as PPE. However, since the RA was greater than its CA, an impairment loss reversal is
applicable as there were previous impairment losses recognised in accordance with IAS 36 of
C18 000.
The plant is then transferred to NCAHFS at C75 000. See working 1.
Once classified as NCAHFS, it must be measured to the lower of CA and FV-CtS. The FV-CtS
was 60 000 and thus the NCAHFS is impaired by C15 000 (in terms of IFRS 5). See working 2.
W1: Measurement of plant before classification as NCAHFS: (IAS 16 & IAS 36) C
PPE: Carrying amount: 08/01/X3 Cost: 100 000 – AD: 18 000 – AIL: 18 000 Note 1 64 000
PPE: Recoverable amount: 08/01/X3 Higher of VIU: 75 000 and FV-CoD: 60 000 (75 000)
PPE: Impairment of plant: 08/01/X3 RA > CA: No further impairment under IAS 36 11 000
but there is an impairment loss reversal
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial
Asset transferred from PPE to NCAHFS Lower of CA and RA 75 000

W2: Measurement of plant after classification as NCAHFS: (IFRS 5) C
NCAHFS: Carrying amount: 8/01/X3 W1 75 000
NCAHFS: FV – CtS: 8/01/X3 Given (60 000)
NCAHFS: Impairment of plant: 8/01/X3 Impairment under IFRS 5 15 000
Journals: 8 January 20X3 Debit Credit

PPE: Plant: acc impairment loss (-A) O/bal (given): 18 000 – reversal: 7 000
11 000 (W1)
PPE: Plant: acc depreciation (-A) Given 18 000
PPE: Plant: cost (A) Given 100 000
NCAHFS: Plant: Cost – AD (A) Cost: 100 000 – AD: 18 000 82 000
NCAHFS: Plant: acc impair loss (-A) Bal in the PPE: AIL account 7 000
Transfer of plant to non-current asset held for sale: CA was 64 000
Impairment loss – NCAHFS (E) IFRS 5 impairment (W2) 15 000
NCAHFS: Plant: acc impairment loss (-A) 15 000
IFRS 5 Impairment loss on date of classification as held for sale
Note:
This asset will no longer be depreciated.
The cumulative impairment loss to date is now C22 000:
(IAS 36: 18 000 – 11 000 + IFRS 5: 15 000)
Solution 3B, 3C & 3D: Re-measurement of NCAHFS: reversal of impairment loss

limitation (previously: cost model)
Comment:
This example shows that any impairment reversal is limited by the following two rules:
First limit: The impairment loss reversal may not exceed the prior accumulated impairment
losses (whether in terms of IAS 36 and / or IFRS 5) – this limit is shown in W1.2 IFRS 5.21
Second limit: The new carrying amount after the impairment loss reversal may not exceed the
carrying amount of the PPE on date of classification, where this carrying amount is interpreted
to mean: ‘cost – accumulated depreciation’ (i.e. ignoring prior IAS 36 impairment losses) – this
limit is shown in W1.3 IFRS 5.15
Example B shows an impairment reversal that is not limited at all. (First limit)
Solution 3B, 3C & 3D: Continued ...
Example C shows an impairment reversal that was not limited by the first limit (i.e. prior
accumulated impairment losses) but was limited by the second limit (i.e. the CA of the NCAHFS
may not exceed the CA of the PPE on the date of classification, ignoring prior impairment losses)
588 Chapter 12
Example D shows an impairment reversal that is limited by both the first and second limit.
Workings: B C D
IFRS 5.15 and 5.20 -.21
W1: Subsequent re-measurement of plant after classification as NCAHFS:
W1.1: Re-measurement to FV-CtS: IFRS 5.20-.21
FV-CtS: 30/06/X3 Given 75 000 82 000 85 000
Less:
Lower of CA & FV-CtS: 08/01/X3 Given (See 3A: W2) (60 000) (60 000) (60 000)
Increase in value: 15 000 22 000 25 000
W1.2: First limit:

B C D
Increase in value: W1.1 15 000 22 000 25 000
Limited to prior cumulative PPE impairment: 7 000 + NCAHFS (22 000) (22 000) (22 000)
impairment losses impairment: 15 000 (see ex 3A: W1 & W2)
Excess disallowed N/A N/A 3 000
Increase in value after See note below: 15 000 22 000 22 000
first limitation*: A: not limited (15 000 – excess: 0)
B: not limited (22 000 – excess: 0)
C: is limited (25 000 – excess: 3 000)
* Note regarding the first limitation:
The cumulative impairment loss recognised on this asset is 22 000 before the reversal, thus:
B: The intended increase of 15 000 (W1.1) is not limited by this first limit (previous cumulative
impairment losses: 22 000 > increase: 15 000). A cumulative impairment loss of 7 000 remains.
C: The intended reversal of 22 000 (W1.1) is not limited by this first limit (the prior cumulative
impairment losses 22 000 = the increase 22 000). The remaining cumulative impairment loss is nil.
D: The intended reversal of 25 000 (W1.1) is limited by the first limit (the previous cumulative imp
loss: 22 000 < the increase: 25 000). The increase of 25 000 may not be processed in full: the
reversal to be processed is limited to 22 000. No cumulative impairment loss remains.
W1.3: Second limit:
New carrying amount is limited to carrying amount on date of classification IFRS 5.15
B C D
NCAHFS: CA on 08/01/X3 was: Given (See 3A: W2) 60 000 60 000 60 000
Plus planned impairment loss W1.2 15 000 22 000 22 000
reversal: 30/06/X3
NCAHFS: CA on 30/06/X3 would be: 75 000 82 000 82 000
Limited to: CA of the PPE on date it Cost: 100 000 – AD: (100 000 (80 000) (80 000) (80 000)
was classified, ignoring imp losses: – RV: 0) x 10% x 2yrs
01/01/X3
Excess disallowed B: not limited N/A 2 000 2 000
C & D: limited
See note below
Thus, impairment loss reversal: Note 1 B: not limited 15 000 20 000 20 000
C & D: increase of 22 000 –
excess disallowed 2 000
Note 1:
B was not limited by either the first limit (W1.2) or the second limit (W1.3).
C was not limited by the first limit (W1.2) but yet was limited by the second limit (W1.3).
D was limited by both the first limit (W1.2) and the second limit (W1.3).
Solution 3B, 3C & 3D: Continued ...
The following is an alternative layout of working 1:
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS:
Chapter 12 589
B C D
Lower of CA 08/1/20X3 and FV-CtS: 30/06/X3 75 000 80 000 80 000
CA on date classified, ignoring Cost: 100 000 – AD Note 1: 80 000 80 000 80 000
imp losses: 08/01/X3 (100 000 - 0) x 10% x 2 yrs
FV - CtS: 30/06/X3 Given 75 000 82 000 85 000
Less:
Lower of CA and FV-CtS: 08/01/X3 Given (See 3A: W2) (60 000) (60 000) (60 000)
Impairment loss reversal 15 000 20 000 20 000
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial
Proof: The impairment loss reversal may not exceed the prior cumulative impairment losses IFRS 5.21
B C D
Impairment loss reversal Above 15 000 20 000 20 000
Limited to prior cumulative imp losses IAS 36: 7 000 + IFRS 5: 15 000 (22 000) (22 000) (22 000)
Excessive reversal disallowed See note below N/A N/A N/A
Note:
impairment losses in the above table is only a proof or a ‘check’ on your workings.
Journals: B C D
30 June 20X3 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
NCAHFS: acc. imp losses (-A) W1.3 or W1 (alternative) 15 000 20 000 20 000
Impairment loss reversed – NCAHFS (I) (15 000) (20 000) (20 000)
Reversal of impairment loss when re-measuring the NCAHFS
Note:
There is no depreciation on this asset as it is classified as a NCAHFS.
The cumulative impairment loss to date is now:
B: 7 000 (AIL 22 000 – Reversal 15 000), but of which a reversal of only C5 000 is possible in
future (a reversal in excess of C5 000 would increase the latest CA of the NCAHFS from
75 000 to above the CA of the PPE on date of classification calculated ignoring any
impairment losses of 80 000 (Cost: 100 000 – Accumulated depreciation on date of
classification: 20 000).
C&D: 2 000 (AIL 22 000 – Reversal 20 000), but of which no further reversal is possible (any
further reversal would increase the CA of the NCAHFS from 80 000 above the CA of the PPE
on date of classification calculated ignoring any impairment losses of 80 000 (Cost: 100 000 –
Accumulated depreciation on date of classification: 20 000).
590 Chapter 12
A: 4.6.2 The tax effect when the cost model was used
As soon as an asset is classified as held for sale, depreciation thereon ceases. The tax
authorities, however, generally do not stop allowing tax deductions (assuming that the cost of
the asset was tax deductible) simply because you have decided to sell the asset.
The difference between an accountant’s nil depreciation (and any impairment losses or
reversals) and the tax authority’s tax deductions (assuming the cost of the asset is tax
deductible) causes a temporary difference on which deferred tax must be recognised.
The principles affecting the current tax payable and deferred tax balances are therefore
exactly the same as for any other non-current asset.
Example 4: Tax effect of classification as NCAHFS and the cost model
Plant, measured using the cost model, has the following balances on 31 December 20X2:
Cost of C100 000 (1 January 20X2)
Accumulated depreciation of C30 000
Accumulated impairment losses of 0
A tax base of C90 000.
All criteria for classification as ‘held for sale’ are met on 8 January 20X3, following a
decision on this date to purchase an upgraded model of the plant. On this date:
Fair value less costs of disposal & Fair value less costs to sell is C65 000, and
Value in use is C80 000.
Other information for the year ended 31 December 20X3:

The tax authorities allow the deduction of the cost of this asset at 10% per annum.
The profit before tax is correctly calculated to be C200 000.
There are no differences between accounting profit and taxable profit other than those
evident from the information provided and no taxes other than income tax at 30%.
Required:
A. Calculate the current tax payable and the deferred tax balance at 31 December 20X3.
B. Journalise the current tax and the deferred tax for the year ended 31 December 20X3.
Solution 4A: Calculations

W1. Current income tax Calculations C
Profit before tax Given 200 000

Add back depreciation on Plant is now a NCAHFS & thus not depreciated 0
plant
Add back impairment on plant Impairment of NCAHFS in terms of IFRS 5: 5 000
CA of PPE: 70 000 (Cost 100 000 – AD: 30 000) – FV-CtS
of NCAHFS: 65 000 (given)
Less tax deduction on plant Cost: 100 000 x 10% pa (10 000)
Current tax 195 000 x 30% 58 500
Note: The impairment and depreciation expenses are added back to profit before tax as they are
accounting entries that are not allowed as a deduction for tax purposes.
W2. Deferred tax: Carrying Tax Temporary Deferred

PPE – NCAHFS amount base difference tax
Balance – 1 January 20X3 70 000 90 000 20 000 6 000 Asset

Less impairment of CA to FV-CtS (5 000) 0
Cr DT,
(CA: 70 000 – FV-CtS: 65 000) (5 000) (1 500)
Dr TE
Depreciation/ tax allowance 0 (10 000)
Balance – 31 December 20X3 65 000 80 000 15 000 4 500 Asset
Chapter 12 591
Solution 4B: Journals

Current tax payable (estimated)
Deferred tax: income tax (A is reduced) 1 500
Deferred tax adjustment
A: 4.7 Measurement principles specific to the revaluation model

A: 4.7.1 The basic principles when the revaluation model was used
If an asset measured under the revaluation model is classified as ‘held for sale’, we need to
follow these steps:
Step 1: immediately before reclassifying the asset as ‘held for sale’, the asset must be
measured using its previous revaluation model in terms of IAS 16:
depreciate it to date of classification as ‘held for sale’;
re-measure to fair value (if materially different to the carrying amount); and
check for impairments;
Step 2: transfer it to NCAHFS;
Step 3: immediately after reclassifying the asset as ‘held for sale’, the asset must be
measured in terms of IFRS 5:
Measure it to the lower of:
- Carrying amount (CA), and
- Fair value less costs to sell (FV-CtS); IFRS 5.15
Stop depreciating it; IFRS 5.25 and
Step 4: Periodically re-measure to ‘fair value less costs to sell’ whenever appropriate:
this may necessitate the recognition of an impairment loss or an impairment loss reversal.
An impairment loss recognised in terms of IFRS 5 is An impairment loss is
always recognised as an expense in profit or loss, even if always expensed in P/L
there is a related revaluation surplus balance (i.e. from a even if there is a
revaluation surplus!
prior revaluation in terms of IAS 16). A revaluation
surplus balance existing on the date of reclassification to
‘held for sale’ remains there until the asset is sold, at which point this balance will be transferred
to retained earnings. IFRS 5.37 & .20
Impairment losses reversed are recognised as income in An impairment loss
profit or loss. IFRS 5.37
The amount of an impairment loss reversed is always an
income in P/L.
reversed is limited to the asset’s cumulative impairment
It is limited in 2 ways:
losses recognised. IFRS 5.21 A further limitation is possible
The IL reversed must never exceed
in that, when reversing an impairment loss, the NCAHFS the cumulative IL recognised in terms
must always be measured at the lower of its carrying of IAS 36 & IFRS 5
amount and fair value less costs to sell, (where the The CA after the IL reversed must
carrying amount is measured on date of classification, never exceed the lower of CA (where
the reval model was used, the CA is
calculated as if it had never been impaired: see the depreciated FV) and FV-CtS (see
interpretation in section A: 4.5.2 above). interpretation in section A: 4.5.2)
Example 5: Measurement on date classified as HFS

previously: revaluation model
An item of plant, measured under IAS 16’s revaluation model, met all criteria for
classification as ‘held for sale’ on 1 January 20X4. The following information is relevant:
Cost: 100 000 (purchased 1 January 20X1)
Depreciation: 10% per annum straight-line to nil residual values
Fair value: 120 000 (revalued 1 January 20X3)
Revaluations are performed using the net replacement value method
592 Chapter 12
The value in use has always been greater than the plant’s carrying amount and therefore
the asset has not previously been impaired. (Costs to sell equal costs of disposal)
Required: Journalise the reclassification of plant (PPE) to HFS assuming that on 1 January 20X4:
A. Fair value is C100 000, the expected selling costs are C9 000 and the value in use is C105 000;
B. Fair value is C150 000, the expected selling costs are C20 000 and the value in use is C155 000.
C. Fair value is C60 000, the expected selling costs are C20 000 and the value in use is C65 000.
Solution 5: Measurement on date classified as HFS (previously: revaluation model)

Comment: This example explains the following:
How to measure an asset on the date it is classified (transferred) from PPE to NCAHFS and where
it was previously measured under the revaluation model:
Measure in terms of IAS 16 before reclassifying: revalue to FV and check for impairments
- A and C reflect a decrease in the FV of the PPE;
- B reflects an increase in the FV of PPE.
Measure in terms of IFRS 5 immediately after reclassifying: at lower of CA & FV - CtS
- A, B and C all reflect an impairment loss.
If the asset is impaired in terms of IFRS 5 (i.e. once the asset has been classified as a NCAHFS),
this impairment loss is expensed, even if there is a revaluation surplus balance (see A and B).
Workings:
W1: Measurement of plant before classification as NCAHFS (IAS 16 & IAS 36)
W1.1 Revaluation in terms of IAS 16 A B C
PPE: CA: 1/01/X3 100 000 – (100 000-0) x 10% x 2 yrs 80 000 80 000 80 000
PPE: Rev surplus:1/01/X3 Balancing: FV 120 000 – CA 80 000 40 000 40 000 40 000
PPE: FV: 1/01/X3 Given 120 000 120 000 120 000
PPE: Acc. depr: 31/12/X3 120 000/ 8 remaining years (15 000) (15 000) (15 000)
PPE:CA: 1/01/X4 Balancing: 120 000 – 15 000 105 000 105 000 105 000
PPE: Incr/(decr): 1/01/X4 Balancing – also see note 1 (5 000) 45 000 (45 000)
-Adjust reval surplus A&C: decrease, limit to RS bal: (W3) (5 000) 45 000 (35 000)
-Adjust reval expense A: nil since deval does not exceed RS bal (0) N/A (10 000)
B: N/A since it was an increase in FV
C: deval: 45 000 exceeds RS bal: 35 000
PPE: FV: 1/01/X4 Given 100 000 150 000 60 000

W1.2 Check for impairments in terms of IAS 16 & IAS 36: A B C
PPE: FV: 01/01/X4 before impairment See W1.1/ Given 100 000 150 000 60 000
PPE: Recov Amt: 01/01/X4 Greater of VIU and FV-CoD 105 000 155 000 65 000
- Value in use Given 105 000 155 000 65 000
- FV less costs of disposal A: 100 000 – 9 000 = 91 000 91 000 130 000 40 000
B: 150 000 – 20 000 = 130 000
C: 60 000 – 20 000 = 40 000
PPE: Imp loss expense RA is greater than CA N/A N/A N/A
Therefore:
PPE: FV: 01/01/X4 before impairment See W1.1/ Given 100 000 150 000 60 000
Less IAS 36 impairment loss expense See W1.2 (0) (0) (0)
PPE: Carrying amt: 01/01/X4 None were impaired 100 000 150 000 60 000
W2: Measurement of plant after classification as NCAHFS (IFRS 5)
(Lower of the PPE’s CA (W1) and FV-CtS IFRS 5.15) A B C
NCAHFS: CA: 1/1/X4 Tfr from PPE: W1.2 100 000 150 000 60 000
NCAHFS: Imp of plant: 1/1/X4 Balancing and see Note 3 9 000 20 000 20 000
NCAHFS: FV-CtS: 1/1/X4 A: 100 000 – 9 000 = 91 000 (91 000) (130 000) (40 000)
B: 150 000 – 20 000 = 130 000
C: 60 000 – 20 000 = 40 000
Chapter 12 593

W3: Balance on revaluation surplus A B C
Revaluation surplus: 01/01/X3 Opening balance 0 0 0

Increase to fair value: 01/01/X3 FV 120 000 – CA 80 000 (W1) 40 000 40 000 40 000
Transfer to ret. earnings: 31/12/X3 40 000 / 8 yrs remaining (5 000) (5 000) (5 000)
Revaluation surplus: 01/01/X4 Before transfer (see Note 1) 35 000 35 000 35 000
Incr/ (decr) in FV: 01/01/X4 W1 (5 000) 45 000 (35 000)
Revaluation surplus: 01/01/X4 After transfer (see Note 4) 30 000 80 000 0
Journals: A B C
1 January 20X4 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
PPE: Plant: acc. depreciation (-A) W1.1: Acc depr to 31/12/X3 15 000 15 000 15 000
PPE: Plant: cost (A) and see Note 2 (15 000) (15 000) (15 000)
NRVM: Acc. depreciation set-off against cost
PPE: Plant: cost (A) W1.1 (5 000) 45 000 (45 000)
Revaluation surplus – plant (OCI) W1.1 5 000 (45 000) 35 000
Revaluation expense – plant (OCI) W1.1 0 0 10 000
Revaluation of plant (PPE) to FV immediately before
reclassification to NCAHFS
NCAHFS: Plant: Cost – AD W1.2 100 000 150 000 60 000
PPE: Plant: cost (A) (100 000) (150 000) (60 000)
Transfer from PPE to NCAHFS on date classified as HFS
(transfer at the CA after any depreciation, revaluation and
impairments to date of classification)
Impairment loss – NCAHFS (E) W2 and see Note 3 9 000 20 000 20 000
NCAHFS: acc imp loss (-A) (9 000) (20 000) (20 000)
Measurement of plant as a NCAHFS on date of classification to
lower of CA as PPE on date of classification and FV-CtS
Comment: There is no further depreciation on this asset.
Notes:
Note 1. We calculate the revaluation surplus balance (W3) immediately prior to the PPE’s final revaluation to fair
value on 1/1/X4, since any drop in its value must first be set-off against this balance and any further
decrease in the value of the PPE is then expensed as a revaluation expense.
Note 2. As the net replacement value method was used, the accumulated depreciation immediately before the
revaluation must be set-off against the cost of the asset before revaluing the asset on 1/1/X4.
Note 3. Despite the fact that a balance remains in the revaluation surplus after the revaluation on 1/1/X4 (see W3: A
& B), the impairment loss relating to the NCAHFS is expensed (i.e. impairments in terms of IFRS 5 are
always expensed). The balance in the revaluation surplus on the date of classification as a NCAHFS
remains there until the asset is disposed of, at which point it will be transferred to retained earnings.
Note 4. While the plant is PPE, the entity would transfer the revaluation surplus to retained earnings over the useful
life of the asset (i.e. at the same rate as the asset is depreciated) but since the asset is now a NCAHFS (from
1/1/X4), both depreciation and this transfer must cease.
Example 6: Re-measurement of a NCAHFS: (previously revaluation model):

further impairments and reversals of impairments
The following relates to a plant that was measured using the revaluation model:
Cost: C100 000 (purchased 1 January 20X1).
Depreciation: 10% per annum straight-line to nil residual values.
Fair value: C120 000 (as at date of revaluation: 1 January 20X3).
Revaluations are performed using the net replacement value method.
594 Chapter 12
The revaluation surplus is transferred to retained earnings over the asset’s useful life.
The recoverable amount has always exceeded the carrying amount.
This plant met all criteria for classification as ‘held for sale’ on 1 January 20X4, on which
date the following values applied (these figures are the same as those used in example 5A):
Fair value of C100 000 and expected selling costs of C9 000 (equated to expected
disposal costs;
Value in use of C105 000.
Required:
Journalise the re-measurement of the NCAHFS at year-ended 30 June 20X4 (i.e. 6 months after
reclassification) assuming that:
A. on 30 June 20X4, the fair value is C110 000 and the expected selling costs are C15 000;
B. on 30 June 20X4, the fair value is C110 000 and the expected selling costs are C3 000;
C. on 30 June 20X4, the fair value is C90 000 and the expected selling costs are C3 000.
Solution 6: Re-measurement of a NCAHFS: the revaluation model
Comment:
This example follows on from example 5A where the journals relating to the measurement on the
date it was classified as a NCAHFS (1 January 20X4) were processed.
This example shows how to re-measure a NCAHFS after the date it was classified as a NCAHFS.
It shows the journals that occur on 30 June 20X4.
This example shows that when re-measuring a NCAHFS, its CA can increase or decrease.
If the CA increases, any impairment loss reversal is limited to prior cumulative impairment losses
(impairments when the asset was PPE: IAS 36 plus impairments when the asset was NCAHFS:
IFRS 5) and the new CA is further limited to the CA that the asset would have had on date of
reclassification, assuming that it had never been impaired:
- Ex 6A shows an impairment loss reversal that was not limited; and
- Ex 6B shows an impairment loss reversal that is limited).
If the CA decreases, the impairment loss is expensed in profit or loss, even if there is a balance on
the RS account:
- Ex 6C shows a further impairment loss when there was a balance in RS (of 30 000).
Workings:
W1: Subsequent re-measurement of plant after classification as NCAHFS: IFRS 5.15 & 5.20-.21
W1.1: Re-measurement to FV-CtS: IFRS 5..20-.21 A B C
FV less costs to sell: 30/06/X4 A: FV: 110 000 – CtS: 15 000 95 000 107 000 87 000
B: FV: 110 000 – CtS: 3 000
C: FV: 90 000 – CtS: 3 000
Less:
Lower of CA & FV-CtS: 01/01/X4 FV: 100 000 – CtS: 9 000 (91 000) (91 000) (91 000)
(see Ex5A: W2)
Increase / (decrease) in value 4 000 16 000 (4 000)
W1.2: First limit: A B C

IFRS 5.21
Subsequent increase in value is limited to prior accumulated impairment losses:
Increase in value before limit W1.1 4 000 16 000 N/A
Limited to prior cumulative PPE impairment: 0 (Ex 5A W1.2) + 9 000 9 000 N/A
impairment losses NCAHFS impairment: 9 000 (Ex 5A: W2)
Increase after the 1st limit NOTE 1 A: 4 000 is not limited by the 9 000 4 000 9 000 N/A
B: 16 000 is limited by the 9 000
C: N/A: there was no increase at all
Chapter 12 595

Note 1: In the case of this first limit:
A: The total cumulative impairment loss recognised on this asset is 9 000 before the reversal, thus the
increase of 4 000 is not limited by the first limitation (the previous cumulative IL of 9 000 is bigger than
4 000). There is a remaining cumulative impairment loss of 5 000.
B: The total cumulative impairment loss recognised on this asset is 9 000 before the reversal, thus the increase
of 16 000 is limited by the first limitation (the previous cumulative IL of 9 000 is less than 16 000). There
is no remaining cumulative impairment loss.
C: The asset decreased in value and thus there is obviously no planned reversal of an impairment loss. The
latest accumulated impairment loss has now increased to 13 000:
the NCAHFS impairment on classification date (Ex 5A: W1.2): 9 000, plus
the NCAHFS impairment after classification date (Ex 6C: W1.1): 4 000.
Impairment losses of 13 000 may thus be reversed in future if necessary.
W1.3: Second limit: A B C

NCAHFS: CA on 01/01/X4 was: Given (See 5A: W2) 91 000 91 000 N/A
Plus planned impairment loss reversal 30/06/X4 W1.2 4 000 9 000 N/A
NCAHFS: CA on 30/06/X4 would be: 95 000 100 000 N/A
Limited to: CA of the PPE on date it was FV: 100 000 – AD: 0 100 000 100 000 N/A
classified (ignoring imp losses): 01/01/X4 (immediately reclassified)
Excess disallowed A, B & C: not limited N/A N/A N/A
Therefore, impairment loss reversal See calculations below 4 000 9 000 N/A
Calculations:
A: planned reversal of 4 000 (W1.2) – excess disallowed 0 (W1.3) = 4 000 reversal of imp loss
B: planned reversal of 9 000 (W1.2) – excess disallowed 0 (W1.3) = 9 000 reversal of imp loss
C: N/A: there was no planned reversal (W1.2); the asset was further impaired instead.
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS:
A B C
Lower of CA: 01/01/X4 and FV-CtS: 30/06/X4 Given 95 000 100 000 87 000
CA on date classified (ignoring FV: 100 000 – Acc depr: 0 100 000 100 000 100 000
imp losses): 01/01/X4
FV - CtS: 30/06/X4 A: FV: 110 000 – CtS: 15 000 95 000 107 000 87 000
B: FV: 110 000 – CtS: 3 000
C: FV: 90 000 – CtS: 3 000
Less:
Lower of CA and FV-CtS: 1/1/X4 FV: 100 000-CtS: 9 000 (Ex5A) (91 000) (91 000) (91 000)
Imp loss reversal / (impairment loss) 4 000 9 000 (4 000)
Check: The impairment loss reversal may not exceed the prior cumulative impairment losses IFRS 5.21
Impairment loss reversal W1 4 000 9 000 N/A
Limited to prior cumulative imp losses See calculation (1) below 9 000 9 000 N/A
Excessive reversal disallowed See note below N/A N/A N/A
Calculation (1): IAS 36 impairment: 0 (Ex 5A: W1.2) + IFRS 5 impairment: 9 000 (Ex 5A: W2)
Note:
impairment losses in the above table is only a ‘check’ on your workings.
596 Chapter 12
Journals: A B C
30 June 20X4 Dr/(Cr) Dr/(Cr) Dr/(Cr)
NCAHFS: acc impairment loss (-A) W1 4 000 9 000 N/A
Reversal of impairment loss – NCAHFS (I) (4 000) (9 000) N/A
Re-measurement of NCAHFS: increase in FV-CtS (W1.3 or W1)
Impairment loss – NCAHFS (E) W1 or W1.1 Note 1 N/A N/A 4 000
NCAHFS: acc impairment loss (-A) N/A N/A 4 000
Re-measurement of NCAHFS: decrease in FV-CtS (W1.1 or W1)
Note 1: Notice that the impairment is recognised in P/L even though there is a balance of C30 000 in
the revaluation surplus (see Ex5A: W3).
Example 7: Re-measurement of a NCAHFS (previously: revaluation model):

prior revaluation expenses may not be reversed
The following relates to a plant that was measured using the revaluation model:
Cost: 100 000 (purchased 1 January 20X1)
Depreciation: 10% per annum straight-line to nil residual values.
Fair value: 120 000 (as at date of revaluation: 1 January 20X3).
Revaluations are performed using the net replacement value method.
The revaluation surplus is transferred to retained earnings over the life of the
underlying asset.
The recoverable amount has always been greater than its carrying amount and thus the
asset has not previously been impaired in terms of IAS 36.
This plant met all criteria for classification as ‘held for sale’ on 1 January 20X4, on which
date the following values applied (following on from example 5C):
Fair value of C60 000 and expected selling costs of C20 000 and
Value in use of C65 000.
Required:
Journalise the re-measurement of the NCAHFS at year-end 30 June 20X4 when its fair value is
C80 000 and the expected selling costs are C10 000.
Solution 7: Re-measurement of a NCAHFS: the revaluation model
Comment:
This example follows on from example 5C where the journals relating to the measurement on the
date it was classified as a NCAHFS (1 January 20X4) were shown.
This example shows that, whilst prior impairment losses may be reversed, prior revaluation
expenses may not be reversed.
Workings:
W1: Subsequent re-measurement of plant after classification as NCAHFS: IFRS 5.15 & 5.20-.21
W1.1: Re-measurement to FV-CtS: IFRS 5..20-.21 C

FV less costs to sell: 30/06/X4 FV: 80 000 – CtS: 10 000 70 000
Less:
Lower of CA & FV-CtS: 01/01/X4 FV: 60 000 – CtS: 20 000 (see Ex5C) (40 000)
- CA: 01/01/X4 FV : Given 60 000
- FV-CtS: 01/01/X4 FV: 60 000 – CtS: 20 000 (see Ex5C) 40 000
Increase in value 30 000
Chapter 12 597

W1.2: First limit: C
Increase in value W1.1 30 000
Limited to prior cumulative impairment losses Calculation (1) below 20 000
Impairment loss reversal NOTE 1 30 000 is limited by the 20 000 20 000
Calculation 1:
IAS 36 impairment before reclassification: 0 (Given)+ IAS 36 impairment on reclassification: 0 (Ex 5C: W1.2) +
IFRS 5 impairment on reclassification: 20 000 (Ex 5C:W2) = 20 000
Note 1: In the case of this first limit:

The total cumulative impairment loss recognised on this asset is 20 000 as at 1/1/X4, thus the
planned reversal of 30 000 on 30/6/X4 is limited by the first limitation (the previous cumulative
IL of 20 000 is less than 30 000). The remaining cumulative impairment loss is nil.
Please notice that when the asset:
- was previously classified as PPE, it was devalued from its CA of 105 000 to a FV of 60 000
(in terms of IAS 16); and then
- was classified as a NCAHFS, its FV of 60 000 was decreased to its FV-CtS of 40 000 (in
terms of IFRS 5).
The CA was thus decreased by a total of 65 000.
- However, the decrease of 45 000 to its FV of 60 000 is a devaluation to fair value and not an
impairment to FV-CtS.
This devaluation to FV is debited to revaluation surplus (35 000) and revaluation expense
(10 000) (See Ex 5C: W1.1 and the journals).
- The remaining decrease of 20 000 was recognised as an impairment loss expense.
Only impairment losses expensed may be reversed and thus only the decrease of 20 000 that
was recognised as an impairment loss expense may be reversed.
W1.3: Second limit: C
NCAHFS: CA on 01/01/X4 was: Given (See 5C: W2) 40 000

Plus planned impairment loss reversal: 30/06/X4 W1.2 20 000
NCAHFS: CA on 30/06/X4 would be: 60 000
Limited to: CA of the PPE on date it was FV: 60 000 – AD: 0 (immediately (60 000)
classified (ignoring imp losses): 01/01/X4 reclassified, thus no depreciation)
Excess disallowed Not limited N/A
Therefore, impairment loss reversal Planned reversal of 20 000 (W1.2) – 20 000
excess disallowed: 0 = 20 000

C
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS
Lower of CA and FV-CtS: 30/06/X4 60 000

CA on date classified (ignoring imp losses): 01/01/X4 FV: 60 000 – Acc depr: 0 60 000
FV - CtS: 30/06/X4 FV: 80 000 – CtS: 10 000 70 000
Less:
Lower of CA and FV-CtS: 01/01/X4 (40 000)
- CA: 01/01/X4 FV : Given 60 000
- FV-CtS: 01/01/X4 FV: 60 000 – CtS: 20 000 (Ex5C) 40 000
Impairment loss reversal / (impairment loss) 20 000
598 Chapter 12
Check: The impairment loss reversal may not exceed the prior cumulative impairment losses IFRS 5.21
Impairment loss reversal Above 20 000
Limited to prior cumulative imp losses IAS 36: 0 + IFRS 5: 20 000 (20 000)
Excessive reversal disallowed N/A
Journals: Dr/(Cr)
30 June 20X4
NCAHFS: acc impairment loss (-A) W1 or W1.3 20 000
Reversal of impairment loss – NCAHFS (I) (20 000)
Re-measurement of NCAHFS: increase in FV-CtS (W1.3 or W1)
A: 4.7.2 The tax effect when the revaluation model was used
Depreciation ceases as soon as an asset is classified as held for sale. However, the tax
authorities generally do not stop allowing the deduction of capital allowances (assuming the
cost of the asset is tax deductible) simply because you have decided to sell the asset.
The difference between the accountant’s nil depreciation (and any impairment losses or
reversals thereof) and the tax authority’s tax deductions (assuming the cost of the asset was
tax deductible) causes a temporary difference on which deferred tax must be recognised.
The principles affecting the current tax payable and deferred tax balances are therefore
exactly the same as for any other non-current asset. But one must be careful when measuring
the deferred tax balance if an asset has been revalued above its original cost.
The reason for this is that this deferred tax balance may have previously been calculated
based on the assumption that the carrying amount of the asset represents the future inflow of
benefits resulting from the usage of the asset. Profits from the usage of the assets would be
referred to as non-capital profits and the deferred tax balance would have been calculated at
the income tax rate.
When this asset is reclassified as ‘held for sale’, however, the future benefits are obviously
now expected to come from the sale of the asset rather than the use thereof. Profits from the
sale of the asset may involve capital profits. These capital profits will generally result in
measuring the deferred tax based on capital gains tax legislation rather than income tax
legislation. If this is the case, the deferred tax balance will simply need to be adjusted to take
into account the effects of the different tax calculations.
As a result, reclassifying an asset into the ‘held for sale’ classification will generally result in
an adjustment to deferred tax in order to re-measured the deferred tax balance using the
capital gains tax legislation rather than the income tax legislation.
Example 8: Tax effect of reclassification and the revaluation model

An item of plant met all criteria for classification as ‘held for sale’ on 1 January 20X4.
Cost: C100 000 (purchased 1 January 20X1);
Depreciation: 10% per annum straight-line to nil residual values;
The plant was measured under the revaluation model:
Fair values were measured in accordance with market prices;
Revaluations were accounted for using the net replacement value method;
31/12/20X2: 31/12/20X3:
date of 1st revaluation date of 2nd revaluation
Fair value 120 000 150 000
Costs to sell 10 000 20 000
Value in use 130 000 155 000
Chapter 12 599
On 31 December 20X4, the fair value was now C140 000 and the cost to sell C20 000.
The tax authorities allow a deduction of 20% on the cost of this asset;
The tax rate is 30%;
Only 50% of the capital gain (proceeds - base cost) is taxable;
Base cost: 120 000.
Profit before tax is correctly calculated to be C200 000 for the year ended 31 December 20X4.
There are no temporary or non-temporary differences other than evident from the above.
Required:
Show all related journal entries for the year ended 31 December 20X2, 20X3 and 20X4 (including the
current tax and deferred tax entries) to the extent possible from the information provided.
Solution 8: Tax effects of reclassification and the revaluation model
Comment: This example shows the effect on the deferred tax adjustments when the intention changes
from using the asset to selling it and when there has been a previous upward revaluation.
Journals
Depreciation: plant (E) (100 000 – 0) / 10 yrs x 1 year 10 000

PPE: Plant: acc depreciation (-A) 10 000
Depreciation on plant: cost 100 000, RV = 0 and useful life 10yrs
PPE: Plant: acc depreciation (-A) (100 000 – 0) / 10 yrs x 2 years 20 000
PPE: Plant: cost (A) 20 000
NRVM: Accumulated depreciation to 31/12/20X2 set-off against cost
PPE: Plant: cost (A) FV: 120 000 – CA: (100 000 - 20 000) 40 000
Revaluation surplus: PPE: Plant (OCI) 40 000
Revaluation of PPE according to IAS 16’s revaluation model
Revaluation surplus: PPE: Plant (OCI) 40 000 x 30% or W2 12 000
Tax on revaluation: tax rates based on usage (i.e. non-capital profits)
Deferred tax balance is adjusted: CA and tax base changed (deferred
tax measured based on intention to use)
31 December 20X3
Depreciation: plant (E) (120 000 – 0) / 8 yrs x 1 year 15 000

PPE: Plant: acc depreciation (-A) 15 000
Depreciation on plant: FV: 120 000, RV: 0,Remaining useful life: 8yrs
PPE: Plant: acc depreciation (-A) 10 000 + 10 000 – 20 000 + 15 000 15 000
PPE: Plant: cost (A) 15 000
NRVM: Accumulated depreciation to 31/12/20X3 set-off against cost
PPE: Plant: cost (A) FV: 150 000 – CA: (120 000 - 15 000) 45 000
Revaluation surplus: PPE: Plant (OCI) 45 000
Revaluation of PPE according to IAS 16’s revaluation model
Revaluation surplus: PPE: Plant (OCI) 45 000 x 30% 13 500
Tax on revaluation: tax rates based on usage (i.e. non-capital profits)
600 Chapter 12
Journals continued ...
NCAHFS: Plant: Cost (A) At fair value 150 000

PPE: Plant: Cost (A) 150 000
Transfer of PPE to NCAHFS: not re-measured in terms of IAS16
immediately prior to the transfer – see note 2 (below)
Deferred tax (A/L) W2 and W3 10 500
Revaluation surplus – plant (OCI) 10 500
Deferred tax balance is adjusted: change in intention (from held for use
to held for sale thus deferred tax measured based on intention to sell)
Impairment loss – NCAHFS (E) CA: 150 000 – FV -CtS: (150 000–20 000) 20 000
NCAHFS: Plant: acc impairment losses (-A) 20 000
Re-measurement to lower of CA or FV -CtS on reclassification:
Deferred tax (A/L) W2 and W3 3 000
tax measured based on intention to sell)
31 December 20X4
Impairment loss – NCAHFS (E) CA: 130 000 – FV -CtS: (140 000 –20 000) 10 000
NCAHFS: Plant: Acc impairment losses (-A) 10 000
Re-measurement to lower of CA or FV -CtS after reclassification:
Income tax expense (E) W2 and W3 4 500
tax measured based on intention to sell)
Current tax payable
Note 1. There is no further depreciation on this asset from 1 January 20X4.

Note 2. Since a revaluation in terms of the plant’s previously applicable standard (IAS 16) had been
done a day before the asset was reclassified as ‘held for sale’, the plant is not revalued in
terms of IAS 16 on 1/1/X4 in terms of IAS 16. In other words, the plant’s carrying amount on
date of reclassification (1/1/X4) was already up-to-date in terms of IAS 16.
Note 3. The plant was not impaired at the end of either 20X2 or 20X3 since its recoverable amount
(greater of FV-CtS and VIU) was greater than its FV on both year-ends.
Workings
W1: Current income tax Calculations 20X4

C
Profit before tax Given 200 000
Add back depreciation Assets held for sale are not depreciated 0
Add back impairment Impairment on the NCAHFS: 20 000 + 10 000 30 000
Less tax allowance 100 000 x 20% (20 000)
Current tax 210 000 x 30% 63 000
Chapter 12 601

W2: Deferred tax: PPE – NCAHFS Carrying Tax Temporary Deferred
amount base difference tax
Purchase: 01/01/X1 100 000 100 000 0 0
Depreciation: (100 000 – 0)/ 10 x 1yr Cr DT
(10 000) (20 000) (20 000) (3 000)
Tax allowance: 100 000 x 20% x 1yr Dr TE
PPE: Balance: 31/12/X1 90 000 80 000 (10 000) (3 000) Liability
(10 000) (20 000) (20 000) (3 000)
80 000 60 000 (20 000) (6 000) Liability
Cr DT
Revaluation (IAS 16): 31/12/X2 40 000 0 (40 000) (12 000)
Dr RS
(15 000) (20 000) (5 000) (1 500)
105 000 40 000 (65 000) (19 500)
Cr DT
Revaluation (IAS 16): 31/12/X3 45 000 0 (45 000) (13 500)
Dr RS
Tfr out of PPE (150 000)
Dr DT
Trf into NCAHFS W3 150 000 10 500
Cr RS
DT adj: change in intention
NCAHFS: Balance: 01/01/X4 W3 150 000 40 000 (110 000) (22 500)
Dr DT
Impairment (IFRS 5): 01/01/X4 W3 (20 000) 0 20 000 3 000
Cr TE
FV – CtS: 150 000 – 20 000 W3 130 000 40 000 (90 000) (19 500)
Impairment (IFRS 5): 31/12/X4 (10 000)
FV – CtS: 140 000 – 20 000 120 000 Cr DT
W3 (10 000) (4 500)
Depreciation: no depreciation 0 Dr TE
(20 000)
Tax allowance: 100 000 x20%x1yr
Balance: 31/12/X4 120 000 20 000 (100 000) (24 000) Liability
Values:
W3: Deferred tax adjustment in above table 01/01/X4 01/01/X4 31/12/X4
150 000 130 000 120 000
DT on the capital gain
Expected selling price Carrying amount ( FV) 150 000 130 000 120 000
Base cost Given (120 000) (120 000) (120 000)
Capital gain 30 000 10 000 0
Inclusion rate Given 50% 50% 50%
Taxable capital gain Capital gain x Inclusion rate 15 000 5 000 0
Taxed at 30% A: Taxable capital gain x 30% 4 500 1 500 0
DT on the recoupment
Selling price limited to cost CA (150 000), limited to cost (100 000) 100 000 100 000 100 000
CA (130 000), limited to cost (100 000)
CA (120 000), limited to cost (100 000)
Tax base 1/1/X4: 100 000 – 100 000 x20% x3yrs (40 000) (40 000) (20 000)
31/12/X4: 100 000 – 100 000 x20%x4yrs
Recoupment 60 000 60 000 80 000
Taxed at 30% B: Recoupment x 30% 18 000 18 000 24 000
Therefore:
DT Balance should be Liability: A + B (22 500) (19 500) (24 000)
DT Balance was Liability: See W2 (33 000) (22 500) (19 500)
Adjustment needed 10 500 3 000 (4 500)
Dr DT; Cr RS Dr DT; Cr TE Cr DT; Dr TE
602 Chapter 12
A: 4.8 Measurement implications of a change to a plan to sell/ distribute (IFRS 5.26 - .29)
A: 4.8.1 Overview
A non-current asset that was previously classified as held for sale (or held for distribution)
could subsequently fail to meet the criteria to remain classified as held for sale (or held for
distribution). If this occurs, then the non-current asset must be reversed out of the held for
sale (or distribution) classification and back to its previous classification (e.g. property, plant
and equipment). See section A: 4.8.2.
It can also happen that a non-current asset that was previously held for sale is now held for
distribution (or vice versa). In this case, there is still a plan to dispose of the asset and thus
the change in classification is considered to be a continuation of the original plan of disposal.
However, this does not mean that there are not adjustments required. See section A: 4.8.3.
A: 4.8.2 If a NCA subsequently fails to meet the HFS or HFD classification criteria
If a non-current asset that was previously classified as ‘held for sale’ (or held for distribution)
no longer meets the criteria necessary for such a classification, the asset must be removed
from this classification. See IFRS 5.26
This means, it will have to be transferred out of the held for sale (or held for distribution)
classification and back into its previous classification (e.g. PPE). See IFRS 5.26
Before the transfer out of ‘held for sale’ (or ‘held for distribution’) it must be re-measured to
the lower of:
its carrying amount had the non-current asset never been classified as such(adjusted for
any depreciation, amortisation and/ or revaluations that would have been recognised had
the asset not been classified as held for sale/ distribution); and
its recoverable amount. See IFRS 5.27
An adjustment to the asset’s carrying amount is recognised in profit or loss unless the asset is
an item of property, plant and equipment or an intangible asset that was previously measured
under the revaluation model. In the case of the asset having previously been measured under
the revaluation model, the adjustment would be recognised in the same way that you would
recognise increases or decreases under the revaluation model. See IFRS 5.28 & footnote 6
A: 4.8.3 If a NCAHFS subsequently becomes a NCAHFD, or vice versa (IFRS 5.26A)
A non-current asset that was previously held for sale may cease to be held for sale and
become held for distribution instead (or vice versa). In this case, the asset would simply be
transferred from the held for sale classification to the held for distribution classification (or
vice versa). This non-current asset, which was previously held for sale (or held for
distribution) would then effectively be classified, measured and presented as a held for
distribution (or held for sale).
A measurement adjustment may be necessary since there is a tiny difference in how each
classification is measured: the held for sale classification is measured at the lower of carrying
amount and fair value less costs to sell, whereas the held for distribution classification is
measured at the lower of carrying amount and fair value less costs to distribute. Any
measurement adjustment would simply be accounted for as an impairment loss or impairment
loss reversal in terms of IFRS 5.20-25.
Since a reclassification from HFS to HFD (or vice versa) does not change the fact that the DG
is to be disposed of, and is thus considered to be a continuation of the original plan of
disposal, the date on which it was originally classified as HFS (or HFD) is not changed.
Chapter 12 603
Example 9: Re-measurement of assets no longer classified as ‘held for sale’

Plant measured under the cost model was classified as held for sale on 31 December 20X2
when its:
Carrying amount was C80 000:
Cost: C100 000 on 1 January 20X1 and
Accumulated depreciation: C20 000 on 31 December 20X2
- 10% straight-line
- to nil residual values;
Recoverable amount was C65 000:
Fair value less costs of disposal: of C65 000
Value in use: C40 000.
Fair value less costs to sell: C65 000
On 30 June 20X3 (six months later), it ceased to meet all criteria necessary for
classification as ‘held for sale’. On this date its recoverable amount was C85 000. Its fair
value less costs to sell remained unchanged at C65 000.
Required: Show the journals as at 30 June 20X3 and 31 December 20X3.
Solution 9: Re-measurement of assets no longer classified as ‘held for sale’

30 June 20X3
NCAHFS: Plant: Acc imp losses (-A) W1 10 000
Impairment loss reversed – NCAHFS (I) 10 000
Re-measurement of NCAHFS before reclassifying as ‘PPE’: criteria for
‘held for sale’ no longer met
PPE: Plant: cost (A) Original cost (given) 100 000
PPE: Plant: acc. depreciation (-A) 100 000 x 10% x 2.5 25 000
NCAHFS: Plant: CA (A) Given: 100 000 – 20 000 80 000
NCAHFS: Plant: Acc imp losses (-A) CA: 80 000 – RA: 65 000 – ILR: 10 000 (W1) 5 000
Transfer from NCAHFS to PPE when no longer classified as HFS
31 December 20X3
Depreciation – plant (E) 100 000 x 10% x 0.5 5 000
Plant: acc. depreciation (-A) 5 000
Depreciation of plant for 6 months from 1 July 20X3
Workings: C
New carrying amount (30 June 20X3) to be lower of: 75 000
Carrying amount had the asset never been 100 000 – [(100 000-0) x 10% x 2.5 yrs] 75 000
classified as ‘held for sale’
Recoverable amount Given 85 000
Current carrying amount (30 June 20X3) Fair value – costs to sell (65 000)
Impairment loss to be reversed 10 000
Comment: Depreciation on this asset is backdated as if it never ceased.
A: 4.9 Measurement involving ‘scoped-out non-current assets’
As mentioned in section A: 2, the measurement provisions of IFRS 5 do not apply to the

following assets (see IFRS 5.5):
Deferred tax assets (IAS 12)
Assets relating to employee benefits (IAS 19)
Financial assets (IFRS 9)
Investment properties measured under the fair value model (IAS 40)
Non-current assets measured at fair value less point-of-sale costs (IAS 41: Agriculture)
Contractual rights under insurance contracts (IFRS 4). IFRS 5.5
604 Chapter 12
The scope exclusion simply means that these assets are not re-measured in terms of IFRS 5
(i.e. to the lower of the carrying amount and fair value less cost to sell). However, IFRS 5 still
requires them to be classified as non-current assets held for sale and still requires the same
presentation and disclosure.
Example 10: Asset falling outside the measurement scope of IFRS 5

Land that is classified as investment property and measured using the fair value model, is
measured at its fair value of C80 000 (cost: 50 000) on 1 January 20X3. On 30 June 20X3
all criteria for separate classification as ‘held for sale’ are met, on which date the:
fair value is C70 000, expected costs to sell are C5 000 and value in use is C60 000.
Required: Journalise the reclassification of the investment property on 30 June 20X3. Ignore tax.
Solution 10: Asset falling outside the measurement scope of IFRS 5

Comment:
Investment properties measured under the fair value model in IAS 40 are excluded from the
IFRS 5 measurement requirements and thus continue to be measured at ‘fair value’. They are thus
not re-measured to ‘fair value less costs to sell’ and thus the selling costs are ignored.
Investment properties measured under the fair value model are not tested for impairment in terms
of IAS 36 and thus the value in use was also ignored.
Remember that the scope exclusion only applies to measurement of the asset and thus, the
investment property, although not measured in terms of IFRS 5, must be reclassified to the HFS
classification and will be presented and disclosed as such.
Remember that the exclusion only applies to investment properties measured under the fair value
model: investment property under the cost model must be re-measured in terms of IFRS 5.
Journal: 30 June 20X3 Debit Credit

Fair value loss on investment property (E) W1 10 000
Investment property: Land (A) 10 000
NCAHFS: Land: CA (A) W1 70 000
Investment property: Land (A) 70 000
Working 1: Impairment of investment property on reclassification: C

Investment property at fair value on 1 January 20X3 Given 80 000
Fair value on 30 June 20X3 Given (70 000)
Impairment of investment property 10 000
A: 5 Disposal Groups Held for Sale
A: 5.1 Overview of disposal groups (IFRS 5 Appendix A and IFRS 5.4-5.5; 5.15 and .25)
As was explained in the introduction to this chapter (see section A: 1), IFRS 5 refers not only
to individual non-current assets that are held for sale, but also to disposal groups that are held
for sale.
The classification of a disposal group as held for sale is exactly the same as the classification
of an individual non-current asset as held for sale. Similarly, the presentation and disclosure
requirements that apply to individual non-current asset as held for sale apply equally to
disposal groups held for sale. Even the measurement principles that apply to individual non-
current asset as held for sale apply equally to disposal groups. However, because a disposal
group includes a variety of items (non-current assets and current assets and possibly even
liabilities), the measurement of a disposal group is slightly more complex than the
measurement of an individual non-current asset held for sale.
This section will explain how to identify whether you have a disposal group. You will then
need to apply the criteria previously discussed in section A: 3 to determine whether you must
Chapter 12 605
classify this disposal group as held for sale. If you find that you have a disposal group that
should be classified as held for sale, this section will then explain how to measure it using the
measurement principles previously discussed in section A: 4. The presentation and disclosure
of disposal groups is explained in section A: 6 together with the presentation and disclosure of
individual non-current assets held for sale.
A: 5.2 Identification of disposal groups
A disposal group is simply a grouping of assets that are A disposal group is defined
to be disposed of by sale or by some other means. What as:
is of supreme importance is that all of these assets a group of assets (and liabilities
(together with any directly related liabilities) are to be directly associated with those assets
disposed of together in a single transaction. that will be transferred in the
transaction)
It is important to notice that there is a difference between to be disposed of:
a disposal group and a disposal group held for sale. If - by sale or
- otherwise,
you look carefully at the definition of a disposal group,
as a group in a single transaction. IFRS
the group can be disposed of through a sale or by any 5 Appendix A (slightly modified)
.
other means. However, for the disposal group to meet
the criteria for classification as held for sale, its carrying amount must be expected to be
recovered mainly through a sale transaction. Thus, for example, although a group of assets
that is to be abandoned may meet the definition of a disposal group, it would not be classified
as a disposal group held for sale.
A: 5.3 Classification, presentation and disclosure of disposal groups held for sale or
distribution
IFRS 5 also explains how to classify, measure, present and disclose disposal groups held for
sale. The principles of classification, presentation and disclosure that apply to non-current
assets held for sale (i.e. individual assets) apply equally to disposal groups held for sale (i.e.
groups of assets – or groups of assets with liabilities). Thus, these topics are not discussed
again. For classification of a disposal group as either held for sale or held for distribution,
please revise the principles that were explained in section A: 3. For presentation and
disclosure of a disposal group held for sale, please revise the principles that will be explained
in section A: 6.
It is just the measurement principles that do not necessarily apply to all items in the disposal
group and may possibly not even apply to any of the items within the disposal group. These
new measurement principles will be explained in section A: 5.4.
A: 5.4 Measurement of disposal groups in general
The measurement of a disposal group that is held for sale Measurement of DGs that
(or held for distribution) is interesting because it could are HFS or HFD:
Disposal groups are measured
include all sorts of assets as well as liabilities but, as was at the lower of:
explained in Section A: 2, the IFRS 5 measurement Its CA, and
requirements do not apply to: Its FV – CtS .
Liabilities; Scoped-in NCAs in the DG are:
Current assets; and Not depreciated or amortised.
Scoped-out non-current assets: Only those items in the DG that are
scoped-in NCAs are affected by the
Assets already measured at fair value with measurement requirements in IFRS 5.
movements recognised in profit or loss:
- Financial assets within the scope of IFRS 9 Financial instruments;
- Investment property measured under the fair value model in terms of
IAS 40 Investment property;
- Non-current assets measured at ‘fair value less costs to sell’ in terms of
IAS 41 Agriculture; and
Assets for which there might be difficulties in determining their fair value:
- Deferred tax assets, measured in terms of IAS 12 Income taxes;
- Assets relating to employee benefits, measured under IAS 19 Employee benefits;
606 Chapter 12
- Contractual rights under insurance contracts, measured under IFRS 4 Insurance

contracts. See IFRS 5.5
We will refer to those assets that the IFRS 5 measurement requirements do apply to as
‘scoped-in non-current assets’.
If the disposal group includes at least one ‘scoped-in non-current asset’, then the disposal
group as a whole will be subjected to the IFRS 5 measurement (as well as the classification,
presentation and disclosure requirements).
If the disposal group does not contain any ‘scoped-in non-current assets’, then the disposal
group will not be subjected to the IFRS 5 measurement requirements at all (although it will
still be subjected to IFRS 5’s classification, presentation and disclosure requirements).
If the disposal group includes at least one ‘scoped-in non-current asset’, the disposal group as
a whole is thus measured in terms of IFRS 5 at:
A disposal group may
the lower of its carrying amount and its fair value include goodwill acquired in
less costs to sell (if held for sale); or a business combination if it:
the lower of its carrying amount and its fair value is an operation within a cash-
generating unit (CGU); or
less costs to distribute (if held for distribution).
is a CGU to which goodwill has been
An entity must not depreciate (or amortise) a disposal allocated in accordance with the
group once it has been classified as held for sale (or held requirements of IAS 36 Impairment
for distribution). of Assets (IAS 36.80-.87).
IFRS 5 Appendix A
If the disposal group contains liabilities, any interest or
other expenses related to these liabilities must continue to be recognised. IFRS 5.25
A: 5.4.1 Initial measurement of disposal groups (IFRS 5.4 and 5.15 - 5.18 and 5.20 and
IAS 36.104)
The process to be followed on initial measurement is:

Initial measurement of a
Immediately before re-classification, all individual DGHFS (or DGHFD):
assets and liabilities within the disposal group (DG)
Before reclassification:
must be measured in terms of their own standard
Measure each item in the DGHFS
(e.g.. a plant measured under the cost model must be using its own IFRSs;
depreciated to date of classification and checked for After reclassification:
impairments whereas inventory must be measured to Measure DGHFS at lower of CA and
the lower of cost and net realisable value on FV-CtS (could lead to an imp loss).
classification date).
The individual assets and liabilities must then be
transferred to the disposal group held for sale An impairment loss on the
initial measurement of a
(DGHFS) or the disposal group held for distribution DGHFS is allocated:
(DGHFD). First to: goodwill, if applicable;
The entire disposal group is then re-measured as Then to: Scoped-in NCAs.
follows:
for a DG held for sale, to the lower of its:
- carrying amount; or
- fair value less costs to sell.
for a DG held for distribution, to the lower of its:
- carrying amount; or
- fair value less costs to distribute.
Any impairment loss is apportioned to those assets in the disposal group which fall within
the measurement scope of IFRS 5:
If goodwill is present, any impairment loss is first allocated to goodwill; and
Chapter 12 607
Any remaining impairment loss is then allocated proportionately to those assets in the
disposal group that fall within the IFRS 5 measurement requirements (i.e. to the
scoped-in non-current assets) based on their relative carrying amounts.
None of the impairment loss is ever to be allocated to the other assets (i.e. to current assets or
scoped-out non-current assets) or to the liabilities within a disposal group.
An unintended consequence of the method of allocating impairment losses
The requirement that the impairment loss on a DGHFS (or DGHFD) be allocated only to those
items in the group that are ‘scoped-in non-current assets’ means that it is possible that the
carrying amount of these individual assets may be decreased to the point that they no longer
reflect their value.
In fact, these individual values may drop not only below their true recoverable amounts but may
even end up being negative (i.e. an asset with a credit balance)!
It seems this was not intentional and that either an interpretation on this issue or an amendment
to IFRS 5 is clearly necessary.
Example 11: Disposal group held for sale – impairment allocation

Aircon Limited decides to dispose of a group of 5 assets and a liability in a single
transaction.
On 20 June 20X3, all criteria for separate classification as a ‘disposal group held for sale’ are met.
Immediately before the assets are classified as ‘held for sale’, they were re-measured in terms of their
own relevant standards to the following carrying amounts:
Inventory: C70 000 (net realisable value: C70 000);
Property, plant and equipment: C150 000 (recoverable amount: C150 000);
Investment property measured using the fair value model: C80 000;
Investment property measured using the cost model: C50 000 (recoverable amount: C60 000);
Goodwill: C30 000
Trade payables: C10 000.
The fair value less costs to sell of the disposal group on 20 June 20X3 is C270 000.
Required: Calculate the impairment loss and show the allocation within the disposal group.
Solution 11: Disposal group held for sale – impairment allocation

Comment:
This example shows the following:
Since the disposal group includes some scoped-in non-current assets, the entire disposal group is
measured in terms of IFRS 5.
An impairment loss is first allocated to goodwill; any remaining impairment loss is allocated to other
scoped-in non-current assets based on their relative carrying amounts.
CA immediately Impairment loss CA immediately
before classification allocation after classification
as HFS as HFS
Note 2
Inventory 70 000 N/A 70 000
Property, plant and equipment 150 000 (52 500) Note 4 & 97 500
Note 2
Investment property (FV model) 80 000 N/A 80 000
Investment property (cost model) 50 000 (17 500) Note 4 & 32 500
Note 3
Goodwill 30 000 (30 000) 0
Note 2
Trade payables (10 000) N/A (10 000)
Note 1
Net assets 370 000 (100 000) 270 000
Note 1. The total impairment loss of 100 000 is calculated as:
CA: 370 000 (per table above) – FV-CtS (given): 270 000 = 100 000
608 Chapter 12
Note 2. The measurement requirements of IFRS 5 only apply to ‘scoped-in non-current assets’ and
thus no part of the impairment loss on the measurement of the disposal group is allocated to
inventory (a current asset), trade payables (a liability) or the investment property under the fair
value model (a scoped-out non-current asset).
Note 3. The impairment loss is first set-off against any goodwill, and any impairment loss remaining is
then allocated to the remaining ‘scoped-in non-current assets’ on the basis of the relative
carrying amounts:
Total IL: 100 000 – Goodwill: 30 000 = IL still to be allocated: 70 000
Note 4. The remaining impairment loss of 70 000 is allocated based on the carrying amounts of the
scoped-in non-current assets:
Property, plant and equipment: 70 000 x 150 000 / (150 000 + 50 000) = 52 500
Investment property (cost model): 70 000 x 50 000 / (150 000 + 50 000) = 17 500
Note 5. Notice how the carrying amount of the scoped-in non-current assets were dropped below the
carrying amounts that they would have had under IAS 36 Impairment of assets (i.e. property,
plant and equipment would not have dropped below C150 000 had this asset not been part of a
disposal group).
If the impairment loss was greater than the carrying amounts of the scoped-in non-current
assets, the allocation of the impairment loss would have resulted in the property, plant and
equipment and investment property under the cost model being measured at negative amounts!
Example 12: Disposal group held for sale – initial impairment

Production Limited decides to dispose of the following group of assets in a single sale
transaction on 30 June 20X3, upon which date all criteria for separate classification as ‘held
for sale’ are met. Production Limited viewed the intention to sell as an indication of a
possible impairment and thus calculated all figures necessary in order to estimate
recoverable amount.
Measurement details relating to the three assets in the group are as follows:
Plant: measured using the cost model:
1 January 20X3: its carrying amount is C80 000 (bought on 1 January 20X1 at a cost of
C100 000 and depreciated at 10% pa to a nil residual value; never impaired);
30 June 20X3: its fair value is C70 000, expected cost to sell is C5 000 and value in use is
C90 000.
Factory building: measured using the cost model:
1 January 20X3: its carrying amount is C180 000 (bought on 1 January 20X1 at a cost of
C200 000 and depreciated at 5% pa to a nil residual value; never impaired);
30 June 20X3: its fair value is C170 000, expected cost to sell C15 000 and value in use is
C210 000.
Investment property: measured using the fair value model:
1 January 20X3, its fair value is C80 000 (bought on 1 January 20X1 at a cost of C50 000);
30 June 20X3: its fair value is C70 000, expected cost to sell is C5 000 and value in use is
C60 000.
On 30 June 20X3, the fair value less costs to sell of the disposal group as a whole was C285 000.
Required: Calculate if there is an impairment or impairment reversal when measuring the disposal group
on date of classification as held for sale, 30 June 20X3. Show how it will be allocated. Ignore tax.
Solution 12: Disposal group held for sale – initial impairment

Comment:
Since the intention to sell was considered to be an indication of a possible impairment, the value in
use (VIU) and fair value less costs of disposal (FV-CoD) were calculated. The higher of these two
amounts is the recoverable amount (RA) - see IAS 36. If the RA is less than the CA (prior to the
classification), then the asset must first be impaired in terms of IAS 36.
Chapter 12 609

Since the disposal group includes some scoped-in non-current assets, the entire disposal group is
remeasured in terms of IFRS 5.
Any scoped-out non-current assets, current assets or liabilities in the disposal group must first be
remeasured in terms of their own standards. In this example, there was one such item, being an
investment property measured under the fair value model.
Any impairment loss is first allocated to goodwill; any remaining impairment loss is allocated to
other scoped-in non-current assets based on their relative carrying amounts. There was no goodwill
in this example and thus the entire impairment loss is allocated to the two scoped-in non-current
assets: plant and building.
W1: Impairment of plant before reclassification: 30/06/20X3 C

(i.e. still PPE, measured in terms of IAS 16):
Plant: carrying amount 80 000 – (100 000 -0) x 10% x 6/12 : Depreciation for 6 months 75 000
Recoverable amount Higher of VIU: 90 000 and FV-CoD: 70 000 – 5 000 = 65 000 (90 000)
Impairment of plant Plant is not impaired 0
W2: Impairment of factory building before reclassification: 30/06/20X3 C

(i.e. still PPE, measured in terms of IAS 16):
Building: carrying amount 180 000 –( (200 000 – 0) x 5% x 6/12) : Depreciation for 6 months 175 000
Recoverable amount Higher of VIU: 210 000 and FV-CoD 170 000–15 000 =155 000 (210 000)
Impairment of building Factory building is not impaired 0
W3: Fair value adjustment of investment property before reclassifying: 30/06/X3 C

(i.e. still investment property, measured in terms of IAS 40):
Investment property at fair value on 1 January 20X3 Given 80 000
Fair value on 30 June 20X3 Given (70 000)
Fair value loss 10 000
W4: Impairment of disposal group after reclassification C

(i.e. now NCAHFS, measured in terms of IFRS 5):
Plant: carrying amount W1 75 000
Building: carrying amount W2 175 000
Investment property : carrying amount W3 70 000
Carrying amount of disposal group 320 000
Fair value less costs to sell Given (285 000)
Impairment of disposal group 35 000
W5: Allocation of impairment to assets in disposal group C

Plant (cost model) 35 000 x 75 000 / (75 000 + 175 000) 10 500
Building (cost model) 35 000 x 175 000 / (75 000 + 175 000) 24 500
Investment property (FV model) None allocated: as outside IFRS 5 measurement scope N/A
Total impairment expense W4 35 000
An alternative layout of workings (instead of W4 and W5):

CA immediately before Impairment loss CA immediately
classification as HFS allocation after classification
as HFS
Note 3
Plant (cost model) 75 000 (10 500) 64 500
Note 3
Building (cost model) 175 000 (24 500) 150 500
Note 2
Note 1
Net assets 320 000 (35 000) 285 000
610 Chapter 12

Note 2. The measurement requirements of IFRS 5 only apply to ‘scoped-in non-current assets’.
Investment property at fair value is a scoped-out non-current asset and thus none of the
disposal group’s impairment loss is allocated to investment property.
Note 3. The impairment loss is first set-off against any goodwill, and any impairment loss remaining is
then allocated to the remaining ‘scoped-in non-current assets’ on the basis of the relative
carrying amounts:
Total impairment loss: 35 000 – Goodwill: 0 = IL still to be allocated: 35 000
The remaining impairment loss of 35 000 is allocated based on the carrying amounts of the
Plant (scoped-in): 35 000 x 75 000 / (75 000 + 175 000) = 10 500
Building (scoped-in): 35 000 x 175 000 / (75 000 + 175 000) = 24 500
A: 5.4.2 Subsequent measurement of a disposal group (IFRS 5.4; 5.19/.20; 5.23; IAS 36.122)
As with an individual asset, a disposal group must be remeasured to its latest ‘fair value less
costs to sell’ at the subsequent reporting date if it remains unsold at this date. However, if a
disposal group includes items that are excluded from the measurement provisions of IFRS 5,
please remember that the carrying amounts of these items must be measured in accordance
with their own relevant IFRS before the disposal group is remeasured to its latest ‘fair value
less costs to sell’. In other words:
Within a disposal group, there may be two categories of items:
Scoped-in non-current assets (measured in terms of IFRS 5): these are not depreciated
or amortised (per IFRS 5); and
Other items (not measured in terms of IFRS 5): Subsequent measurement of
current assets and/ or scoped-out non-current a DGHFS or DGHFD:
assets and liabilities: these continue to be
measured in terms of their relevant standards. Before remeasurement:
Scoped-in NCAs in the DG: do not
The carrying amount of the disposal group is depreciate or amortise
adjusted to reflect any changes to the carrying All other items in the DG: measure
amounts of the items not measured by IFRS 5 (i.e. using their own IFRSs;
current assets, scoped-out non-current assets and Remeasurement:
liabilities), as measured in terms of their own Measure the DG at its latest FV-CtS
standards. (or FV-CtD): this could lead to an:
- impairment loss
The latest fair value less costs to sell (or costs to - impairment loss reversal.
distribute) for the disposal group as a whole is then
re-estimated and appropriate adjustments may be necessary, involving either:
a further impairment loss; or
an impairment loss reversal.
An impairment loss will need to be recognised if the carrying amount of the disposal group as
a whole is greater than its latest most recent fair value less costs to sell (or fair value less
costs to distribute). An impairment loss arising on subsequent measurement of the disposal
group is allocated to individual assets in the disposal group in the same way that an
impairment loss on initial measurement was allocated. In other words, the impairment loss is:
first allocated against any goodwill that may be An impairment loss on
included, and then subsequent measurement
of a DG is allocated:
any remaining impairment loss is allocated to the First to: goodwill, if applicable;
other scoped-in non-current assets based on their Then to: scoped-in NCAs.
relative carrying amounts. (i.e. same as for initial measurement).
Chapter 12 611
An impairment loss reversal will need to be recognised if the carrying amount of the disposal
group as a whole is less than its latest most recent fair value less costs to sell (or fair value
less costs to distribute). However, an impairment loss reversal is limited in that it may only
be recognised to the extent that:
It has not been recognised in the re-measurement of any current assets, scoped-out non-
current assets or liabilities; and
It does not exceed the cumulative impairment losses recognised in terms of IAS 36
Impairment of assets and/ or IFRS 5.
An impairment loss reversed would then be allocated to An impairment loss

the scoped-in non-current assets based on their relative reversal on subsequent
carrying amounts but may never be allocated to goodwill. measurement of a DG is:
allocated to scoped-in NCAs (there is
There are no limits to which an impairment / reversal no limit to the amount allocated to
may be allocated to a scoped-in non-current asset in the these items);
disposal group. never allocated to goodwill or any of
the other items in the DG.
Example 13: Disposal group held for sale – subsequent impairment

This example is a continuation of the example 12, relating to Production Limited.
A disposal group containing one scoped-out non-current asset, (investment property at fair value), was
impaired to its fair value less costs to sell of C285 000 on date of classification (30 June 20X3) as
follows:
Plant 75 000 (Example 12: W4) – 10 500 (Impairment: Ex 12: W5) 64 500
Building 175 000 (Example 12: W4) – 24 500 (Impairment: Ex 12: W5) 150 500
Investment property 70 000 (Example 12: W3) – N/A (Impairment: Ex 12: W5) 70 000
285 000
At 31 December 20X3, the disposal group has not yet been sold but still meets the criteria for
classification as ‘held for sale’. On this date, the investment property has a fair value of C69 000 and
the disposal group as a whole has a fair value less costs to sell of C270 000.
Required: Calculate whether there is an impairment or impairment reversal when re-measuring the
disposal group as at the year ended 31 December 20X3. Show how it would be allocated. Ignore tax.
Solution 13: Disposal group held for sale – subsequent impairment

Comment:
This example shows how a subsequent impairment loss on a disposal group is recognised and
allocated in the same way as an initial impairment loss.
W1: Fair value adjustment of investment property at year end: C

Carrying amount is currently Example 13 (W4 and W5) : 70 000 70 000
Fair value Given (69 000)
Fair value loss 1 000
W2: Impairment of disposal group at year end: C

Plant 75 000 (Example 12: W4) – 10 500 (Example 12: W5) 64 500
Building 175 000 (Example 12: W4) – 24 500 (Example 12: W5) 150 500
Investment property Given; or 70 000 – 1 000 (W1) 69 000
Carrying amount: 31/12/X3 284 000
FV - costs to sell: 31/12/X3 Given (270 000)
Impairment of disposal group 14 000
W3: Allocation of impairment to assets in disposal group C

Plant 14 000 x 64 500 / (64 500 + 150 500) 4 200
Building 14 000 x 150 500 / (64 500 + 150 500) 9 800
Investment property None allocated as outside IFRS 5 measurement scope 0
Total impairment expense W7 14 000
612 Chapter 12

An alternative layout of workings (instead of W2 and W3)
CA immediately before Impairment loss CA immediately
re-measurement allocation after re-
measurement
Note 3
Plant (cost model) 64 500 (4 200) 60 300
Note 3
Building (cost model) 150 500 (9 800) 140 700
Note 2
Note 1
Net assets 284 000 (14 000) 270 000

Note 2. The measurement requirements of IFRS 5 only apply to ‘scoped-in non-current assets’.
Investment property at fair value is a scoped-out non-current asset and thus none of the
disposal group’s impairment loss is allocated to investment property.
Note 3. The impairment loss is first set-off against any goodwill, after which any impairment loss
remaining is allocated to the remaining ‘scoped-in non-current assets’ on the basis of the
relative carrying amounts:
Total impairment loss: 14 000 – Goodwill: 0 = IL still to be allocated: 14 000
The remaining impairment loss of 15 000 is allocated based on the carrying amounts of the
Plant (scoped-in): 14 000 x 64 500 / (64 500 + 150 500) = 4 200
Building (scoped-in): 14 000 x 150 500/ (64 500 + 150 500) = 9 800
Example 14: Disposal group held for sale – subsequent impairment reversal
Rescue Limited has a disposal group that met the criteria for classification as held for sale
on 5 May 20X2. The inexperienced accountant has calculated the values of the individual
items in the disposal group using their relevant individual standards as follows but has not journalised
anything:
Immediately prior to the reclassification on 5 May 20X2:
Inventory: lower of cost and net realisable value: C30 000 (IAS 2 Inventory);
Plant: depreciated cost: C50 000 (IAS 16 Property, plant & equipment).
At year-end, 31 December 20X2:
Inventory: lower of cost and net realisable value: C75 000 (IAS 2 Inventory);
Plant: depreciated cost: C25 000 (IAS 16 Property, plant & equipment).
It has never been necessary to impair the plant.
The fair value less costs to sell of the disposal group as a whole was estimated as follows:
5 May 20X2: C70 000;
31 December 20X2: C150 000.
Required:
Show the measurement of the disposal group on 5 May and 31 December 20X2 and explain to the
accountant how the disposal group should be measured.
Solution 14: Disposal group held for sale – subsequent impairment reversal
Comment:
This example shows a disposal group involving:
An initial impairment; and
A subsequent impairment loss reversal.
The example shows that such a subsequent impairment loss reversal on a disposal group is
recognised only to the extent that:
it has not been recognised in the re-measurement of any current assets, scoped-out non-current
assets or liabilities; and
it does not exceed the cumulative impairment losses recognised in terms of IAS 36
Impairment of assets and/ or IFRS 5.
Chapter 12 613

W1: On 5 May 20X2 CA immediately Impairment loss CA immediately
before classification allocation after classification as
as HFS HFS
Inventory (scoped-out) 30 000 Note 1 N/A Note 3 30 000
Plant (scoped-in) 50 000 Note 1 (10 000) Note 3 40 000
Net assets 80 000 (10 000) Note 2 70 000 Note 2
Note 1. All individual items in the disposal group are first measured in terms of their own relevant
standards before classifying the items into the disposal group held for sale.
Note 2. The disposal group is then initially measured to the lower of its carrying amount (80 000) and
fair value less costs to sell (70 000). An impairment loss of 10 000 must be processed.
Note 3. The impairment loss must first be allocated to goodwill (not applicable in this example) and
then allocated to the scoped-in non-current assets (there was only one such item: plant).
W2: On 31 December 20X2 CA immediately Impairment loss CA immediately

before re- reversal after re-
measurement allocation measurement
Inventory (scoped-out) 75 000 Note 1 N/A Note 4 75 000
Plant (scoped-in) 40 000 Note 2 10 000 Note 4 50 000
Net assets 115 000 10 000 Note 3 125 000 Note 2
Note 1. All items other than the scoped-in non-current assets must be remeasured in terms of their own
relevant standards first. Inventory is a current asset and must thus first be measured to the
lower of cost or net realisable value of C75 000 (given) in terms of IAS 2 Inventory.
Note 2. The depreciated cost that the accountant had calculated of C25 000 must be ignored because,
from 5 May, he should no longer be depreciating the plant. Thus the plant’s carrying amount
before the IFRS 5 remeasurement should be its carrying amount after the last IFRS 5
remeasurement (i.e. C40 000).
Note 3. The fair value less costs to sell have increased by C80 000 (from C70 000 to C150 000). An
impairment loss reversal, however, may only be recognised to the extent that:
the increase has not already been recognised in terms of standards relating to items other
than the scoped-in non-current assets;
the increase does not exceed the previous cumulative impairment losses recognised in
terms of IAS 36 Impairment of assets and IFRS 5.
Part of the C80 000 increase has already been recognised by re-measuring the inventory
upwards by C45 000 (from C30 000 to C75 000). See note 1.
This leaves an increase of C35 000 (total increase: 80 000 – increase recognised in terms of
other standards: 45 000) but the portion thereof that will be recognised is limited to the
cumulative impairment losses in terms of IAS 36 Impairment of assets and IFRS 5.
The plant has never been impaired in terms of IAS 36 Impairment of assets (given) but was
impaired by C10 000 in terms of IFRS 5 (see W1). The remaining gain of C35 000 is thus
limited to the cumulative impairment loss of C10 000 (IAS 36: 0 + IFRS 5: C10 000).
Note 4. The impairment reversal would be allocated to the scoped-in non-current assets based on their
relative carrying amounts and would never be allocated to goodwill (not applicable in this
example). The entire impairment reversal is allocated to plant as it is the only scoped-in asset.
Explanation to accountant re measurement of disposal group:

On 5 May 20X2:
Immediately before the classification as ‘held for sale’, all individual items within the disposal
group should be measured based on their relevant standards. The accountant was therefore correct
in measuring inventory using IAS 2 Inventory and measuring plant in terms of IAS 16 Property,
plant and equipment.
The items are then transferred to the ‘held for sale’ category. The carrying amount of this disposal
group held for sale is C80 000 (Inventory: C30 000 + Plant: C50 000).
614 Chapter 12

Immediately after the classification as ‘held for sale’, the disposal group as a whole should then
have been measured to the lower of carrying amount and fair value less costs to sell. Since the fair
value less costs to sell were C70 000 and the carrying amount of the disposal group as a whole was
C80 000 the disposal group should have been impaired to the lower amount of C70 000 by
processing an impairment loss in terms of IFRS 5 of C10 000.
The impairment loss must first be allocated to goodwill (not applicable in this example) and then
allocated to scoped-in non-current assets (there was only one such asset: plant). The plant should
thus have been impaired by C10 000 to C40 000 (C50 000 – C10 000).
The revised carrying amount of the disposal group would thus have been C70 000 (Inventory:
C30 000 + Plant: C40 000).
On 31 December 20X2:
The fair value of the disposal group as a whole was re-estimated to be C150 000. Before any
adjustment is made, however, any current assets, scoped-out non-current assets and liabilities
should first be re-measured using their relevant standards.
There was only one such item, being inventory (a current asset). Inventory was correctly re-
measured to the lower of cost and net realisable value in terms of IAS 2 Inventory: C75 000.
This required a write-back of C45 000 (C75 000 – C30 000).
Since plant is a scoped-in non-current asset, it should not have been measured using IAS 16
Property, plant and equipment. The plant should have remained measured at C40 000.
The carrying amount of the disposal group would then have been adjusted to C115 000:
Inventory of C75 000 + Plant of C40 000 = C115 000, or
Previous CA of disposal group: C70 000 + IAS 2 Inventory write-back: C45 000 = C115 000.
The fair value less costs to sell of the disposal group as a whole has increased from C70 000 to
C150 000, however, being an increase of C80 000. This impairment loss reversal may only be
recognised to the extent that it has not already been recognised in terms of other standards and to
the extent that it does not exceed prior impairment losses in terms of IAS 36 and IFRS 5:
Since inventory has already been increased by C45 000 (write-back in terms of IAS 2
Inventory), the impairment loss reversal is limited to C80 000 – C45 000 = C35 000;
The remaining impairment loss reversal of C35 000 is then limited to the prior impairment
losses in terms of IAS 36 Impairment of assets (nil) and IFRS 5 (C10 000).
Thus an impairment loss reversal of C10 000 is recognised in terms of IFRS 5, raising the carrying
amount of the disposal group to C125 000. This gain would be allocated to scoped-in non-current
assets (only the plant in this example). (Please note: any impairment on goodwill may never be
reversed). Thus the carrying amount of the disposal group would be adjusted to:
Inventory of C75 000 + Plant of C50 000 (40 000 + 10 000) = C125 000, or
Previous CA of disposal group: C115 000 + IFRS 5 Impairment reversal: C10 000 = C125 000.
A: 5.5 Measurement of disposal groups that are not expected to be sold within one year
When measuring the fair value less costs to sell of a DGHFS that is not expected to be sold
within a year, we must measure the costs to sell at their present value. This present value will
obviously ‘unwind’ over time (i.e. the present value will increase over time) and this increase
in the present value must be recognised in profit or loss. See IFRS 5.17
A: 5.6 Measurement of disposal groups acquired with the intention to sell
A disposal group that is acquired with the intention to sell, and meets the necessary criteria
for classification as held for sale, will be immediately recognised and measured as a disposal
group held for sale and measured in terms of IFRS 5 (i.e. at the lower of carrying amount and
fair value less costs to sell). In other words, the assets and liabilities contained within the
newly acquired disposal group will not first be recognised and measured in terms of their own
relevant standards before then being transferred to the held for sale classification and
measured in terms of IFRS 5.
Chapter 12 615
Thus, the measurement of a disposal group held for sale that was acquired with the purpose of
selling, will be initially measured at the lower of:
its carrying amount had it not been so classified (for example, cost); and
its fair value less costs to sell. IFRS 5.16 (slightly reworded)
When measuring the DGHFS on initial recognition, the carrying amount is the cost that would
have been recognised had the assets and liabilities contained in the disposal group not been
immediately classified as held for sale.
A: 5.7 Measurement of disposal groups when there is a change to a plan to sell or

distribute (IFRS 5.26 - .29)
A: 5.7.1 Overview
A disposal group that was previously classified as held for sale (or held for distribution) could
subsequently fail to meet the criteria to remain classified as held for sale (or held for
distribution). If this occurs, then the disposal group must be reversed out of the held for sale
(or distribution) classification and back to its previous classification (e.g. property, plant and
equipment). See section A: 5.7.2.
It can also happen that a disposal group that was previously held for sale is now held for
distribution (or vice versa). In this case, there is still a plan to dispose of the disposal group
and thus the change in classification is considered to be a continuation of the original plan of
disposal. However, this does not mean that there will be no adjustments needed. See
section A: 5.7.3.
A: 5.7.2 If a DG subsequently fails to meet the HFS or HFD classification criteria
If a disposal group that was previously classified as ‘held for sale’ (or held for distribution) no
longer meets the criteria necessary for such a classification, the disposal group must be
removed from this classification. See IFRS 5.26
This means, that the disposal group, (i.e. the individual assets and liabilities that were
contained in the disposal group) will have to be transferred out of the classification as ‘held
for sale’ (or ‘held for distribution’) and back into its previous classification (e.g. PPE). See IFRS
5.26
Before transferring the disposal group out of the classification as ‘held for sale’ (or ‘held for
distribution’), the disposal group must be re-measured to the lower of:
its carrying amount had the disposal group never been classified as such (adjusted for any
depreciation, amortisation and/ or revaluations that would have been recognised had the
disposal group not been classified as held for sale/ distribution); and
its recoverable amount. See IFRS 5.27
Any remeasurement adjustments necessary (i.e. any adjustments to the carrying amounts of
the individual assets and liabilities) are generally recognised in profit or loss. However, if the
item that is being adjusted is an item of property, plant and equipment or an intangible asset
that was previously measured under the revaluation model, then the adjustment would be
recognised in the same way that you would recognise increases or decreases under the
revaluation model. See IFRS 5.28 & footnote 6
If it is only an individual asset or liability from within DG that subsequently fails to meet the
criteria to be classified as HFS or HFD, then we remove that asset or liability from the
disposal group held for sale (or held for distribution) but we must then also reassess whether
the remaining disposal group will continue to meet the relevant classification criteria.
616 Chapter 12
If the remaining disposal group continues to meet the relevant classification criteria, then it
remains measured as a disposal group in terms of IFRS 5.
However, if the remaining disposal group no longer meets the relevant classification criteria,
then it may no longer be measured as a group in terms of IFRS 5. However, each of the
individual non-current assets that were contained in the disposal group will need to be
individually assessed in terms of these criteria. If the individual non-current assets:
meet the criteria to be classified as held for sale (or held to distribute) then each such asset
would be individually measured in terms of IFRS 5 (i.e. at the lower of its carrying
amount and fair value less costs to sell/ distribute);
do not meet the criteria to be classified as held for sale (or held to distribute) then each
such asset would cease to be classified as held for sale (or held for distribution). See IFRS 5.29
A: 5.7.3 If a DGHFS subsequently becomes a DGHFD, or vice versa (IFRS 5.26A)
A disposal group that was previously held for sale may cease to be held for sale and become
held for distribution instead (or vice versa). In this case, the disposal group must simply be
transferred from the held for sale classification to the held for distribution classification (or
vice versa). This disposal group, which was previously held for sale (or distribution) is now
effectively classified, measured and presented as a held for distribution (or sale).
A measurement adjustment may be necessary since there is a tiny difference in how each
classification is measured: the held for sale classification is measured at the lower of carrying
amount and fair value less costs to sell, whereas the held for distribution classification is
measured at the lower of carrying amount and fair value less costs to distribute. Any
measurement adjustment would simply be accounted for as an impairment loss or impairment
loss reversal in terms of IFRS 5.20-25.
Since a reclassification from HFS to HFD (or vice versa) does not change the fact that the DG
is to be disposed of, and is thus considered to be a continuation of the original plan of
disposal, the date on which it was originally classified as HFS (or HFD) is not changed.
A: 6 Presentation and disclosure:

Non-Current Assets (or Disposal Groups) Held for Sale or Distribution
(IFRS 5.30 and .38 - .42)
A: 6.1 Overview
Presentation and disclosure refer to different things: presentation refers simply to how and
where the item/s should appear in the financial statements and whether, for example, certain
line items may be offset whereas disclosure refers to the more detailed information that must
be included in the financial statements (generally in the notes) (i.e. presentation is more
‘surface level’ whereas disclosure refers to the ‘detail’ or ‘deeper level’ information).
When talking about presentation of a non-current asset (or disposal group) held for sale, the
key word to remember is ‘separate’.
Extra disclosure will be required where the financial statements include either:
a ‘non-current asset (or disposal group) held for sale’; or
a ‘sale of a non-current asset’.
Please note that the classification of a non-current asset (or disposal group) as ‘held for sale’
will only affect the period during which it was classified as ‘held for sale’. This means that
no adjustment should be made to the measurement or presentation of the affected assets in the
comparative periods presented. See IFRS 5.40
The presentation and disclosure requirements will now be discussed with reference to each
component that is affected.
Chapter 12 617
A: 6.2 In the statement of financial position
A non-current asset (and any asset held within a disposal group) that is classified as ‘held for
sale’ must be presented separately from the other assets in the statement of financial position.
If a disposal group includes liabilities, these liabilities must also be presented separately from
other liabilities in the statement of financial position. Liabilities and assets within a ‘disposal
group held for sale’ may not be set-off against each other – the assets held for sale must be
shown under assets (but separately from the other assets) and the liabilities held for sale must
be shown under liabilities (but separately from the other liabilities). See IFRS 5.38
A non-current asset (or disposal group) held for sale is presented as a current asset. See IFRS 5.3
A: 6.3 In the statement of financial position or notes thereto
The major classes of assets and major classes of liabilities that are classified as held for sale
must be separately presented from one another. In other words, if an item of property, plant
and equipment is classified as held for sale and an investment property is classified as held for
sale, each of these asset types would need to be presented as held for sale, but separately from
one another. This presentation may be made on the face of the statement of financial position
or in the notes (in which case, they would be added together for purposes of the face of the
statement of financial position). See IFRS 5.38
A: 6.4 In the statement of other comprehensive income
Any other comprehensive income recognised on a non-current asset (or disposal group) held
for sale must be separately presented.
A: 6.5 Comparative figures
Comparative figures are not restated to reflect a reclassification to ‘held for sale’. For
example, if an item of property, plant and equipment is reclassified to held for sale during the
current period, the asset remains presented as property, plant and equipment in the
comparative period.
A: 6.6 Other note disclosure (IFRS 5.12 and 5.41-.42)
A: 6.6.1 General note (IFRS 5.41)
An entity shall disclose the following information in the notes in the period in which a non-
current asset (or disposal group) has been classified as held for sale or sold:
a) a description of the non-current asset (or disposal group);
b) a description of the facts and circumstances of the sale, or leading to the expected
disposal, and the expected manner and timing of that disposal;
c) the gain or loss recognised in accordance with IFRS 5 (paragraph 20-22) and, if not
separately presented in the statement of comprehensive income, the caption in the
statement of comprehensive income that includes that gain or loss;
d) if applicable, the segment in which the non-current asset (or disposal group) is presented
in accordance with IFRS 8 Operating Segments. IFRS 5.41
A: 6.6.2 Change to a plan of sale (IFRS 5.42)
If, during the current period, there was a decision to reverse the plan to sell the non-current
asset (or disposal group), the following extra disclosure would be required:
a) the description of the facts and circumstances leading to the decision not to sell; and
b) the effect of the decision on the results of operations for all periods presented. See IFRS 5.42
618 Chapter 12
A: 6.6.3 Events after the reporting date (IFRS 5.12 and 5.41)
If the criteria for classification as ‘held for sale’ are met after the year-end, the non-current
asset must not be classified as held for sale in that reporting period (no re-measurements
should be performed and no reclassification of the asset to ‘held for sale’ should take place).
Instead, it is treated as a non-adjusting event, with the following disclosure:

a) a description of the non-current asset (or disposal group);
b) the facts and circumstances of the sale, or leading to the expected disposal;
c) the expected manner and timing of that disposal; and
d) the segment (if applicable) in which the non-current asset (or disposal group) is presented.
IFRS 5.12 and 5.41 (a) (b) & (d)
The note disclosure of an event after the reporting period might look like this:
Example Ltd
4. Events after the reporting period

On 15 February 20X4, the board of directors decided to dispose of the shoe division following
severe losses incurred by it during the past 2 years.
The division is expected to continue operations until 30 April 20X4, after which its assets will be
sold on a piecemeal basis. The entire disposal of the division is expected to be completed by
31 August 20X4.
This shoe division is reported in the Clothing Segment.
Example 15: Disclosure of non-current assets held for sale

An entity owns only the following non-current assets:
Factory buildings; and
Plant.
Details of the factory buildings are as follows:
The factory buildings were purchased on 01/01/20X1 at a cost of C600 000,
Depreciation is provided over 10 years to nil residual values on the straight-line basis
The company is transferring part of its business to a new location and thus the existing factory
building is to be sold. The sale is expected to take place within 7 months of the end of the reporting
period. The factory building is expected to be sold for cash.
Factory buildings were reclassified as ‘held for sale’ on 30/06/20X3, on which date its fair value
less costs of disposal was C445 000 and its value in use was C440 000. Costs to sell and costs of
disposal are the same. Fair value less costs to sell remained unchanged at 31/12/20X3.
Details of the plant are as follows:
Plant was purchased on 01/01/20X1 at a cost of C100 000;
Depreciation is provided over 10 years to a nil residual value on the straight-line basis;
Plant was reclassified as ‘held for sale’ on 31/12/20X2 on which date:
- its fair value less costs of disposal was C65 000 (costs to sell = costs of disposal); and
- its value in use was C60 000;
On 30/06/20X3 (six months later), plant ceased to meet all criteria necessary for classification as
‘held for sale’, on which date its recoverable amount is C85 000 (fair value less costs to sell were
still C65 000). The plant is no longer classified as ‘held for sale’ since the intention is now to
redeploy it to other factories rather than it being sold together with the factory buildings.
Required: Disclose all information necessary in relation to the plant and factory buildings in the
financial statements for the year ended 31 December 20X3.
Chapter 12 619
Solution 15: Disclosure of non-current assets held for sale

Comment:
This example explains how to disclose:
non-current assets held for sale,
a non-current asset that is no longer held for sale.
Company name
At 31 December 20X3
20X3 20X2
C C
Non-current assets
Current assets
Non-current assets (and disposal groups) held for sale 27 445 000 65 000
Current liabilities
Liabilities of a disposal group held for sale 27 xxx xxx
Company name
20X3 20X2
Profit before tax is stated after taking into consideration the following (income)/ expenses:
Depreciation: factory building 30 000 60 000
Depreciation: plant 5 000 10 000
Impairment loss: factory building 5 000 0
Impairment loss: plant 0 15 000
Impairment loss reversed: non-current asset held for sale COMMENT 1 (10 000) 0

Factory building 0 480 000
Plant 70 000 0
70 000 480 000
Factory building:
Net carrying amount – 1 January 480 000 540 000
Gross carrying amount – 1 January 600 000 600 000
Accumulated depreciation and impairment losses – 1 January (120 000) (60 000)
Depreciation (to 30 June 20X3) (30 000) (60 000)
Impair loss in terms of IAS 36 (CA: 450 000 – FV-CoD: 445 000) (5 000) 0
Non-current asset now classified as ‘held for sale’ (445 000) 0
Net carrying amount – 31 December 0 480 000
Gross carrying amount – 31 December 0 600 000
Accumulated depreciation and impairment losses – 31 December 0 (120 000)
Plant:
Net carrying amount – 1 January 0 90 000
Gross carrying amount – 1 January 0 100 000
Accumulated depreciation and impairment losses – 1 January 0 (10 000)
Non-current asset no longer classified as ‘held for sale’ COMMENT 1 75 000 0
Depreciation (20X3: (75 000 – RV: 0) / 7,5 remaining years x 6/12) (5 000) (10 000)
Impairment loss in terms of IAS 36 (CA: 80 000 – FV-CoD: 65 000) 0 (15 000)
Non-current asset now classified as ‘held for sale’ 0 (65 000)
Net carrying amount – 31 December 70 000 0
Gross carrying amount – 31 December 100 000 0
Accumulated depreciation and impairment losses – 31 December (30 000) 0
620 Chapter 12

Company name
20X3 20X2
27. Non-current assets held for sale C C
Factory buildings 445 000 0
Plant 0 65 000
Less non-current interest bearing liabilities COMMENT 2 0 0
445 000 65 000
The company is transferring its business to a new location and thus the existing factory building is
to be sold (circumstances leading to the decision).
The sale is expected to take place within 7 months of year-end (expected timing). The factory
building is expected to be sold for cash (expected manner of sale).
No gain or loss on the re-measurement of the buildings was recognised in terms of IFRS 5.
Plant is no longer classified as ‘held for sale’ since it is now intended to be moved to other existing
factories instead of being sold as part of the factory buildings (reasons for the decision not to sell).
The effect on current year profit from operations is as follows: C
- Gross (impairment loss reversed: 10 000 – depr:5 000) 5 000
- Tax (1 500)
- Net 3 500
Comment 1: The NCAHFS is transferred back to PPE on 30 June 20X3: the NCAHFS is first re-measured to
the lower of its RA: 85 000 and its historical CA: 75 000 (100 000 – 100 000 x 10% x 2,5 years);
thus an increase from 65 000 to 75 000 (the lower). It is thus measured as if it had always been
measured in terms of IAS 16.
Comment 2: The presentation of the non-current interest bearing liabilities is shown here purely for interest
purposes since there are no liabilities in this example.
A: 7 Summary: Non-current assets held for sale

Non-current assets held for sale/ distribution
Classification
See IFRS 5.6-.7

Held for sale: Held for distribution: See IFRS 5.12A
A NCA/DG is classified as HFS if its CA is A NCA/DG is classified as HFD if the entity is
expected to be recovered mainly through a sale committed to distributing it to the owners.
of the asset than through use of the asset.
We prove the above if these criteria are met: We prove the above if these criteria are met:
the asset is available for immediate sale (in the asset is available for immediate
its present condition and at normal terms); & distribution (in its present condition); &
the sale thereof is highly probable. the distribution thereof is highly probable.
Highly probable sale: See IFRS 5.8 Highly probable distribution:

A sale is highly probable if: A distribution is highly probable if:
the appropriate level of mgmt is committed to it; actions to complete the distribution have begun
an active programme to sell has begun; the distribution is expected to be concluded
it must be actively marketed at a reasonable price within 1 yr of the date of classification as HFD
relative to its FV; actions required to complete the distribution
the sale is expected to be concluded within 1 yr should suggest that it is unlikely that:
of the date of classification as HFS (unless a - significant changes to the distribution will be
longer period is permitted in terms of IFRS 5.9) made; or that
actions required to complete the sale should - the distribution will be withdrawn
suggest that it is unlikely that:
- significant changes to the plan to sell will be
made; or that
- the plan to sell will be withdrawn.
Chapter 12 621
Non-current assets (or disposal groups) held for sale
Classification: as held for sale
General If asset not expected to Assets acquired with

be sold within 1 yr intention to sell
Normal 6 criteria 3 scenarios and related criteria 2 criteria
Measurement: Non-current asset held for sale
Cost model Revaluation model Assets acquired with

intention to sell
Initially: at cost Initially: at cost Initially: Lower of CA (cost)
Subsequently: Subsequently: and FV – CtS
Before reclassification: Before reclassification:

Depreciate and impair (if Depreciate; revalue (if FV
necessary and material) materially different to CA) and
impair (if necessary and material)
Reclassify:
Reclassify: Transfer to NCAHFS
Transfer to NCAHFS After reclassification:
After reclassification: Adjust to lower of CA & FV –
Adjust to lower of CA or FV – CtS
CtS Stop depreciating
Stop depreciating Remeasure to latest FV – CtS
Remeasure to latest FV – CtS at subsequent reporting dates
(reversals of IL limited to (reversals of IL limited to
accumulated IL’s & never accumulated IL’s & never
exceed Cost - AD) exceed FV - AD)
ILs are always expensed –
never debited to a RS bal.
If no longer held for sale
Transfer back to PPE Remeasure to lower of:

CA (had asset never been classified as
NCAHFS); and
RA
Resume depreciation
622 Chapter 12
Measurement: Disposal groups held for sale (DGHFS)

Can include:
Non-current assets (NCAs)
- Scoped-in
- Scoped-out
Current assets
Liabilities
Only scoped-in NCAs are measured in terms of IFRS 5.

All other items remain measured in terms of their own IFRSs.
If the DG includes at least one scoped-in If the DG does not include any scoped-
non-current asset in non-current assets
The disposal group as a whole will be measured in The disposal group as a whole will not be measured
terms of IFRS 5 in terms of IFRS 5
The disposal group will be classified and disclosed The disposal group will be classified and disclosed
in terms of IFRS 5 in terms of IFRS 5
Measurement of the DG if the DG includes at least one scoped-in NCA
Immediately before Immediately after Subsequent remeasurement

classification as HFS classification as HFS of a DGHFS
Re-measure each item in the DG Measure the DG to the lower Measure each of the items
based on their own standards of: excluding the scoped-in NCAs
Cost or using their own standards.
FV-CtS. Calculate the DG’s new CA.
Measure the DG to its latest FV-
CtS.
An impairment loss is first Calculate the difference: New CA
allocated to goodwill (if any) less latest FV-CtS
and any further IL is allocated
An impairment loss is first
to the scoped-in NCAs, pro-
allocated to goodwill (if any) and
rata based on their relative
any further IL is allocated to
carrying amts.
the scoped-in NCAs, pro-rata
based on their relative carrying
amts
An IL Reversal is recognised (a)
to the extent that it has not
been recognised through an
increase in the CA of scoped-out
assets when measured in terms
of their own standards, and (b)
to the extent that it does not
exceed cumulative ILs in terms
of IAS 36 and IFRS 5, and (c)
prorata to the scoped-in NCAs
based on their relative carrying
amounts (but prior ILs
recognised against GW may
never be reversed).
Chapter 12 623
PART B:
Discontinued Operations
B: 1 Introduction to Discontinued Operations (IFRS 5.31 - .36)
IFRS 5 Non-current assets held for sale and

discontinued operations explains how to account for A component of an entity
is defined as comprising:
both non-current assets held for sale and discontinued
operations. Part A explained how we account for non- operations and cash flows
current assets (and disposal groups) held for sale. In this that can be clearly distinguished,
part, Part B, we will look at how to account for a operationally and for financial
reporting purposes,
discontinued operation.
from the rest of the entity.
IFRS 5 Appendix A
IFRS 5 states that, if an entity has a component that is

identified as a discontinued operation, certain additional A component of an entity is either:
a cash-generating unit (CGU), or
presentation and disclosure requirements will need to be a group of CGUs. IFRS 5.31
applied to this discontinued operation so that users can
assess the impact of the discontinuance. The discontinued operation is measured in the same
way that a disposal group held for sale is measured.
B: 2 Identifying a Discontinued Operation (IFRS 5.31 - .36)
The definition of a discontinued operation explains that a component (i.e. being a CGU or
group of CGU’s) would need to be identified as a discontinued operation if it has been
disposed of already or is currently classified as held for sale.
This means that a component that has not yet been

disposed of but is intended to be disposed of by A discontinued operation
is defined as:
abandonment instead of by sale would not meet the
criteria to be classified as held for sale. a component of an entity that has
either been
Since it does not qualify to be classified as held for sale, - disposed of, or
it will not be able to be classified as a discontinued - is classified as held for sale;
operation until the operation has actually been and meets one of the following
criteria:
abandoned (i.e. in which case it will have been disposed
- is a separate major line of
of). business or geographical area
of operations; or
Abandonment includes the following two situations: - is part of a single co-ordinated
where the non-current assets (or DGs) will be used plan to dispose of a separate
major line of business or
until the end of their economic life; and geographical area of
where the non-current assets (or DGs) will not be operations; or
sold but will be simply closed down instead. - is a subsidiary acquired
exclusively with a view to
resale. IFRS 5 Appendix A (Reworded)
It can happen that a non-current asset (or disposal group)
classified as ‘held for sale’ also meets the definition of a discontinued operation.
For example: If a disposal group that meets the criteria to be classified as held for sale, also
meets the definition of a component and is also a separate major line of business, it will also
meet the definition of a discontinued operation. In this case, the disclosure requirements for
both disposal groups held for sale and discontinued operations would have to be provided.
Conversely, it can happen that a non-current asset (or disposal group) classified as held for
sale does not meet the definition of a discontinued operation.
624 Chapter 12
For example: If a disposal group that meets the criteria to be classified as held for sale is only
part of a cash generating unit, it would not meet the definition of a component (because a
component is either a cash generating unit or a group of cash generating units: see IFRS 5.31).
Since the disposal group held for sale does not meet the definition of a component, it would
not meet the definition of a discontinued operation. In this case, only the disclosure
requirements for disposal groups held for sale would have to be provided.
B: 3 Measurement of a Discontinued Operation
A discontinued operation is, in effect, a disposal group that is held for sale (or one that has
already been disposed of) that simply also meets the definitions of both a component and a
discontinued operation.
Thus, the principles that we applied when measuring non-current assets (or disposal groups)
as held for sale are also applied when measuring the individual items within a discontinued
operation. In other words, just as with ‘disposal groups held for sale’ (DG), ‘discontinued
operations’ (DO) could also involve all sorts of assets as well as directly related liabilities.
Whereas the classification and presentation requirements of IFRS 5 applies to all

‘discontinued operations’, the measurement requirements apply only to those non-current
assets that are included in the discontinued operation and which are ‘not scoped-out’ from the
measurement requirements.
For more information on measurement, please revise section A: 4 and section A: 5.
B: 4 Disclosure of a Discontinued Operation
B: 4.1 Profit or loss from discontinued operation (IAS 1.82 (ea) & IFRS 5.33)
A single amount showing the profit for the period from the discontinued operation must be
presented in the profit or loss section of the face of the statement of comprehensive income
where this single amount must be the total of:
the post-tax profit or loss of the discontinued operations;
the post-tax gain or loss recognised on measurement to fair value less costs to sell; and
the post-tax gain or loss recognised on the disposal of assets/ disposal groups making up
the discontinued operations. IFRS 5.33 (a)
An analysis of this single amount that is presented in the statement of comprehensive income
must be presented ‘for all periods presented’. This single amount must be analysed into the
following:
revenue of discontinued operations; IFRS 5.33 (b) (i)
expenses of discontinued operations; IFRS 5.33 (b) (i)
profit (or loss) before tax of discontinued operations; IFRS 5.33 (b) (i)
tax expense of the profit (or loss on the discontinued operations); IFRS 5.33 (b) (ii)
gain or loss on re-measurement to fair value less costs to sell; IFRS 5.33 (b) (iii)
gain or loss on disposal of discontinued operation’s assets/ disposal groups; IFRS 5.33 (b) (iii)
tax effects of gain/ loss on re-measurement or disposal. IFRS 5.33 (b) (iv)
IFRS 5.34
The analysis of this single amount must be provided ‘for all periods presented’.
The analysis of this single amount may be provided in the notes (see option A) or on the face
of the statement of comprehensive income (see option B). IFRS 5.33 (b)
Chapter 12 625
Option A: If the analysis of the profit is presented on the face of the statement of
comprehensive income, the presentation would be as follows (the figures are assumed):
Example Ltd
20X3 20X3 20X3 20X2 20X2 20X2
C’000 C’000 C’000 C’000 C’000 C’000
Continuing Discontinued Total Continuing Discontinued Total
Revenue 800 150 800 790
Expenses (300) (100) (400) (500)
Profit before tax 500 50 400 290
Taxation expense (150) (32) (180) (97)
Gains/ (losses) after tax 40 7
Gain/ (loss): re-measurement 30 10
to fair value less costs to sell
Gain/ (loss): disposal of assets 20 0
in the discontinued operations
Tax on gains/ (losses) (10) (3)

Other comprehensive income: 0 0 0 0 0 0
Option B: If the total profit or loss is presented on the face of the statement with the analysis
in the notes, the presentation would be as follows (the figures are assumed):
Example Ltd
20X3 20X2
Note C’000 C’000
Revenue 800 800
Expenses (300) (400)
Taxation expense (150) (180)
Profit for the period from continuing operations 350 220
Profit for the period from discontinued operations 4 58 200
Profit (or loss) for the period 408 420
Example Ltd
20X3 20X2
C’000 C’000
4. Discontinued operation: analysis of profit
The profit from discontinued operations is analysed as follows:
Revenue 150 790
Expenses (100) (500)
Tax on profit before tax (32) (97)
Gains/ (losses) after tax (this line item is not required) 40 7
Gain/ (loss on re-measurement to fair value less selling costs 30 10
Gain/ (loss) on disposal of assets 20 0
Tax on gains/ (losses) (10) (3)
626 Chapter 12
B: 4.2 Cash flows relating to a discontinued operation (IFRS 5.33(c))

An entity must disclose the following in respect of discontinued operations, either on the face
of the statement of cash flows or in the notes thereto, and ‘for all periods presented’:
net cash flows from operating activities;
net cash flows from investing activities; and
net cash flows from financing activities.
Example Ltd
Notes to the statement of cash flows
20X3 20X2
4. Discontinued operation: analysis of cash flows C’000 C’000
The statement of cash flows includes the following net cash flows from a discontinued operation:
Net cash flows from operating activities (assumed figures) 5 6
Net cash flows from investing activities (assumed figures) 0 1
Net cash flows from financing activities (assumed figures) (9) (4)
Net cash inflows/outflows (assumed figures) (4) 3
B: 4.3 Comparative figures (IFRS 5.34)

Comparative figures are re-presented when a component becomes classified as a discontinued
operation. For example, if a component is classified as a discontinued operation during the
current period, the profit or loss from this component in the prior period must be re-presented
as being from a discontinued operation, even though the component did not become a
discontinued operation in that prior period. The fact that the prior period profit or loss has
been re-presented must obviously be disclosed to the users.
B: 4.4 Changes in estimates (IFRS 5.35)
A change in estimate may arise in respect of the profit or loss from the period relating to a
discontinued operation disposed of in a prior period. Examples of situations in which a
change in estimate may arise include the resolution of previous uncertainties relating to:
the disposal transaction (e.g. adjustments to the selling price); and
the operations of the component before its disposal (e.g. adjustments to warranty/ legal
obligations retained by the entity).
The nature and amount of the change in estimate must be disclosed (prior periods are
obviously not adjusted since changes in estimates are processed prospectively).
B: 4.5 Other note disclosure
B: 4.5.1 Components no longer held for sale (IFRS 5.36)
Where the component is no longer ‘held for sale’, the amounts previously disclosed as
‘discontinued operations’ in the prior periods must be reclassified and included in ‘continuing
operations’. The prior period amounts must be described as having been re-presented. This
will facilitate better comparability.
See the examples of disclosure provided in B: 4.1 and assume that the discontinued operation
was first classified as such in 20X2, but that during 20X3 the criteria for classification as
‘discontinued’ were no longer met. Now look at the example disclosure below (using
option B as the preferred layout) which shows the statement of comprehensive income for
20X3. Notice that the prior year 20X2 figures shown below, whereas previously split into
‘continuing’, ‘discontinued’ and ‘total’ (in B: 4.1’s Option B) are now re-presented by
reabsorbing the discontinued amounts into the line items relating to the continuing operation.
There is now no reference to a discontinued operation.
Although IFRS 5 does not require it, it is suggested that a note be included explaining to the
user that a previously classified ‘discontinued operation’ has been reabsorbed into the figures
representing the ‘continuing operations’ of the entity, thus explaining the re-presentation of
the 20X2 figures (see the heading at the top of the 20X2 column, where the fact that it is re-
presented is made clear).
Chapter 12 627
Example Ltd
20X3 20X2
C’000 C’000
Re-presented
Revenue X2: 800 + DO revenue: 790 + DO gain: 10 1 000 1 600
X3: 800 + DO revenue: 150 + DO gains: 50
Expenses X2: 400 + DO expense:500 (400) (900)
X3: 300 + DO expense:100
Tax expense X2: 180 + DO taxes(97 + 3) (192) (280)
X3: 150 + DO taxes(32 + 10)
Comment: The above amounts tie up with the previous Option A and Option B (see Section B: 4.1).
B: 4.5.2 If the discontinued operation also meets the definition of ‘held for sale’
If the discontinued operation is also a non-current asset or disposal group that is ‘held for
sale’, then all the disclosure relating to non-current assets (or disposal groups) held for sale
would also be required:
The assets in the discontinued operation would be presented as held for sale and separated
from the entity’s other assets. The same would apply to its liabilities. IFRS 5.38
A note would be required showing:
a description of the non-current asset (or disposal group); IFRS 5.41 (a)
a description of the facts and circumstances leading to the expected disposal; IFRS 5.41 (b)
the expected manner and timing of the disposal; IFRS 5.41 (b)
the gain or loss on re-measurements in accordance with IFRS 5 and if not presented
on the face of the statement of comprehensive income, the line item that includes this
gain or loss; and IFRS 5.41 (c)
the segment (if applicable) in which the NCA (or DG) is presented. IFRS 5.41 (d)
B: 5 Summary: Discontinued Operations
Discontinued operations
Identification A component that has been disposed of or is classified as held for sale and is:
Separate major line or geographical area; or
Part of a single disposal plan to dispose of a separate major line or geographical area; or
Is a subsidiary acquired to sell
Measurement Same as for non-current assets held for sale
Disclosure Statement of comprehensive income:
Face:
Total profit or loss from discontinued operations (show in profit or loss section)
Notes or on the face:
Analysis of total profit or loss for the period:
Profit or loss
Tax effects of P/L
Gain or loss on re-measurement
Gain or loss on disposals
Tax effects of gains/ losses
Changes in estimates
Statement of cash flows: (face or notes)
Operating activities
Investing activities
Financing activities
Other notes:
Components no longer held for sale
Criteria met after the end of the reporting period
628 Chapter 12
Gripping GAAP Inventories
Chapter 13
Inventories
Reference: IAS 2; IFRS 13; IFRS 15 (including any amendments to 10 December 2014)
Contents: Page
1. Introduction 631
2. Scope 632
3. The recognition and classification of inventory 632
4. Initial measurement: cost 633
4.1 Overview 633
4.2 Purchase costs 633
4.2.1 Overview 633
4.2.2 Transport costs 634
4.2.2.2 Transport/ carriage inwards 634
4.2.2.3 Transport/ carriage outwards 634
Example 1: Transport costs 634
4.2.3 Transaction taxes and import duties 635
Example 2: Transaction taxes 635
4.2.4 Rebates 636
Example 3: Rebates 636
4.2.5 Discount received 636
Example 4: Discounts 637
4.2.6 Finance costs due to extended settlement terms 638
Example 5: Extended settlement terms 638
4.2.7 Imported inventory 640
4.2.7.1 Spot rates 640
Example 6: How to convert a foreign currency into a local currency 640
4.2.7.2 Transaction dates 640
Example 7: Imported inventory – transaction dates 641
4.3 Conversion costs (manufacturing costs) 641
4.3.1 Overview 641
4.3.2 Conversion costs are split into direct and indirect costs 642
Example 8: Conversion costs 642
4.3.3 The ledger accounts used by a manufacturer 643
4.3.3.2 Accounting for the movements: two systems 645
4.3.3.3 Calculating the amount to transfer: three cost formulae 645
Example 9: Manufacturing ledger accounts 646
4.3.4 Manufacturing cost per unit 648
4.3.5 Variable manufacturing costs (costs that vary directly with production) 649
Example 10: Costs that vary directly with production 649
4.3.6 Fixed manufacturing costs (costs that do not vary directly with production 650
Example 11: Using a suspense account 651
Example 12: Using a suspense account – 3 scenarios 652
4.3.6.1 Under-production leads to under-absorption 654
Example 13: Fixed manufacturing costs – under-absorption 654
4.3.6.2 Over-production leads to over-absorption 656
Example 14: Fixed manufacturing costs – over-absorption 656
Chapter 13 629

4.3.6.3 Budgeted versus actual fixed manufacturing rates summarised 657
Example 15: Fixed manufacturing costs – over-absorption 658
Example 16: Fixed manufacturing costs – under-absorption 659
4.4 Other costs 660
Example 17: All manufacturing costs including other costs 660
5. Recording inventory movement: periodic versus perpetual systems 662

5.1 Overview 662
5.2 Perpetual system 662
5.3 Periodic system 663
Example 18: Perpetual versus periodic system 664
5.4 Stock counts, inventory balances and stock theft 665
5.4.1 The perpetual system and the use of stock counts 665
5.4.2 The periodic system and the use of stock counts 666
Example 19: Perpetual versus periodic system and stock theft 666
5.4.3 Presenting inventory losses due to theft 667
Example 20: Perpetual and periodic system: stock theft and profits 668
6. Subsequent measurement: inventory movements (cost formulae) overview 670
6.1 Overview 670
6.2 Specific identification method (SIM) 670
Example 21: SIM purchases and sales 671
6.3 First-in, first-out method (FIFO) 671
Example 22: FIFO purchases 671
Example 23: FIFO sales 671
6.4 Weighted average method (WA) 672
Example 24: WA purchases 672
Example 25: WA sales 673
6.5 The cost formula in a manufacturing environment 673
Example 26: Manufacturing ledger accounts – FIFO vs WA formulae 674
7. Subsequent measurement: year-end 677
7.1 Overview 677
7.2 Net realisable value 677
Example 27: Net realisable value based on purpose of the inventory 678
Example 28: Net realisable value considers events after reporting period 678
7.3 Inventory Write-downs 679
Example 29: Lower of cost or net realisable value: write-downs 679
7.4 Reversals of inventory write-downs 680
Example 30: Lower of cost or net realisable value: reversal of write-downs 680
7.5 Testing for possible write-downs: practical applications 682
7.6 Presenting inventory write-downs and reversals of write-downs 682
Example 31: Lower of cost or net realisable value – involving raw materials 683
8. Disclosure 684
8.1 Accounting policies 684
8.2 Statement of financial position and supporting notes 684
8.3 Statement of comprehensive income and supporting notes 685
Example 32: Disclosure of inventory asset and related accounting policies 685
Example 33: Disclosure of cost of sales and inventory related depreciation 686
Example 34: Disclosure – comparison between the nature and function method 687
9. Summary 689
630 Chapter 13
1. Introduction
IAS 2 Inventories is the standard that explains how to account for inventory.
Inventory is simply an asset that an entity intends to sell or intends to use to provide services.
It can be anything at all, whether tangible or intangible. What is interesting is that the
classification of inventories, as is the case with other items, often depends largely on
management’s intentions. For example, we may own a variety of properties each of which
could be classified differently – based purely on intentions:
Property that we purchase with the intention of using as our factory would be classified
as property in terms of IAS 16 Property, plant and equipment;
Property that we purchase with the intention of holding for capital appreciation would be
classified as investment property in terms of IAS 40 Investment property; and
Property that we purchase with the intention of selling in the ordinary course of business
is classified as inventories in terms of IAS 2 Inventories.
The kind of inventory that a business owns depends on whether the business is a retailer,
manufacturer or service provider, or perhaps a combination thereof.
Classes of inventory according to business-type:

Retailer: Manufacturer: Service provider:
Merchandise Finished goods (or Consumable stores (e.g.
‘merchandise for sale’) fuel, cleaning materials
Work-in-progress and other incidentals) Note 1
Raw materials
Note 1:
Consumable stores do not only appear as inventory assets in the books of a service provider – they
could also appear as part of the inventory assets in the books of retailers and manufacturers.
Many entities own inventories and these inventories often represent a significant portion of
an entity’s assets. As these inventories are sold, this inventory asset is expensed and this
expense (generally called cost of sales) is then often one of the biggest expenses an entity
has. Thus, since inventory has a material effect not only on the measurement of our assets
(presented in our SOFP) but then also has an indirect effect on the measurement of our profit
or loss (through the cost of sales presented in our SOCI), how we measure our inventory is
clearly very important. The topic ‘inventories’ is thus an extremely important section for us
to understand.
The issues regarding inventories that we need to consider include:

the recognition and classification of the acquisition of inventory,
how to measure the initial recognition,
how to measure inventory subsequently:
- how to measure the cost of inventory that is sold (i.e. how to measure the amount of
the inventory that should be expensed),
- how to measure the cost of inventory that remains unsold at year-end,
when to derecognise inventory when it is sold or scrapped,
how to disclose inventories in the financial statements.
Chapter 13 631
2. Scope
The standard on inventories (IAS 2) does not apply to certain assets:

Financial instruments (these are accounted for in terms of IFRS 9 Financial instruments
and IAS 32 Financial instruments: Presentation)
Biological assets related to agricultural activity and agricultural produce at the point of
harvest (these are accounted for in terms of IAS 41 Agriculture). IAS 2.2 (reworded)
Although IAS 2 does apply to the following assets, its measurement requirements do not:
producers of agricultural and forest products, agricultural produce after harvest, and
minerals and mineral products, to the extent that they are measured at net realisable value
in accordance with well-established practices in those industries: when such inventories
are measured at net realisable value, changes in that value are recognised in profit or loss
in the period of the change.
commodity broker-traders who measure their inventories at fair value less costs to sell:
when such inventories are measured at fair value less costs to sell, changes in fair value
less costs to sell are recognised in profit or loss in the period of the change. IAS 2.3 (reworded)
Please note that prior to the publication of IFRS 15 Revenue from contracts with customer,
IAS 2 clarified that costs incurred by a service provider would be recognised as inventory to
the extent that the related revenue could not be recognised. This clarification has since been
removed from IAS 2 (previously included in IAS 2.8). After the publication of
IFRS 15 Revenue from contracts with customers, IAS 2 has also been amended to clarify that
any costs that are not able to be accounted for in terms of IAS 2 Inventories or in terms of any
other standard (e.g. IAS 16 Property, plant and equipment) will be accounted for in terms of
IFRS 15 instead.
3. The Recognition and Classification of Inventory
IAS 2 does not focus on when inventory should be

recognised as an asset but rather on the measurement of An asset is:
inventory that has been recognised as an asset and on
Recognised: when it meets the
how and when the inventory that has been recognised as recognition criteria
an asset should be recognised as an expense. Classified as inventory: when it meets
the definition of inventory
Since IAS 2 does not explain when inventory should be
recognised as an asset, we look to the Conceptual
Framework for guidance. This is because the definition of inventory (given in IAS 2) states
clearly that inventory is an asset and thus inventory would be initially recognised as an asset
when the Conceptual Framework’s definition of an asset and related recognition criteria are
met. (See chapter 2).
Once we have decided that the cost of our inventory Inventory is defined as:
should be recognised as an asset, we must then decide if An asset that is held:
it may be classified as inventory. We do this by - for sale in the ordinary course of
assessing whether it meets the inventory definition given business; or
in IAS 2 (see pop-up alongside). - in the process of production for
such sale; or
If we look carefully at this definition of inventory, we - in the form of materials or
see that it essentially includes what: supplies to be consumed in the
retailers commonly refer to as merchandise; production process or in the
manufacturers commonly refer to as raw materials, rendering of services. IAS 2.6
work in progress and finished goods; and
service providers, retailers and manufacturers commonly refer to as consumable stores.
632 Chapter 13
If we look carefully at this definition of inventory, we will also see that it clarifies that, other
than consumables held in the production process or in the rendering of services, an asset may
only be classified as inventory if it is being held for sale (or held in the process of
manufacture for the eventual sale) in the ordinary course of business. Thus, for example, if
our ordinary business involves buying and selling properties, we would classify these
properties as inventories, but if our ordinary business is not the buying and selling of
properties and yet we happen to buy a property that we intend to sell as soon as we can make
a profit, although our intention is to sell it, we would not classified this property as inventory
because it will not be sold as part of our ordinary business activities.
Inventory assets are subsequently recognised either as expenses or as other assets as follows:
inventory is subsequently recognised as an expense in the periods in which:
- the inventory is sold and the related revenue is recognised, or
- the inventory is written down to net realisable value; or
inventory is subsequently recognised as part of another asset if the inventory was used in
the manufacture of the other asset (e.g. a self-constructed plant), in which case the cost of
this inventory will eventually be expensed when depreciating the plant. See IAS 2.34 -.35
Inventory write-down expenses (i.e. cr inventory asset, dr write-down expense) may
subsequently be reversed (e.g. dr inventory asset, cr write-down expense reversed). See IAS 2.34
4. Initial Measurement: Cost (IAS 2.10 - .18)
4.1 Overview (IAS 2.10 and IAS 2.20)

Cost includes:
The initial measurement of inventory (whether we
simply purchase the inventory or manufacture it Purchase cost
ourselves) is always at cost. The costs that one should Conversion costs
Other costs to bring to its current
capitalise to the inventory account include the:
location and condition. See IAS 2.10
costs to purchase the inventory,
In the case of agricultural produce
costs to convert the inventory, and harvested from biological assets, cost is
other costs required in order to bring the inventory FV less costs to sell See IAS 2.20
to its present location and condition.
Conversion costs arise if an entity buys goods that still need to be put into a saleable or usable
condition (e.g. an entity that manufactures its own inventory). In other words, entities that
simply purchase goods for immediate resale (merchandise), would not incur conversion costs.
When dealing with agricultural produce harvested from biological assets, the cost is measured
on the date it is harvested at fair value less costs to sell. See IAS 2.20
4.2 Purchase costs (IAS 2.11 & including IAS 2.11: E1, E2 and E3)
4.2.1 Overview
All purchase costs should be capitalised as part of the cost of the inventory asset. Purchase
costs are the costs directly associated with the acquisition, being the:
purchase price,
transport costs (inwards) (section 4.2.2),
import duties and transaction taxes that the entity is unable to reclaim (section 4.2.3), and
other directly attributable costs. See IAS 2.11
Purchase costs exclude the following (i.e. these would not be capitalised to inventory):
transport costs (outwards) (section 4.2.2.3),
import duties and transaction taxes that are reclaimable by the business (section 4.2.3),
financing costs due to extended payment terms (section 4.2.6).
Chapter 13 633
The following would be set-off against (i.e. deducted from) the cost of the inventory:
rebates received (section 4.2.4),
trade, bulk and cash discounts received (section 4.2.5),
settlement discounts received or expected to be received (section 4.2.5).
A further issue to consider (although not complicated at all) is how to calculate cost when the
inventory is imported rather than purchased from a local supplier (section 4.2.7).
4.2.2 Transport costs (IAS 12.11)
4.2.2.1 Overview
There are two types of transport (carriage) costs, each of which is accounted for differently:
transport inwards; and
transport outwards. Transport costs:
4.2.2.2 Transport/ carriage inwards Inwards: capitalise to inventory

Outwards: expense.
The cost of transport inwards refers to the cost of transporting the purchased inventory from
the supplier to the purchaser’s business premises.
It is a cost that was incurred in ‘bringing the inventory to its present location’ and should
therefore be capitalised to (i.e. included in) the cost of inventory asset.
4.2.2.3 Transport/ carriage outwards

Frequently, when a business sells its inventory, it offers to deliver the goods to the customer’s
premises. The cost of this delivery is referred to as ‘transport outwards’.
It is a cost that is incurred in order to sell the inventory rather than to purchase it and may
therefore not be capitalised (since it is not a cost that was incurred in ‘bringing the inventory
to its present location’). Transport outwards should, thus, be recorded as a selling expense in
the statement of comprehensive income instead of capitalising it to the cost of the inventory.
Example 1: Transport costs
Bee Limited purchased inventory for C100 000 on credit. No VAT was charged.
This inventory was then sold for C150 000 on credit.
A professional trucking company charged C25 000 to:
transport this inventory inwards (from the supplier to Bee) C10 000
transport this inventory outwards (from Bee to the customer) C15 000
Required: Calculate the cost of the inventory and show all related journals.
Solution 1: Transport costs

Debit Credit
Trade payable (L) 100 000
Cost of inventory purchased on credit
Transport (E) 15 000
Cost of delivery: delivery to our premises (transport inwards) is
capitalised and delivery to our customer (transport outwards) is expensed.
Trade receivable (A) 150 000
Sale (I) 150 000
Sale of inventory
Cost of sales (E) 100 000 + 10 000 110 000
Cost of the inventory sold
634 Chapter 13
4.2.3 Transaction taxes and import duties (IAS 2.11)
The acquisition of inventory very often involves the Transaction taxes &
payment of transaction taxes and import duties. Import duties:
Not claimable: capitalise to inventory
However, the only time that transaction taxes (e.g. VAT)
Claimable: capitalise to receivable a/c.
and import duties will form part of the cost of inventory
is if they may not be claimed back from the tax authorities.
This happens, for example, where the entity fails to meet certain criteria laid down by the tax
authority (e.g. if the entity is not registered as a vendor for VAT purposes).
In summary:
If the transaction taxes and import duties are not reclaimable, then obviously the business
has incurred a cost and this cost may then be capitalised to the inventory account.
If the transaction taxes and import duties are able to be reclaimed at a later date from the
tax authorities, then no cost has been incurred.
Example 2: Transaction taxes
An entity purchased inventory. The costs thereof were as follows:
Total invoice price (including 14% VAT) paid in cash to the supplier: C9 120
Import duties paid in cash directly to the country’s Customs Department: C5 000
Required: Show the ledger accounts assuming:
A. The VAT and the import duties were refunded by the tax authorities one month later.
B. The VAT and the import duties will not be refunded.
Solution 2A: Refundable taxes and import duties

Inventory (Asset) VAT (Asset)
(1) (5) (1)
Bank 8 000 Bank 1 120 Bank (3) 1 120
Bank Import duties receivable (Asset)
VAT (3) 1 120 Inv & VAT (1) 9 120 Bank (2) 5 000 Bank (4) 5 000
(4) (2)
I/D receivable 5 000 I/D receivable 5 000
Comments:
(1) The VAT portion of the invoice price must be recognised separately as a receivable because the entity claims
this VAT back: C9 120 / 114 x 14 = C1 120. The rest of the invoice price is recognised as inventory since this
represents a real cost to the entity: C9 120 / 114 x 100 = C8 000
(2) The import duties payable directly to the Customs Department were refundable and therefore the entire import
duty paid is recognised as a receivable – and not as part of the cost of the inventory.
(3) VAT refund received.
(4) Import duty refund received.
(5) Notice that the inventory account reflects C8 000 and that equals net amount paid per the bank account is also
C8 000: Payments: C9 120 + C5 000 – Receipts: C1 120 + C5 000.
Solution 2B: Non-refundable taxes and import duties

Inventory (Asset) Bank
Bank (1) 9 120 Inv (1) 9 120
Bank (2) 5 000 Inv (2) 5 000
14 120 (3) 14 120
Comments:
(1) The VAT portion of the invoice price is not separated since none of it is refundable.
(2) The import duties payable directly to the Customs Department were not refundable and are therefore part of
the costs of acquiring the inventory.
(3) Notice that the inventory account reflects a balance of C14 120 and that this equals the amount paid per the
bank account: C9 120 + C5 000.
Chapter 13 635
4.2.4 Rebates (IAS 2.11 & IAS 2.11:E2)
The entity that is purchasing inventory may receive a

rebate. There are many different types of rebates possible, Rebates received:
but essentially the rebate received could be designed:
against purchase cost: cr inventory.
to reduce the purchase price; or
against selling costs: cr income
to refund certain of the entity’s selling expenses.
If the rebate received was meant to reduce the purchase price, the rebate must be credited to
the inventory asset (i.e. the rebate will reduce the cost thereof).
If the rebate received was meant to refund certain of our selling expenses (the rebate is not a
direct reduction of the inventory purchase price), the rebate must be credited to income (i.e.
the rebate will not reduce the cost of inventory).
Example 3: Rebates
An entity purchased inventory for cash. The details thereof were as follows:
C
Invoice price (no VAT is charged on these goods) 9 000
Rebate offered to the entity by the supplier 1 000
Required: Show the ledger accounts assuming that the terms of the agreement indicated the rebate:
A. was a reduction to the invoice price of the inventory;
B. was a refund of the entity’s expected selling costs.
Solution 3A: Rebate reducing cost of inventory

Bank (1) 8 000 Inv (1) 8 000
Comments:
(1) The rebate reduces the cost of inventory: 9 000 – 1 000 = 8 000
Solution 3B: Rebate not reducing cost of inventory

Bank (1) 9 000 Inv (1) 8 000
Rebate received (Income)

Inv (1) 1 000
Comments:
(1) The cost of inventory is shown at C9 000 even though only C8 000 is paid. This is because the rebate of
C1 000 is not connected to the cost of the inventory but the entity’s future expected selling costs. The rebate is
recognised as income instead because, by recognising it as income, it enables the rebate income to be matched
with the related selling expenses.
4.2.5 Discount received (IAS 2.11 and IAS 2.11E1&E2)

All discounts received:
There are a variety of discounts that you could receive on are credited to the inventory account.
the purchase of goods:
trade discount or bulk discount: this is usually received after successfully negotiating the
invoice price down, because you are a regular customer or you are buying in bulk;
cash discount: this is sometimes received as a ‘reward’ for paying in cash;
settlement discount: this is sometimes received as a ‘reward’ for paying promptly.
All these discounts are deducted from the cost of the inventory. Trade discounts, bulk
discounts and cash discounts are generally agreed to on the transaction date. Settlement
discounts, however, will have to be estimated on the transaction date based on when the entity
expects to settle its account with the creditor.
636 Chapter 13
As mentioned above, the cost of our inventory is reduced by all and any discounts offered to
us – it is even reduced by settlement discounts offered to us... even though we are not yet sure
that we will be successful in paying in time and thus securing the settlement discount.
The way settlement discount works is that we reduce the cost of our inventory (credit) by the
amount of any settlement discount offered to us and debit a negative liability account
‘deferred finance expense’. I call this a negative liability account simply because this account
is used to reduce the measurement of a liability account: the account payable.
For example: if we buy inventory for C1 000 and are offered a C200 settlement discount, we
would credit the account payable with C1 000 (liability) and would debit the deferred finance
expense with C200 (negative liability): the net of these two accounts would be reflected in
the statement of financial position as an account payable of C800 (C1 000 – C200).
Thus, this so-called ‘negative liability ‘account (i.e. the deferred finance account) shows us
how much we are able to reduce our payable balance by if we can pay on time:
If we do pay on time, and thus we secure the settlement discount, the deferred finance
account (which will have had a debit balance) will be reversed out (credited) and set off
(debited) against the trade payable account, thus reducing the amount we owe.
If we do not pay on time, and thus we lose our settlement discount, it simply means that
the deferred finance account (which will have had a debit balance), instead of reducing
the amount we have to pay, will be reversed out (credited) and expensed (debited) instead.
Example 4: Discounts
An entity purchased inventory. The costs thereof were as follows: C
Marked price (no VAT is charged on these goods) 9 000
Trade discount 1 000
Required: Show the ledger accounts assuming:
A. The entity pays in cash on transaction date and receives a cash discount of C500.
B. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the
entity pays within the required period of 20 days.
C. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the
entity pays after a period of 20 days.
Solution 4A: Trade discounts and cash discounts

Bank (1) 7 500 Inventory (1) 7 500
(1) The marked price is reduced by the trade discount and the cash discount: 9 000 – 1 000 – 500
Solution 4B: Trade discounts and settlement discounts – payment on time

Inventory (Asset) Trade payables (Liability)
Bank (1) 7 600 Bank (2) 7 600 Inventory (1) 8 000
DFE (3) 400
Bank Deferred finance expense (DFE) (negative liability)
Tr Payable (2) 7 600 Inventory (1) 400 Tr Payable (3) 400
Comments:
(1) The marked price is reduced by the trade discount and the estimated settlement discount:
9 000 – 1 000 – 400 = 7 600.
The settlement discount is an estimated discount until the payment is made within the required period, at
which point the discount becomes an actual discount received.
Until then, the creditor’s account is credited with the full amount payable and an allowance for possible
settlement discount of C400 is debited. The C400 potential discount is journalised even if the entity
does not expect to pay within the settlement period.
Trade payables presented in the statement of financial position are shown net of the allowance account
(i.e. not shown separately).
Chapter 13 637

(2) The entity pays within 20 days and the settlement discount becomes a reality (i.e. the estimated discount
becomes an actual discount). The payment is therefore only C7 600.
(3) Since the creditor is paid within the required settlement period, the entity earned its settlement discount
Thus reverse the settlement discount allowance to creditors account (i.e. the balance owing becomes nil).
Solution 4C: Trade discounts and settlement discounts – payment late

Inventory (Asset) Trade payables (Liability)
Bank (1) 7 600 Bank (2) 8 000 Inventory (1) 8 000
Bank Deferred finance expense (negative liability)

Tr Payable (2) 8 000 Inv (1) 400 Fin exp (3) 400
Finance expense
DFE (3) 400
Comments:
(1) The marked price is reduced by the trade discount and the estimated settlement discount: 9 000 – 1 000
– 400 = C7 600.
The settlement discount is an estimated discount until the payment is made within the required period, at
which point the discount becomes an actual discount received.
Until then, the creditor’s account is credited with the full amount payable and a deferred finance
expense of C400 is debited (this reduces the carrying amount of the creditors presented in the statement
of financial position).
The C400 potential discount is journalised even if the entity does not expect to pay within the settlement
period.
Trade payables presented in the statement of financial position are shown net of the deferred finance
expense account (i.e. these 2 accounts are not shown separately).
(2) The entity pays after 20 days and the settlement discount is forfeited. They must now pay C8 000.
(3) Because we did not pay the creditor within the required period, we lose the settlement discount.
The deferred finance expense (negative liability) is thus reversed and recognised as an expense.
4.2.6 Finance costs due to extended settlement terms

Extended settlement terms:
Instead of paying in cash on transaction date or paying measure inventory at PV (cash price)
within a short period of time after transaction date, an if difference between PV and agreed
entity may arrange to pay after a long period of time. price is material (the difference is
This is referred to as an extended settlement period. An recognised as interest expense).
arrangement to pay a supplier after an extended
settlement period, is often referred to as extended credit terms/ extended settlement terms /
deferred payment terms etc.
If we purchased inventory on extended credit terms, the price we would be charged would
generally be higher than the cash price equivalent. In all cases, however, (i.e. even if our
supplier purports to be allowing us to pay after an extended period of time but with no related
increase in the price), we must still account for the time value of money when estimating the
cost of the inventory. This is a general principle that applies in all cases where the effect of
the time value of money is considered to be material. Thus we reduce the price we have to
pay by the cost of the time value of money and recognise this reduced price as the cost of the
inventory. The cost of the time value of money, being the extra cost incurred in order to pay
after an extended period of time, must be reflected as an interest expense. See IAS 2.18
Example 5: Extended settlement terms
An entity purchased inventory on 1 January 20X1. The costs were as follows:
Invoice price payable on 31 December 20X2 C6 050
Market interest rate 10%
A. The effect of the time value of money is not considered to be material; and
B. The effect of the time value of money is considered to be material.
638 Chapter 13
Solution 5A: Extended settlement terms: immaterial effect

Inventory (A) 6 050
Cost of inventory purchased on credit (time value ignored because
effects immaterial to the company)
31 December 20X2
Bank (A) 6 050
Payment for inventory purchased from X on 1 Jan 20X1 (2 years ago)
Solution 5B: Extended settlement terms: material effect

The cost of the inventory must be measured at the present value of the future payment (thereby
removing the finance costs from the cost of the purchase, which must be recognised as an expense).
The present value can be calculated using a financial calculator by inputting the repayment period
(2 years), the future amount (6 050) and the market related interest rate (10%) and requesting it to
calculate the present value. (n = 2; FV = 6 050, i = 10, COMP PV)
This can also be done without a financial calculator, by following these steps:
Step 1: calculate the present value factors (PV factor)
PV factor on due date 1.00000
PV factor 1 year before payment is due 1 / (1+10%) 0.90909
PV factor 2 years before payment is due 0.90909 / (1 + 10%) or 1 / (1 + 10%) / (1 + 10%) 0.82645
Step 2: calculate the present values
Present value on transaction date 6 050 x 0.82645 (2 years before payment is due) 5 000
Present value one year later 6 050 x 0.90909 (1 year before payment is due) 5 500
Present value on due date Given: future value (or 6 050 x 1) 6 050
The interest and balance owing each year can be calculated using an effective interest rate table:
Year Opening balance Interest expense Payments Closing balance
20X1 5 000 Opening 500 5 000 x (0) 5 500 5 000 + 500
PV 10%
20X2 5 500 550 5 500 x (6 050) 0 5 500 + 550 – 6 050
10%
1 050 (6 050)
Notice that the present value is C5 000 and yet the amount paid is C6 050. The difference between these
two amounts is C1 050, which is recognised as interest expense over the two years.
Inventory (A) 5 000
Trade payable (L) * 5 000
Cost of inventory purchased on credit (invoice price is 6 050, but
recognised at present value of future amount) – see step 2 above
31 December 20X1
Interest expense (E) 500
Trade payable (L) * 500
Effective interest incurred on present value of creditor: 5 000 x 10%
31 December 20X2
Interest expense (E) 550
Trade payable (L) * 550
Effective interest incurred on present value of creditor: 5 500 x 10%
Bank (A) 6 050
Payment of creditor: 5 000 + 500 + 550
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* Notice that the trade payable balance:
At 1 January 20X1 (2 years before payment is due) is 5 000. This is calculated using the ‘present value factor
for two years’: 6 050 x 0.82645 = 5 000,
At 31 December 20X1 (1 year before payment is due) is 5 500 (5 000 + 500). This can be checked by using
the ‘present value factor after 1 year’ of 0.90909: 6 050 x 0.90909 = 5 500.
At 31 December 20X2 (immediately before payment) is 6 050 (5 000 + 500 + 550). This can be checked using
the ‘present value factor for now’ of 1: 6 050 x 1 = 6 050
4.2.7 Imported inventory

When inventory is purchased from a foreign supplier the goods are referred to as ‘imported’.
4.2.7.1 Spot rates Cost of imported inventory:
A complication of an imported item is that the cost of the the cost in foreign currency
goods purchased is generally denominated (stated) in a currency
converted into the cost in local
foreign currency on the invoice. Before we can record using the spot exchange rate on
this purchase, the foreign currency amount must be: transaction date
converted into the reporting entity’s functional
currency (generally his local currency)
using the spot exchange rate (the exchange rate on a specific date) on transaction date.
Example 6: How to convert a foreign currency into a local currency
We want to convert $1 000 (USD) into our local currency: South African Rands (R).
Required: Calculate the number of Rands we will receive if the exchange rate ruling on the date we
want to exchange Dollars for Rands is:
A. R5: $1 (direct method); and
B. $0.20: R1 (indirect method).
Solution 6: How to convert a foreign currency into a local currency

Tip: divide by the currency you’ve got and multiply by the currency you want. Thus, since we have a
dollar amount and want to know the Rand amount, we divide by the dollar and multiply by the Rand.
A: Dollar is the base (the exchange rate is reflected based on $1): $1 000 / $1 x R5 = R5 000
B: Rand is the base (the exchange rate is reflected based on R1): $1 000 / $0.20 x R1 = R5 000
4.2.7.2 Transaction dates The transaction date is

generally the date on which
Imports generally involve quite a delay between the date the control and risks and
on which the goods are ordered, loaded for transportation rewards of ownership transfer to us.
and then finally received. Somewhere between these
dates is the transaction date. The transaction date for an imported item of inventory is
determined as with any purchase of inventory. It is simply when the item purchased meets
the definition of an asset and the recognition criteria relating to assets as set out in the
Conceptual Framework. To determine this date, we must pay special attention to when the
risks and rewards of ownership are transferred.
There are many ways to purchase goods from a foreign supplier, two common ways being: on
a ‘free on board’ (FOB) basis or ‘delivered at terminal’ (DAT) basis. The difference between
the two terms affects the date on which risks and rewards are transferred and thus the
transaction date. The terms of the agreement must always be thoroughly investigated first; for
example, consider the effect of FOB or DAT on the date of transfer of risks and rewards:
if goods are purchased on a FOB basis, the risks and rewards are transferred as soon as
the goods are literally delivered over the ship’s rail at the foreign port; and
if goods are purchased on a DAT basis, the risks and rewards are transferred when the
goods are unloaded at the named destination terminal/ port/ other named destination.
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Since currency exchange rates vary daily, it is very important to identify the correct
transaction date since this is not only the date on which we recognise the purchase but it also
determines which spot exchange rate to use when measuring the cost of the inventory.
Example 7: Imported inventory – transaction dates
A South African company (currency: Rands: R) purchases $100 000 of raw materials from
an American supplier (currency: Dollars: $).
The following are the spot rates (rates of exchange on a particular date):
Date: R: $1
1 January 20X2 R7,20:$1
15 February 20X2 R7,30: $1
15 March 20X2 R7,50: $1
The goods were loaded onto the ship in New York on 1 January 20X2 and were
unloaded at the prescribed Durban harbour (South Africa) on 15 February 20X2.
The company pays the American supplier on 15 March 20X2.
Required: Show the related journal entries, assuming the following:
A. The goods are purchased FOB.
B. The goods are purchased DAT: Durban harbour (SA) .
Solution 7: Imported inventory – transaction dates Ex 7A: FOB Ex 7B:

DAT
1 January 20X2 (FOB) OR 15 February 20X2 (DAT) Dr/ (Cr) Dr/ (Cr)
Inventory (A) A: $100 000 x 7,20 = R720 000 720 000 730 000
Account payable (foreign) (L) B: $100 000 x 7,30 = R730 000 (720 000) (730 000)
Purchase of inventory from a supplier in New York, on credit
15 March 20X2
Foreign exchange loss (E) A: ($100 000 x 7,50) – 720 000 30 000 20 000
Account payable (foreign) B: ($100 000 x 7,50) – 730 000 (30 000) (20 000)
Translation of foreign creditor on payment date
Account payable (foreign) (L) A & B: $100 000 x 7.50 750 000 750 000
Bank (A) (750 000) (750 000)
Payment of foreign creditor
Comment:
The amount paid under both situations is R750 000 (using the spot rate on payment date).
The transaction dates differed between part A (FOB) and part B (DAT) and thus the cost of inventory differs
in each case since inventory is measured at the rate ruling on the transaction date.
The movement in the spot rate between transaction date and payment date is recognised in profit and loss (i.e.
not as an adjustment to the inventory asset account).
4.3 Conversion costs (manufactured inventory) (IAS 2.12 - .14)

4.3.1 Overview
Some businesses simply purchase finished goods (often called merchandise) and sell these to
customers. These entities are in the retail business. Other businesses manufacture goods
(often called finished goods) and sell these to their customers.
Whilst the cost of purchased inventory is very often simply the purchase cost, inventory that
is manufactured would normally include purchase costs and costs of conversion. Conversion
costs are the costs incurred during the manufacturing process (i.e. where raw materials are
converted into finished goods) and are often referred to as manufacturing or production costs.
Retail business Manufacturing business
Purchase cost: merchandise Purchase cost: raw materials

+ +
Other costs: to bring to its present location & condition Conversion costs (manufacturing costs)
+
Other costs: to bring to present location & condition
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4.3.2 Conversion costs are split into direct costs and indirect costs
The process of conversion refers to the process of
Conversion costs (i.e
turning raw materials into a finished product. This manufacturing costs) include:
conversion is commonly referred to as the production or
Direct costs (factory wages)
manufacturing process. Conversion costs are thus the
Indirect costs (overheads)
costs of production – also called manufacturing costs.
- Fixed overheads
These conversion costs can be separated into direct costs - Variable oveheads.
(e.g. direct raw materials and direct labour) and indirect costs (i.e. manufacturing overheads).
The indirect costs (manufacturing overheads) can also be Variable costs are defined
separated into two different types: as the manufacturing costs
Variable costs (also called variable manufacturing (indirect costs) that:
overheads) are the indirect costs that increase or vary directly or nearly directly
decrease as production increases or decreases (e.g. with the volume of production. IAS 2.12
cleaning materials).
Fixed costs (also called fixed manufacturing Fixed costs are defined as
overheads) are the indirect costs that remain the manufacturing costs
(indirect costs) that:
relatively unchanged despite the number of items
remain relatively constant
produced (e.g. factory rent and administration costs
regardless of the volume of
relating to the factory). See IAS 2.12 IAS 2.12
production.
When calculating the cost of manufactured inventory, we must ensure that we exclude costs
that are not related to the manufacturing process (e.g. administration costs relating to sales or
to head office activities) and exclude costs incurred during periods of idleness. See IAS 2.12-.13
Figure 1: Conversion costs
Conversion costs
Direct costs Note Indirect costs

(e.g. factory labour) (i.e. manuf. overheads)
Variable costs Fixed costs

(e.g. electricity) (e.g. factory rent)
Vary Do not vary

with production levels with production levels
Note: Direct costs generally vary with production but some don’t (e.g. the cost of wages for factory workers
where the terms of the wage contracts result in a constant wages irrespective of the level of production)
The cost of the raw materials start by being allocated to the raw materials account but when
the process of converting the raw materials into a finished product begins, the cost of these
raw materials plus the costs involved in converting them into a finished product (i.e. the
conversion costs) are then allocated to the work-in-progress account.
Example 8: Conversion costs
Local Limited manufactures flags. The following information applies:
Depreciation of C50 000 is incurred during January 20X1:
- 80% relates to factory machinery and 20% relates to office equipment
- 25% of this equipment is used by factory administration staff and 75% relates to
office equipment used by head office administration staff
- the machinery was used 70% of the time in manufacturing inventory and the
balance of the time, the machinery was idle.
Required: Journalise the above information.
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Solution 8: Conversion costs

Debit Credit
Depreciation – factory machinery (E) 50 000 x 80% 40 000
Factory machinery: accumulated depreciation (-A) 40 000
Depreciation on factory machinery
Depreciation – office equipment (E) 50 000 x 20% 10 000
Office equipment: accumulated depreciation (-A) 10 000
Depreciation on office equipment
Inventory: work-in-progress (A) 30 500
Depreciation – factory machinery (E) 40 000 x 70% 28 000
Depreciation – office equipment (E) 10 000 x 25% 2 500
Capitalisation of depreciation used to make inventory
Comments:
The depreciation on machinery incurred:
- that is incurred while inventory was being manufactured is capitalised to the inventory account as part of
the directly attributable costs of conversion [IAS 2.11];
- while the machinery is idle is expensed [IAS 2.13 states that costs of idle plant should not be capitalised].
Thus the depreciation on the factory machinery to be capitalised to the cost of inventory as an indirect and
fixed production cost is: C40 000 x 70% = C28 000
The depreciation on the office equipment that relates to the management/ administration of the factory
qualifies to be capitalised to the cost of inventory but the depreciation on the equipment that is used for
administration purposes outside of the factory process remains expensed [IAS 2.12]
The total depreciation is first expensed and then, at year-end, a proportion thereof is re-allocated to the asset
account (i.e. first expensed in full and then a portion capitalised).
The reason why the depreciation is first expensed (i.e. not capitalised directly to the inventory account) is so
that the total depreciation incurred during the period can be easily calculated for inclusion in the property,
plant and equipment roll forward (i.e. the reconciliation between the opening and closing carrying amounts).
Having evidence of the total depreciation charge also enables reconciliation between the total depreciation
and the total depreciation expensed to be disclosed. An extract of the related note is as follows:
Profit before tax Jan 20X1
Profit before tax is stated after taking into account the following separately disclosable items:
Depreciation expense – factory machinery See IAS 1.104
12 000
See IAS 16.73
- Total depreciation per machinery note 40 000
- Less depreciation capitalised to inventory (28 000)
Depreciation expense – office equipment See IAS 1.104
7 500
See IAS 16.73
- Total depreciation per office equipment note 10 000
- Less depreciation capitalised to inventory (2 500)
4.3.3 The ledger accounts used by a manufacturer
4.3.3.1 Overview
The physical sequence of events in a manufacturing business is reflected in the inventory
ledger accounts that we use. Start by imagining three buildings:
A store-room: we use this to store our raw materials;
A factory building: we use this to convert our raw materials into finished goods;
A shop: we use our shop to sell our finished goods.
Now, we need to describe what is happening in each of these three imaginary buildings in our
ledger. We do this as follows:
What happens in our store-room is reflected in the raw materials account;
What happens in our factory building is reflected in the work-in-progress account; and
What happens in our shop is reflected in the finished goods account.
Chapter 13 643
Store-room Factory Shop Customer

Raw materials account Work-in-progress account Finished goods account Cost of sales account
Imagine the following scene:

Raw materials are purchased. They are delivered to
our premises and put in a storeroom. The accountant Manufacturing process
shows raw materials stored in the storeroom in the Raw materials account (RM)
raw materials account. - In: purchases
Some of the raw materials are now loaded onto a - Out: transfers to WIP:
truck and driven out of the storeroom to the factory Work-in-progress account (WIP)
building, 100 metres away. The accountant shows this - In: transfers from RM plus
scene by moving an amount out of the raw materials conversion costs
account and into the work-in-progress account. - Out: transfers to FG: completed item
Now, the events occurring in the factory building are Finished goods account (FG)
reflected in the work-in-progress account. Thus, as - In: transfers from WIP
- Out: transfers to CoS: items sold
the raw materials come into the factory building
(from the store-room), so this work-in-progress Cost of sales (CoS)
account is increased. But it is obviously not just the - In: transfers from FG
raw materials that enter the factory building: the factory workers come inside too (costing
us factory wages), as do a variety of other supplies such as cleaning materials, electricity
and water – and our machinery gets used up too. The cost of each of these items is also
added to the work-in-progress account (and yes – if costs such as wages and depreciation
occur due to the manufacturing process, these costs are capitalised to the inventory
account and are thus not expensed!)
When some of the raw materials have been successfully converted into finished products
(i.e. completed), the finished products are loaded onto a vehicle and driven out of the
factory and delivered to our shop (or our finished goods warehouse if we do not sell
directly to the public). The accountant reflects this movement of inventory out of the
factory and into the shop by taking an appropriate amount out of the work-in-progress
account and putting it into the finished goods account instead.
The finished goods account shows the story about what happens in our shop. When these
goods are sold to customers, the relevant cost per unit sold is removed from this account
and allocated to the cost of goods sold account (the final expense account).
Figure 1: Flow of ledger accounts in a manufacturing environment
Raw materials account Conversion costs
Direct costs Indirect costs

(e.g. factory labour) (i.e. manufacturing overheads)
Variable costs Fixed costs

(e.g. electricity) (e.g. factory rent)
Work-in-progress account
Finished goods account
Cost of sales account
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4.3.3.2 Accounting for the movements: two systems

The movement of inventory between these inventory accounts can be accounted for in two
different ways, commonly referred to as the perpetual
There are two systems:
system and the periodic system.
Perpetual system
Periodic system
The perpetual system involves accounting for the
movements as and when they are physically happening.
The periodic system involves counting the items of inventory on hand periodically (e.g. at
year-end) and assuming that all items that are no longer on hand were used or sold as the case
may be. In other words, the periodic system does not continually record the movement but
balances back to the movement. For example: if we use the periodic system and had 50 units
of raw materials on hand at the beginning of the year and bought another 100 units during the
year, and counted 30 units on hand at the end of the year, we would assume that 120 units of
the raw material (50 + 100 – 30) must have been transferred from the store-room to the
factory and thus that these items should be transferred to the work-in-progress account.
The periodic system is simpler than the perpetual system but has a few disadvantages (e.g. we
assume that the 120 units were all used and that none of these were stolen). The periodic
system is thus generally used by smaller businesses that do not have the necessary
computerised accounting systems to run a perpetual system. With the proliferation of
computerised accounting packages, most businesses nowadays, and certainly most
manufacturing businesses, would normally apply the perpetual system. The perpetual and
periodic systems are explained in more detail in section 5.
4.3.3.3 Calculating the amount to transfer: three cost formulae

In the above explanation, where we spoke about the physical movement in and out of the
three imaginary buildings being reflected in the relevant inventory accounts (raw materials,
work-in-progress, finished goods and eventually cost of inventory expense – often called cost
of sales), we spoke of an amount being transferred out from one account to another. For
example, we mentioned that an amount would be taken out of the raw materials account and
put into our work-in-progress account when raw materials were taken out of our store-room
and put into the factory (where they would then be worked on in order to convert into finished
goods). In this example, this amount would be the cost of the raw materials being transferred.
There are three formulae which may be used to calculate the cost of the inventory being
transferred: the specific identification formula, the weighted average formula and the first-in-
first-out formula. These cost formulae are explained in more depth in section 6, but a quick
discussion in the context of a manufacturing environment may be helpful to you.
The specific identification formula must be used in There are three cost
certain situations. However, if your situation does not formulae:
warrant the use of the specific identification formula, then Specific identification
you could choose between the weighted average formula First-in-first-out
and the first-in-first-out formula. Weighted average
The first-in-first-out formula assumes that the items that are bought or manufactured first are
the items that will be sold first. This approach is ideal for items of inventory that may perish
(e.g. food) or may quickly become obsolete (e.g. technology items).
The weighted average formula simply calculates the average cost per item based on the cost
of the items on hand at the beginning of the period plus the cost of the items purchased during
the period.
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Entities that manufacture mass-produced goods (as opposed to manufacturing customised

products for each of their specific customers) typically use the weighted average formula to
account for their inventories, although the first-in-first-out formula can also be used.
The same formula should be used for all inventory with similar natures and similar uses. This
means that it is possible to use different formulae for inventory with different natures or uses.
For example, if we manufacture sweets and cups, we could argue that the first-in-first-out
formula is the most appropriate cost formula to use for the sweets since the sweets have a sell-
by date and thus we should cost the movements of the sweets based on our reality (which is
that we would need to be selling the oldest sweets first – thus, the reality is indeed that the
first sweets made would be the first sweets we would sell) but that we could cost the cups on
the weighted average formula.
The following example shows the flow of costs from raw materials through to cost of
inventory expense (commonly referred to as cost of sales). It uses the perpetual system but
has been designed in such a way that the complications of which cost formula to use (specific
identification, first-in-first-out or weighted average) was not necessary. These cost formulae
are explained in more depth in section 6 together with a more complex version of example 9
(example 26: involving manufacturing ledger accounts using the first-in-first-out and
weighted average formulae).
Example 9: Manufacturing ledger accounts

Saudi Limited manufactures sunglasses. The following information applies:
C20 000 of raw materials were available on 1 January 20X1, (20 000 kilograms).
C40 000 of raw materials were purchased during January 20X1 (40 000 kilograms).
40% of the raw materials available during January 20X1 were used in January 20X1.
Wages of C100 000 were incurred and paid during January 20X1:
- 80% related to factory workers,
- 6% related to cleaning staff operating in the factory,
- 4% related to cleaning staff operating in the head office and
- 10% related to office workers in the administrative offices.
Electricity of C62 000 was incurred and paid during January 20X1. All of this related to
the factory operations.
- 80% relates to machinery used in the factory; and
- 20% relates to equipment used by head office.
The machinery was used 70% of the time in manufacturing inventory and the balance of
the time, the machinery was idle.
There was no opening balance of work-in-progress on 1 January 20X1.
All of the work-in-progress was complete by 31 January 20X1 (20 000 complete units).
There was an opening balance of C30 000 of finished goods on 1 January 20X1
(representing 3 000 units).
All units of finished goods were sold during January 20X1.
Required: Show all the above information in the ledger accounts using the perpetual system.
Solution 9: Manufacturing ledger accounts

Inventory: raw materials (A)
O/ balance 20 000 Work-in-progress (2) 24 000
Bank (1) 40 000 C/ balance c/f 36 000
60 000 60 000
C/ balance b/f 36 000
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Inventory: work-in-progress (A)
O/ balance 0 Finished goods (6) 200 000
Raw materials (2) 24 000 C/ balance c/f 0
Bank (3) 86 000
Bank (4) 62 000
Depreciation – machines (5) 28 000
200 000 200 000
C/ balance b/f 0
Inventory: finished goods (A)

O/ balance 30 000 Cost of sales (7) 230 000
Work-in-progress (6) 200 000 C/ balance c/f 0
230 000 230 000
C/ balance b/f 0
Cost of goods sold (E)

Finished goods (7) 230 000
Wages (E)
Bank (3) 14 000
Bank (A)
Inventory: raw material (1) 40 000
Inventory: WIP & Wages (3) 100 000
Inventory: WIP (4) 62 000
Depreciation – machines (E)

Machines: acc depreciation 40 000 Inventory: WIP (5) 28 000
Machines: accumulated depreciation (-A)

Depreciation 40 000
Depreciation – equipment (E)

Equipment: acc depreciation 10 000
Equipment: accumulated depreciation (-A)

Depreciation 10 000
Comments:
(1) Purchase of raw materials – assumed for cash.
(2) Raw materials used: (opening balance 20 000 + purchases 40 000) x 40% = 24 000. Please note
that since the cost per kilogram of the opening balance was C1/ kg (C20 000/ 20 000 kg) and the
cost per kilogram of the purchases was also C1/ kg (C40 000 / 40 000 kg), there is no complication
when allocating the raw materials used to the work-in-progress account. If the costs per kg had
differed, we would have had to decide whether we should be using the specific identification
method, first-in, first-out method or weighted average method of measuring the portion of raw
materials used. These three methods are explained in section 6.
(3) The wages incurred in the factory environment are capitalised whereas the wages incurred relating
to administration that has nothing to do with the factory are expensed: 100 000 x (80% + 6%) =
86 000 (the wages for the factory workers is direct labour and the wages for the factory cleaners is
indirect labour – both are a necessary part of the manufacturing process).
(4) Electricity of C62 000 is incurred and paid for.
Chapter 13 647

(5) The depreciation on machinery during the manufacture of inventory is capitalised to the inventory
account: C40 000 x 70% as part of the directly attributable costs of conversion [IAS 2.11]. The
depreciation incurred while the machinery is idle is expensed [IAS 2.13 states that costs of idle
plant should not be capitalised].
The depreciation on the office equipment remains expensed since it has nothing to do with the
manufacturing process.
The total depreciation is first expensed and then, at year-end, a proportion thereof is re-allocated to
the asset account (i.e. first expensed in full and then a portion capitalised).
(6) 100% of the work-in-progress is completed: (0 + 24 000 + 86 000 + 62 000 + 28 000) x 100% =
100 000. Please note that since all of the work-in-progress was completed, we simply allocated the
entire balance on the work-in-progress account to the finished goods account. Had there been
some work-in-progress incomplete at either the beginning or the end of the year, we would have
had to decide whether to use the specific identification method, first-in, first-out method or
weighted average method of measuring the portion of work-in-progress that had been completed.
These three methods are explained in section 6.
(7) 100% of the finished goods are sold. Please note that since all of the finished goods were sold, we
simply allocated the entire balance on the finished goods account to the cost of sales account. Had
there been some finished goods that remained unsold at either the beginning or the end of the year,
we would have had to decide whether to use the specific identification method, first-in, first-out
method or weighted average method of measuring the portion of finished goods that should be
expensed as cost of sales. These three methods are explained in section 6.
As mentioned previously, when goods are completed, they get moved from the factory to the
shop (or warehouse) and thus a journal is processed to transfer the cost of these goods from
the work-in-progress account to the finished goods account. This previous example was
simple in that the entire work-in-progress balance was completed and thus we simply
transferred the entire balance of the work-in-progress costs to the finished goods account.
However, if only a portion of the work-in-progress was completed, we would have to identify
how many units had been completed and how many were incomplete. We would then need to
calculate how much it had cost the entity to manufacture each of these completed units. This
cost per unit is called the manufacturing cost per unit. When journalising the transfer of
completed goods from the work-in-progress account to the finished goods account, we would
multiply the manufacturing cost per unit by the number of items that had been completed.
4.3.4 Manufacturing cost per unit
The cost per completed unit is called the estimated manufacturing cost per unit. This
manufacturing cost per unit is not only used to calculate The manufacturing cost
the amount to transfer from the work-in-progress account per unit includes:
to the finished goods account but is also useful when Variable costs / unit (direct/ indirect)
quoting customers. Fixed costs / unit (indirect)
The manufacturing cost per unit includes the purchase cost of the raw materials plus the
conversion costs and the related other costs.
In order to estimate the manufacturing cost per unit, however, it is important to remind
ourselves of the categories of conversion costs and how they may or may not fluctuate with
levels of production. There are two basic categories of conversion costs:
Direct costs: These are the core production costs and include things like direct labour. By
nature, direct costs generally vary directly with the level of production.
Indirect costs: These are costs that are necessary in the production process but which are
not core production costs – these are often referred to as overheads. These indirect costs
may include costs that vary directly or nearly directly with the level of production
(variable overheads) and may include costs that do not vary with the level of production
(fixed overheads).
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Interestingly, however, what is important when calculating the manufacturing cost per unit is
not whether the conversion cost is classified as a direct cost or indirect cost, but rather
whether the cost is:
A variable cost:
Variable costs are the costs that vary directly with the level of production and thus
typically include both direct costs and indirect variable costs; or
A fixed cost:
Fixed costs are the costs that do not vary directly with the level of production and thus
typically include the indirect fixed overheads.
Sadly, the terminology is really confusing – for example, remember that an indirect cost can
vary directly with production and yet a direct cost may not necessarily vary directly (e.g.
factory wages are a core production cost and are thus direct costs, but depending on the terms
of the wage contracts, the wage may not necessarily increase or decrease with the level of
production). Over and above the direct conversion costs and indirect conversion costs, the
purchase cost of raw materials would normally vary with production as do many of the other
costs.
Figure 1: Manufacturing costs
Manufacturing costs
Variable manufacturing costs Fixed manufacturing costs

Includes, for example: Includes, for example:
Purchase cost of raw materials Direct conversion costs that do not vary
Direct conversion costs that vary with with production (e.g. wages that do not
production (e.g. direct labour) increase or decrease with production
Indirect conversion costs that vary with levels)
production (e.g. electricity) Indirect conversion costs that don’t
vary with production (e.g. factory rent)
4.3.5 Variable manufacturing costs (costs that vary directly with production)
Variable manufacturing costs are simply those costs that The variable cost per unit
vary with the level of production. By their very nature it could include:
is easy to calculate the variable cost per unit. Purchase cost of raw materials
Direct conversion costs that vary
Variable manufacturing costs per unit would thus be the Indirect conversion costs that vary
total of all the costs per unit that vary with production, Other costs that vary
thus including costs such as:
the purchase cost of the raw materials;
the direct conversion costs that vary with production (e.g. factory labour)
the indirect conversion costs (i.e. overheads) that vary with production, in which case
they would be called variable manufacturing overheads, (e.g. electricity).
Example 10: Costs that vary directly with production

Choc Limited manufactured 10 units, each of which used:
3 manufacturing labour hours (at C20 per hour), paid in cash
2 cleaning labour hours (at C10 per hour), paid in cash
1 kilogram of raw material X (at C50 per kg excluding VAT)
1 litre of cleaning material (at C5 per litre).
Required:
A. Calculate the variable manufacturing cost per unit of inventory.
B. Journalise the above assuming all materials were already in stock, there were no opening balances
of raw materials or work-in-progress and that all 10 units were finished.
Chapter 13 649
Solution 10A: Calculation: variable manufacturing cost per unit

C
Direct labour: 3 hours x C20 60
Indirect labour: 2 hours x C10 20
Direct materials: 1 kg x C50 50
Indirect materials: 1 litre x C5 5
Variable manufacturing cost per unit 135

Debit Credit
Inventory: work-in-progress (A) 500
Inventory: raw materials (A) 500
Cost of manufacture of 10 units: raw materials used (10 x C50)
Inventory: consumables (A) 50
Cost of manufacture of 10 units: cleaning materials used (10 x C5)
Bank (A) 600
Cost of manufacture of 10 units: factory labour cost (10 x C60)
Bank (A) 200
Cost of manufacture of 10 units: cleaning labour cost (10 x C20)
Inventory: finished goods (A) 500 + 50 + 600 + 200 1 350
Inventory: work-in-progress (A) 1 350
Completed units transferred to finished goods (10 units x C135)
4.3.6 Fixed manufacturing costs (costs that do not vary directly with production)
Manufacturing costs that do not vary with the level of production are referred to as fixed
manufacturing costs. These costs are generally assumed to include only those indirect costs
that are fixed (fixed overheads). However, as was explained, even direct costs may turn out
to actually be fixed in nature (e.g. factory wages that are considered to be core production
costs, and thus termed direct costs, may be a fixed cost if the wage bill remains the same
irrespective of the number of units produced).
Fixed manufacturing costs are thus costs that do not vary Fixed manufacturing costs
in relation to the number of units produced. What makes are:
accounting for these fixed costs slightly different to how First debited to a suspense account
we account for variable costs is that these fixed costs Then the suspense account is
cannot simply be debited to the inventory account (as is allocated to:
the case with variable manufacturing costs). Why? - Inventory: # of units x fixed
Because imagine the extreme situation where we pay, on manufacturing cost per unit
the first day of the year, C100 000 rent for our factory - Expense: Any remaining unallocated
building (a fixed cost): if we debit this amount directly to balance is expensed
the inventory account and were then immediately
required to draft a statement of financial position (e.g. to Example 9 involved a
raise a loan from the bank), we would be declaring that manufacturing entity but
we had C100 000 of inventory on hand – and yet it avoided fixed costs:
manufacturing had not yet even begun! all costs were variable
To get around this problem, our fixed manufacturing costs are initially debited to a suspense
account instead. A suspense account is simply an account that one uses when one is not yet
sure what element to debit or credit. In this instance, we are not yet sure how much of the
fixed cost will ultimately be debited to the asset account (inventory) and how much will be
debited to the expense account (fixed overhead expense).
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As units are produced during the period, the amount in the suspense account is gradually
allocated to the inventory work-in-progress account. To do this, we will need a fixed cost per
unit, which is often referred to as the fixed manufacturing cost application rate (FMCAR).
There are two such rates – one that we estimate at the beginning of the period (budgeted) and
one that we calculate at the end of the period (actual):
Budgeted fixed manufacturing cost application rate (BFMCAR)
Actual fixed manufacturing cost application rate (AFMCAR).
There are 2 fixed
The actual rate (AFMCAR) obviously depends on the manufacturing application
actual level of inventory produced in any one year and is rates:
thus only calculated at year-end: Budgeted rate (BFMCAR)
Fixed manufacturing costs Actual rate (AFMCAR)

Greater of: actual and normal production The budgeted rate is used to allocate
our fixed costs to inventory during the
year – we only know what our actual
As mentioned above, a rate is needed from the beginning rate is after our year has ended.
of the year to use in allocating fixed manufacturing costs
from the suspense account to the inventory account (as well as for the purposes of quoting,
budgeting and interim reporting). This means that a budgeted rate (BFMCAR), using
budgeted normal production as the denominator, is calculated as an interim measure:
Fixed manufacturing costs
Normal production
Example 11: Using a suspense account
Fixed annual head-office overheads (paid for at the beginning of the year) C50 000
Fixed annual manufacturing overheads (paid for at the beginning of the year) C100 000
Budgeted annual production (normal expected production in units) 50 000
Actual production for 3 months (units) 15 000
Required: Show the journals and the ledger accounts after the 3 month period.
Solution 11: Using a suspense account
Calculation of the budgeted fixed manufacturing cost per unit (BFMCAR):

= Fixed manufacturing costs
Normal production
= C100 000
50 000 units
= C2 per unit
Comment on the rate:
We do not have an actual fixed rate per unit yet since our year has not yet ended, with the result that we do
not know what our actual production for the year will be. Thus, we calculate a budgeted rate in the interim.
We use the budgeted rate (C2/unit) when quoting customers and when processing journals during the year.
Journals:
Debit Credit
Administration costs (E) Given 50 000
Bank (A) 50 000
Fixed costs relating to administration are expensed
Fixed manufacturing costs (Suspense a/c) Given 100 000
Bank (A) 100 000
Fixed costs relating to manufacturing are first allocated to the
suspense account
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Inventory: work-in-progress (A) 15 000u x C2 (BFMCAR) 30 000
Fixed manufacturing costs (Suspense a/c) 30 000
Allocation of fixed manufacturing costs to inventory over the 3 months
Ledger accounts:
Bank Fixed manufacturing costs (Suspense)
Admin (1) 50 000 Bank (2) 100 000 Inv WIP (3) 30 000
FMCS (2) 100 000 Balance (4) 70 000
100 000 100 000
Balance 70 000
(4)
Inventory: work-in-progress (Asset) Administration costs (Expense)

FMCS (3) 30 000 Bank (1) 50 000
Notes to the ledger accounts:

(1) Payment of head-office costs are non-manufacturing fixed overheads: C50 000 – these are always expensed.
(2) Payment of manufacturing fixed overheads: C100 000 – these are first accumulated in a suspense account
(after this, they will be either capitalised to inventory or expensed).
(3) Fixed manufacturing costs are allocated to the inventory asset (i.e. absorbed/ capitalised into inventory) using
the budgeted rate:
BFMCAR x actual production: C2 x 15 000 = C30 000
(4) Notice that the suspense account still has a balance. This is because the remaining 35 000 units that we expect
to make have not yet been made.
The fact that we are processing journals using a budgeted rate during the period results in
three possible outcomes. These possible outcomes (illustrated in example 12) are that, at year-
end the suspense account could have:
a zero balance because our actual production equalled our normal production,
a debit balance because our actual production was less than the normal production,
a credit balance because our actual production exceeded the normal production.
Example 12: Using a suspense account – 3 scenarios
Fixed manufacturing overheads (paid for at the beginning of the year) C100 000
Budgeted production (normal expected production in units) 50 000
Required: Show the journals and the ledger accounts at the end of the period, before any possible
adjustments that may be necessary due to under- or over-production, assuming:
A. 50 000 units were produced during the year;
B. 40 000 units were produced during the year;
C. 60 000 units were produced during the year.
Solution 12: Using a suspense account – the budgeted rate used

Normal production
= C100 000
50 000 units
= C2 per unit
Solution 12A: Using a suspense account – no balance (because AP = BP)

Comment: Part A shows how, when actual production equals the normal production, that the fixed
manufacturing costs are perfectly absorbed into the inventory account (i.e. there is no balance left in the
suspense account).
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Solution 12A continued ...

Bank (A) 100 000
Fixed manufacturing costs are first allocated to the suspense account
Allocation of fixed manufacturing costs to the number of units of
inventory actually produced during the year
Ledger accounts:
FMCS (1) 100 000 Bank (1) 100 000 Inv WIP (2) 100 000
Balance (3) 0
100 000 100 000
Balance (3) 0
Inventory: work-in-progress (Asset)
FMCS (2) 100 000
(1) Payment of fixed manufacturing overheads: C100 000 (first recorded in the suspense account).
(2) Fixed manufacturing overheads are allocated to the inventory asset (i.e. absorbed into inventory) as units are
produced using the budgeted fixed manufacturing cost application rate: C2 x 50 000 = C100 000
(3) The suspense account now has a nil balance because the actual production equalled the normal production.
Solution 12B: Using a suspense account – a debit balance (because AP < BP)
Comment: Part B shows how, when actual production is less than the normal production, that the fixed
manufacturing costs are under-absorbed into the inventory account (i.e. there is a debit balance
remaining in the suspense account).

Bank (A) 100 000
Allocation of fixed manufacturing costs to the number of units of inventory
actually produced during the year
Ledger accounts:
FMCS (1) 100 000 Bank (1) 100 000 Inv (2) 80 000
Balance (3) 20 000
100 000 100 000
Balance (3) 20 000
FMCS (2) 80 000
(1) Payment of fixed manufacturing overheads: C100 000 (first recorded in the suspense account).
(2) Fixed manufacturing overheads are allocated to the inventory asset (i.e. absorbed into inventory) as units are
produced using the budgeted fixed cost application rate: C2 x 40 000 = C80 000
(3) The suspense account still has a balance because the actual production was less than the normal production.
This must be transferred to an expense account (see section 4.3.6.1). This is an example of under-absorption.
Chapter 13 653
Solution 12C: Using a suspense account – a credit balance (because AP >BP)

Comment: Part C shows how, when actual production is greater than the normal production, that the
fixed manufacturing costs are over-absorbed into the inventory account (i.e. there is now a credit
balance in the suspense account).

Bank (A) 100 000
Allocation of fixed manufacturing costs to the number of units of inventory
actually produced during the year
Ledger accounts:
Bank (Asset) Fixed manufacturing costs (Suspense)
FMCS (1) 100 000 Bank (1) 100 000 Inv (2) 120 000
(3)
Balance 20 000
120 000 120 000
(3)
Balance 20 000
FMCS (2) 120 000

(1) Payment of manufacturing fixed overheads: C100 000 (first recorded in the suspense account).
(2) Manufacturing fixed overheads are allocated to the inventory asset (i.e. absorbed into inventory) as units are
produced using the budgeted fixed cost application rate: C2 x 60 000 = C120 000
(3) Notice that the suspense account now has a credit balance. This is because the actual production exceeded the
normal production. The problem is now that the inventory account is not shown at cost since it reflects an
amount of C120 000, when in fact the actual cost was only C100 000. This will need to be reversed – see
section 4.3.6.2. This is an example of over-absorption.
4.3.6.1 Under-production leads to under-absorption

If an entity actually produces at a level below the budgeted normal production, the use of the
budgeted rate means that a portion of the fixed manufacturing costs in the suspense account
will not get allocated to the inventory asset account (see part B of the previous example). This
unallocated amount is termed an under-absorption (or under-allocation) of fixed
manufacturing costs.
Since an under-absorption results from under-productivity, it effectively reflects the cost of
the inefficiency, which quite obviously cannot be an asset! It thus makes sense that the
amount of the under-absorption must be expensed instead.
Example 13: Fixed manufacturing costs – under-absorption

Fixed annual manufacturing overheads (paid for at the beginning of the year) C100 000
Normal expected production per year (units) 100 000
Actual production for the year (units) 50 000
Required:
A. Calculate the budgeted fixed manufacturing cost application rate;
B. Journalise the fixed manufacturing costs; and
C. Calculate the actual fixed manufacturing cost application rate.
D. Explain what is meant by the actual fixed manufacturing cost application rate, how it is calculated
and why, when allocating fixed manufacturing costs to the inventory account, we used a rate that
was calculated by dividing the cost by the normal production rather than the actual production.
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Solution 13A: Budgeted fixed manufacturing cost application rate

Normal production
= C100 000
100 000 units
= C1 per unit
Solution 13B: Fixed manufacturing costs – journals

During the year Debit Credit
Fixed manufacturing costs (Suspense account) 100 000
Bank (A) 100 000
Fixed manufacturing overheads paid: given
Inventory: work-in-progress (A) 50 000 x C1 (BFMCAR) 50 000
Fixed manufacturing costs (Suspense account) 50 000
Allocation of fixed manufacturing costs to inventory over the year
At year-end
Fixed manufacturing cost (Expense) C100 000 (total paid) – 50 000
Fixed manufacturing costs (Suspense) C50 000 (capitalised) 50 000
Under-absorption: balance on the fixed manufacturing cost suspense
account at year-end is expensed
Solution 13C: Actual fixed manufacturing cost application rate

Calculation of the actual fixed manufacturing cost per unit (AFMCAR):
Greater of: normal (100 000u) and actual (50 000u) production
= C100 000
100 000 units
= C1 per unit *
*: This is the actual fixed manufacturing costs per unit that will have been allocated to the inventory account. It is
based on the total fixed manufacturing costs divided, in this case, by the budgeted production in units.
Check: Actual rate: C1/u x Actual production: 50 000 = C50 000 (which is the amount allocated to inventory).
Solution 13D: Explanation of the actual fixed manufacturing cost application rate
The actual fixed manufacturing costs application rate (AFMCAR) refers to the actual rate at which the
fixed manufacturing costs ended up being applied to the units of inventory that were actually produced
(C1 per unit – see solution 13C).
To calculate this actual rate (i.e. the actual fixed cost that we ended up allocating to each unit), we
divide the fixed manufacturing costs by the greater of the normal production (100 000u) and the actual
production (50 000u).
If, in this case, (where actual production was less than normal production), we had incorrectly used an
application rate that was calculated by dividing the fixed cost by the actual production levels rather
than the normal production levels, we would have calculated a rate of C2 per unit (C100 000 /
50 000u). If we had then used this rate of C2 to allocate the fixed costs to the inventory account, we
would have allocated the full C100 000 to inventories (C2 x 50 000u actually produced). However,
this means that we would have effectively capitalised inefficiency: capitalising fixed costs of C2 per
unit instead of the normal C1 per unit doesn’t make sense given that the only reason for the higher cost
of C2 is that we produced less than we should have. In other words, the C2 fixed cost per unit was
inflated purely due to the company’s inefficiency! Bearing in mind that the Conceptual Framework
states that an asset must reflect the probable inflow of future economic benefits from the asset, it does
not make sense to measure the asset at a cost that includes the cost of inefficiency.
Chapter 13 655
4.3.6.2 Over-production leads to over-absorption

If the entity actually produced more units than the normal budgeted production (over-
production), by using our budgeted rate, the fixed manufacturing costs allocated to the
inventory account will initially be greater than the actual costs incurred.
In other words, this over-allocation (also known over-absorption) results in too much being
taken out of the suspense account (leaving the suspense account with a credit balance) and
results in the inventory asset being overstated (i.e. the inventory asset will be shown at a value
that exceeds the costs that were actually incurred). Since inventory may not be measured at
an amount higher than cost (remember: inventory is measured at the lower of cost and net
realisable value), the inventory balance must be reduced. An over-absorption is thus simply
reversed out of the inventory account (credit) and back into the suspense account (debit).
Example 14: Fixed manufacturing costs – over-absorption
Fixed annual manufacturing overheads (paid at the beginning of the year) C600 000
Normal expected production per year (units) 100 000
Actual production for the year (units) 150 000
Required:
A. Calculate the budgeted fixed manufacturing cost application rate;
B. Journalise the fixed manufacturing costs; and
C. Calculate the actual fixed manufacturing cost application rate.
D. Using your own words, explain the use of the budgeted application rate and how this compares to
use of the actual application rate and what happens in the case of an over-absorption.
Solution 14A: Budgeted fixed manufacturing cost application rate (BFMCAR)

Normal production
= C600 000
100 000 units
= C6 per unit
Solution 14B: Fixed manufacturing cost – journal

During the year Debit Credit
Fixed manufacturing costs (suspense account) 600 000
Bank(A) 600 000
Fixed manufacturing overheads paid at the beginning of the year: given
Inventory: work-in-progress (A) 150 000 x C6 (BFMCAR) 900 000
Fixed manufacturing costs (suspense account) 900 000
Allocation of fixed manufacturing overheads to inventory over the year
At year-end
Fixed manufacturing costs (suspense account) C600 000 (pd) – C900 000 300 000
Inventory: work-in-progress (A) (capitalised) 300 000
Over-absorption: reversing the excess fixed manufacturing costs out of the
inventory account and back into the suspense account (after which the suspense
account will now have a nil balance)
Solution 14C: Actual fixed manufacturing cost application rate

Greater of: normal (100 000u) and actual (150 000u) production
= C600 000
150 000 units
= C4 per unit
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Solution 14D: Explanation of budgeted and actual rates in context of over-absorption

The actual fixed manufacturing costs application rate (AFMCAR) refers to the actual rate at which the
fixed manufacturing costs effectively ended up being applied to the units of inventory that were
actually produced. In other words, it is the amount of fixed manufacturing costs that were actually
included in the cost of each unit. This actual application rate was C4 per unit (see solution 14C).
To calculate this actual rate (i.e. the actual fixed cost that we ended up allocating to each unit), we
divide the fixed manufacturing costs by the greater of the budgeted normal production (100 000u) and
the actual production (150 000u).
The budgeted fixed manufacturing costs application rate (BFMCAR) is the rate used throughout the
year to quote customers and to allocate fixed manufacturing costs to inventory during the period. This
budgeted application rate was C6 per unit (see solution 14A).
At the end of the period, we compare our actual production with our budgeted normal production. In
this example, our actual production exceeded our normal production, and thus our actual rate per unit
(C4) was lower than the budgeted rate per unit (C6).
Since we used the budgeted rate (C6) to allocate fixed costs to the units of inventory actually produced
(150 000u), by the end of the year we will have allocated too much to the inventory account: we will
have allocated C900 000 (150 000u x C6), when the fixed costs were only C600 000. This excess
allocation of C300 000 means that, instead of clearing the debit balance in the suspense account to nil,
the suspense account will now have a credit balance of C300 000 and we will have effectively debited
inventory with costs that were not incurred.
This cannot be allowed since the inventory standard prohibits the measurement of inventory at above
cost. IAS 2.13 This over-allocation of C300 000 must be reversed out of inventory (credit) and back to the
suspense account (debit) and in so doing, reversing the nonsensical credit balance in this account.
4.3.6.3 Budgeted versus actual fixed manufacturing rates summarised
The fixed manufacturing cost application rate is calculated at:

the start of the year to estimate the fixed cost per unit of inventory during the year; and
the end of the year to measure the actual fixed cost per unit of inventory.
The budgeted fixed manufacturing cost application rate is calculated at the start of the year:
BFMCAR =
Normal production
The actual fixed manufacturing cost application rate is calculated at the end of the year:
AFMCAR =
Greater of: normal production and actual production
If actual production is:

greater than normal production, the actual fixed cost application rate (AFMCAR) is
calculated using actual production since this avoids inventory being overvalued as a result
of over-efficiency. So, if AP > BP, use AP.
less than normal production, the actual fixed cost application rate is calculated using
normal production, since this avoids inventory being overvalued as a result of
inefficiencies. So, if AP < BP, use BP.
Our budgeted normal production will seldom equal actual production and thus the budgeted
costs per unit (BFMCAR) will generally not equal the actual costs per unit (AFMCAR). Thus
when the actual units produced are multiplied by the budgeted fixed overhead absorption rate
(BFMCAR), either too much or too little of the overhead costs actually incurred will be
included in the inventory cost. This refers to the over-absorption or under-absorption of fixed
costs and adjustments to correct this are then required.
Chapter 13 657
Example 15: Fixed manufacturing costs – over-absorption

Budgeted normal annual production 1 000 units
Actual annual production 1 500 units
Fixed non-manufacturing costs per year C10 000
Fixed manufacturing costs per year C40 000
Variable manufacturing costs per unit C12 per unit
Required:
A. Calculate the budgeted fixed cost application rate at the beginning of the year.
B. Show the journal entries processed in the related ledger accounts.
C. Calculate the actual cost per unit of inventory.
Solution 15A: Budgeted fixed manufacturing overheads rate (AP > BP)
Normal production
= C40 000
1 000 units
= C40 per unit
Solution 15B: Ledger accounts (AP > BP)

Bank (A) Fixed manufacturing costs (Suspense)
FOE (1) 10 000 Bank (2) 40 000 Inv (4) 60 000
FMCS (2) 40 000 Inv (5)
20 000
Inv (3) 18 000 (7)
60 000 (7)
60 000
Inventory: work-in-progress (Asset) Fixed non-manufacturing costs (Expense)
Bank (3) 18 000 FMCS (5) 20 000 Bank (1) 10 000
(4)
FMCS 60 000 Balance c/d 58 000
78 000 78 000
Balance (6) 58 000
(1) Payment of fixed non-manufacturing costs: C10 000 – these are always expensed
(2) Payment of fixed manufacturing costs: C40 000 – these are first accumulated in a suspense account and then
either capitalised to inventory or expensed
(3) Payment of variable manufacturing costs: C12 x 1 500 = C18 000, debited directly to inventory
(4) Fixed manufacturing costs are allocated to the inventory asset (i.e. absorbed into inventory) using the
budgeted rate: C40 x 1 500 = C60 000
(5) Since the fixed manufacturing costs incurred only amounted to C40 000, C20 000 too much (Allocated:
C60 000 – Incurred: C40 000) has been debited to inventory: this over-absorption is simply reversed.
(6) Note that the balance is C58 000, which equals the variable cost per unit plus the final fixed man. costs per
unit: (C12 + C26,67) x 1 500 = C58 000 (C26.67 is calculated in part C)
(7) Notice that the suspense account has been cleared out (has a zero balance)!
Solution 15C: Actual cost per unit (AP > BP)

C
Variable manufacturing cost per unit Given 12.00
Fixed manufacturing cost per unit: AFMCAR W1 26.67
38.67
W1: Actual fixed manufacturing cost application rate:
Greater of: normal and actual production
= C40 000
1 500 units
= C26,67 per unit
658 Chapter 13
Example 16: Fixed manufacturing costs – under-absorption

Budgeted normal production 1 000 units
Actual production 500 units
Fixed non-manufacturing costs per year C10 000
Fixed manufacturing costs per year C40 000
Variable manufacturing costs per unit C12 per unit
Required:
A. Calculate the budgeted fixed cost application rate at the beginning of the year.
B. Show the entries in the related ledger accounts.
C. Calculate the actual fixed cost application rate at the end of the year.
Solution 16A: Budgeted fixed manufacturing overheads rate (BP > AP)
Normal production
= C40 000
1 000 units
= C40 per unit
Solution 16B: Ledger accounts (BP > AP)

Bank (Asset) Fixed manufacturing cost (Suspense)
FOE (1) 10 000 Bank (2) 40 000 Inv (4) 20 000
FMCS (2) 40 000 FMCE (5) 20 000
Inv (3) 6 000 Balance (7) 0
40 000 40 000
Balance (7) 0
Inventory: work-in-progress (Asset) Fixed non-manufacturing costs (Expense)
(3)
Bank 6 000 Bank (1) 10 000
FMCS (4) 20 000 Balance c/d 26 000
26 000 26 000
Balance (6) 26 000
Fixed manufacturing costs (Expense)

FMCS (5) 20 000

(1) Payment of fixed non-manufacturing costs: C10 000 – these are always expensed
(2) Payment of fixed manufacturing costs: C40 000 – these are first accumulated in a suspense account and then
either capitalised to inventory or expensed
(3) Payment of variable manufacturing costs: C12 x 500 = C6 000 – debited directly to inventory
(4) Fixed manufacturing overheads are allocated to (i.e. absorbed into) inventory using the budgeted fixed cost
application rate: BFMCAR x actual production: C40 x 500 = C20 000
(5) The fixed manufacturing costs incurred amounted to C40 000, but since only 500 units have been produced,
only C20 000 has been debited to inventory, with C20 000 remaining unallocated in the fixed manufacturing
cost suspense account. This must be recognised as an expense since this relates to the cost of the inefficiency
(abnormal wastage).
(6) Notice that the inventory balance is C26 000, which is the number of units on hand measured at the total of
the prime cost (the total of the variable manufacturing costs) plus the final fixed manufacturing costs per unit:
500u x (C12 + C40) = C26 000
(7) Notice that the balance on the fixed manufacturing cost suspense account has been reduced to nil.
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Solution 16C: Actual fixed manufacturing overheads rate (BP > AP)
C
Variable manufacturing cost per unit Given 12.00
Fixed manufacturing cost per unit (actual): AFMCAR W1 40.00
52.00
W1: Actual fixed manufacturing cost application rate:
Greater of: normal (1 000u) and actual (500u) production
= C40 000
1 000 units
= C40 per unit
4.4 Other costs (IAS 2.15 -.16) Other costs are capitalised
if they are:
If other costs (i.e. other than purchase costs and incurred in bringing the inventory to
conversions costs) were incurred in relation to inventory, its present location and condition.
these other costs would be capitalised to the inventory
Examples given in IAS 2 include
asset account but only if they were incurred in the borrowing costs, which may need to be
process of bringing the inventory to its ‘present location capitalised in certain instances
and condition’. In all other cases, they would be
expensed.
It may be appropriate, for example, to include certain borrowing costs in the cost of the
inventory asset (how much if any of the borrowing costs should be capitalised would be
determined in terms of IAS 23 Borrowing costs).
However, IAS 2 makes it clear that the following ‘other costs’ may never be capitalised:
abnormal amounts of production costs (e.g. excessive wastage of materials or labour);
administration costs, unless these help bring the inventory to its location and condition;
storage costs, unless storage was necessary in the production process before a further
production stage (i.e. the cost of necessary storage in-between production processes is
capitalised, but the costs of storage during or after a final production process is expensed);
and
selling costs.
Example 17: All manufacturing costs including other costs
Super Limited manufactures concrete statues. The following information is provided:
Raw materials of C500 000 were used during the year:

- 10% of the raw materials were wasted during the normal manufacturing process
- 2% of the raw materials were lost in the manufacturing process when a machine operator
collapsed due to illness, leaving the machine unmanned for 5 hours
- 20% of the raw materials were destroyed during a riot for higher wages
Rent of C800 000 was incurred and paid for (to a single landlord) during the year:
- 10% was for the storeroom (used to store raw materials)
- 75% was for the factory building:
- 60% is for the main factory production processes
- 20% storage of work-in-progress whilst the concrete set (before painting thereof)
- 15% storage of work-in-progress whilst the paint dried (no further process required
afterwards)
- 5% was storage of finished goods prior to being taken to the shop
- 15% was for the shop where finished goods are sold to the public
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Advertising costs totalling C100 000 were incurred and paid for during the year.
Salaries to administration personnel totalling C200 000 was incurred during the year:
- 10% was for paperwork related to the importation of some of the raw materials
- 70% was for general head-office administration costs
- 20% was for paperwork involved in the sale of finished goods
Required: Show the journal entries that would have been necessary during the period.
Solution 17: All manufacturing costs including other costs

Debit Credit
Inventory expense: raw material write-off (E) 500 000 x (20% + 2%) 110 000
Inventory: raw materials (A) 110 000
Raw materials destroyed during a riot (20%) and raw materials destroyed
during manufacture (abnormal wastage: 2%)
Inventory: work-in-progress (A) 500 000 - 110 000 390 000
Inventory: raw materials (A) 390 000
Raw materials used during the year: C500 000 less that which was lost due
to abnormal causes: (riot: 20% +operator illness: 2%) x 500 000
Rent expense (E) Storeroom: 800 000 x 10% = 80 000 320 000
Factory: 800 000 x 75% x (15% + 5%) = 120 000
Shop: 800 000 x 15% = 120 000
Thus: 80 000 + 120 000 + 120 000 = 320 000
Fixed manuf. cost suspense Factory: 800 000 x 75% x (60%+20%) 480 000
Bank (A) 800 000
Rent paid: storeroom, factory building and shop Note 1 and Note 2
Advertising (E) 100 000
Bank (A) 100 000
Advertising costs paid for relating to the sale of goods Note 3
Administration expense – sales (E) 200 000 x 20% 40 000
Administration expense – other (E) 200 000 x 70% 140 000
Inventory: work-in-progress (A) 200 000 x 10% 20 000
Bank/ salaries payable (A/L) 200 000
Administration costs incurred: 10% related to costs incurred to get
inventories to location and condition that enabled them to be sold, the
balance related to general administration costs and selling costs
Notes:
1. The rent relates to an area using for storage (various kinds of storage), a shop and production.
The portion of the rent relating to production is capitalised as part of the fixed manufacturing overheads.
Rent relating to the shop is expensed because it is part of the cost of selling the inventory and not part of the
producing the inventory.
The rent that relates to storage may only be capitalised to inventory if it is:
necessary in the production process
before a further production phase.
The storage of raw materials occurs before the production process begins and must thus be expensed.
The rent relating to the storage while the concrete dries is capitalised because there is still a further production
process after the concrete dries (i.e. the painting) – it is a necessary cost between production processes.
The rent relating to storage while the paint dries is expensed because it does not relate to storage before a further
production process (i.e. there is no further production process after the painting process).
2. The fixed manufacturing costs that are to be capitalised to the cost of inventory (rental of certain areas of the
factory – see note 1 above) is first debited to the fixed manufacturing cost suspense account. These will then be
capitalised to the cost of inventory (by crediting the suspense account and debiting the inventory work-in-progress
account) using the budgeted fixed manufacturing cost allocation rate. The budgeted fixed manufacturing cost
allocation rate was not provided in the question and thus the journal allocating these fixed overheads to inventory
is not shown.
3. The advertising costs are expensed since these are selling costs and selling costs may never be capitalised.
Chapter 13 661
5. Recording Inventory Movement: Periodic Versus Perpetual Systems
5.1 Overview
Inventory movements may be recognised using either the perpetual or periodic system. These
systems are not laid down in the standard and thus the exact mechanisms of how to record
inventory movements under these two systems differ slightly from entity to entity.
Essentially, however, the difference between these two systems is simply that:
under the perpetual system, we perpetually (i.e. continually) update our ledger accounts
for inventory purchased and inventory sold; where
under the periodic system, although we update our ledger accounts for inventory
purchases, we do not update it for the inventory sold.
The ability to detect the theft of inventory is generally not possible using the periodic system.
This may mean that the gross profit calculated according to the perpetual system may differ
from that calculated under the periodic system. The final profit or loss calculated in the profit
or loss account will, however, be the same. This is explained under section 5.4.
5.2 Perpetual system
This perpetual system is used by businesses that have more sophisticated needs (i.e. large
businesses and manufacturing concerns) or have access to computerised accounting systems
that can accommodate this ‘real-time’ processing.
The perpetual system has been used as the default system in all prior examples throughout
this chapter and thus the following serves as a simple summary.
The perpetual system uses two accounts:

The perpetual system:
an inventory account (an asset); and
a cost of sales account (an expense). is used by bigger entities
ledger accounts are continously
Both these accounts are perpetually (constantly) updated updated:
- inventory account &
for each purchase and each sale of inventory, as and - cost of sales account
when these transactions occur. Thus the balance in the
can detect thefts.
inventory account on any one day reflects what we
should physically have on hand on that day and similarly the cost of sales account reflects the
latest cumulative cost of sales.
The balance on the inventory account is checked by performing a stock count at the end of the
period (normally at year-end).
The fact that we our inventory account reflects what the closing balance should be means that
the physical stock count can then be used to check our closing balance. This comparison
between the balance in the inventory ledger account and the results of the physical count will
thus be able to identify any theft of inventory (referred to as an inventory loss).
At the end of the period, the sales account and the cost of sales account are both closed off to
a trading account. This trading account is a temporary account used for closing entries and
serves to calculate the gross profit (or gross loss).
This gross profit (or gross loss) is then closed off to the profit or loss account, together with
all other income and expense accounts. The total on the profit or loss account will thus equal
the profit or loss for the year that we present in our statement of comprehensive income.
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5.3 Periodic system
With the proliferation of computerised accounting The periodic system:

packages, it is now quite unusual to find businesses still is used by smaller entities
employing the periodic system. However, it is still an ledger accounts are not continously
important system to understand since it is used by updated:
smaller businesses that do not have sufficient capital to - purchases account
invest into the necessary accounting systems. Many - inventory account &
- cost of sales account
economies rely heavily on the success of these smaller
does not identify stock thefts
businesses.
Under the periodic system, we update our ledger accounts for the cost of inventory purchased
but we do not update our ledger accounts for the cost of inventory sold. Thus our ledger
accounts will not be able to reflect the cost of the sales at any one time. For the same reason,
they will also not reflect the latest inventory balance on hand at any one time. In order to
work these out, we will need to physically count the inventory on hand (called a stock count)
and then value it. This stock count is done periodically, generally at year-end.
This stock count gives us our inventory closing balance: we multiply the number of units
counted by the cost per unit.
We then use this inventory closing balance to calculate our cost of sales. We do this by
comparing this inventory closing balance with the total of our inventory opening balance plus
the cost of our inventory purchased during the year (i.e. opening balance + purchases –
closing balance). All inventory that is ‘missing’ is assumed to have been sold and thus the
cost of the missing inventory is recognised as a cost of sales expense.
In other words, using the periodic system, we use a physical count to determine the value of
our closing inventory and then use this to balance backwards to the cost of sales.
The periodic system uses three accounts:

a purchases account in which we record the cost of all the purchases during the period;
an inventory account in which we periodically record the inventory we have on hand on a
specific date (often year-end) where this amount is calculated by doing a physical stock
count – this account is not continuously updated for cost of purchases and cost of sales;
a cost of sales account which we use to calculate the cost of sales during the period (by
comparing the information in the purchases account and the balances in the inventory
account) – this account is not continuously updated for the cost of sales during the year.
We would record the following journal to recognise the purchases of inventory during the
period – notice that we do not debit it to the inventory asset account but use a separate
purchases account (this purchases account is simply a temporary account (T) that will
eventually be transferred to the cost of sales account):
Debit Credit
Purchases (T) xxx
Bank/ accounts payable xxx
Purchase of inventories
We would record the following three journals after we had counted the stock on hand and
calculated the value thereof.
The first journal is to remove the opening inventory balance (if any) by transferring it to
cost of sales account.
The second journal is to recognise the latest inventory balance as the new closing
inventory balance for the period.
The third journal is to transfer the total purchases for the period to the cost of sales
account.
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Debit Credit
Cost of sales (E) xxx
Inventory (A) xxx
Transfer of the inventory opening balance to cost of sales
Inventory (A) xxx
Recognition of the results of the stock count as the new inventory closing
balance, with the contra entry being to cost of sales
Purchases (T) xxx
Transfer of the inventory purchases to cost of sales
At this point, we simply balance our cost of sales account to calculate what the cost of sales
expense is for the period.
Cost of sales (expense)
Inventory (opening balance) xxx Inventory (closing balance) xxx
Purchases xxx Balance c/f
xxx xxx
Balance b/f xxx
At the end of the period, the sales account and the cost of sales account are both closed off to
a trading account. This trading account is a temporary account used for closing entries and
serves to calculate the gross profit (or gross loss).
This gross profit (or gross loss) is then closed off to the profit or loss account, together with
all other income and expense accounts. The total on the profit or loss account will thus equal
the profit or loss for the year that we present in our statement of comprehensive income.
The fact that we assumed that what we counted was indeed what the inventory closing
balance should have been – thus assuming that all ‘missing’ inventory had been sold and that
none of it had been stolen means that this system is not designed to automatically detect and
separately record stock theft and thus this system is not as accurate as the perpetual system.
The periodic system and the detection of stock theft is explained in more detail in section 5.4.
Example 18: Perpetual versus periodic system

Opening inventory balance C55 000
Purchases during the year (cash) C100 000
A stock count at year-end reflected 18 000 units on hand (each unit had been purchased for C5).
Required: Show the ledger accounts using:
A. the periodic system
B. the perpetual system assuming that 13 000 units were sold during the year.
Solution 18A: Using the periodic system
Purchases (Temporary) Cost of sales (Expense)

Bank (2) 100 000 Invent o/b(3) 55 000 Inventory c/b(4) 90 000
Cost of sales (5) 100 000 Purchases (5) 100 000 Total c/f (6) 65 000
100 000 100 000 155 000 155 000
Total c/f 0 Total b/f (6) 65 000
Inventory (Asset)
O/ bal (1) 55 000 Cost of sales (3) 55 000
(4)
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(1) This balance remains C55 000 for the entire period until such time as the stock count is performed.
(2) The purchases are recorded in the purchases account during the period.
(3) In order for the closing balance to be recorded, the opening balance (C55 000) first needs to be removed from
this account. This is done by transferring it out and into the cost of sales account.
(4) The closing balance of the inventory account is determined at the end of the period by physically counting the
inventory on hand and valuing it (C90 000). This figure is debited to the inventory account with the credit-
entry posted to the cost of sales account: given as C90 000
(5) The total of the purchases during the period is transferred to the cost of sales account.
(6) Notice how the balance on the cost of sales account now reflects the cost of sales expense.
Solution 18B: Using the perpetual system
Inventory (Asset) Cost of sales (Expense)

O/ balance 55 000 Cost of sales (2) 65 000 Inventory (2) 65 000
Bank (1) 100 000 C/ balance 90 000
155 000 155 000
C/ bal (3) 90 000

(1) The cost of the purchases is debited directly to the inventory (asset) account.
(2) The cost of each sale is calculated: 13 000 x C5 = C65 000 (the cost per unit was constant at C5 throughout
the year). In reality, this amount would have been processed as individual cost of sales journals as and when
each sale occurred (i.e. rather than as a total cost of sales journal).
(3) The final inventory on hand at year-end is calculated as the balancing figure by taking the opening balance
plus the increase in inventory (i.e. purchases) less the decrease in inventory (i.e. the cost of the sales): 55 000
+ 100 000 – 65 000 = 90 000. This is then compared to the physical stock count that reflected that the balance
should indeed be 90 000. If the stock count suggested that the actual inventory balance was lower than
C90 000, this would have suggested that there had been theft and an adjustment would have had to be
processed to account for the theft. In this example, the stock count also reflected 90 000 and thus no
adjustment was necessary.
5.4 Stock counts, inventory balances and stock theft
In example 18, the cost of sales and inventory balances are not affected by whether the
periodic or perpetual system is used (i.e. cost of sales was C65 000 and inventory was
C90 000 in both part A and part B). However, this may not always be the case since a
disadvantage of the periodic system is that any stock thefts will generally remain undetected.
The periodic system is, however, still useful to small businesses due to its simplicity.
5.4.1 The perpetual system and the use of stock counts
When using the perpetual system, the accountant is able The perpetual system uses
to calculate the balance on the inventory account without stock counts as a check
the use of a stock count. This balance, however, reflects
what the balance should be – not necessarily what the actual balance is. A sad truth of our
society is that it is plagued by theft. Thus, an advantage of the perpetual system is that a
physical stock count may be used as a control measure that will highlight possible thefts.
If the physical count reveals a lower stock level than is reflected by the balance on the
inventory account, the difference will be accounted for as a theft of inventory (expense). We
would reduce the carrying amount of the inventory asset and recognise this reduction as an
inventory loss expense, as follows:
Debit Credit
Inventory loss (E) xxx
Inventories (A) xxx
Inventory loss recognised (theft of inventories)
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If the physical count reflects more stock than appears in the inventory account, then this
suggests that an error has occurred in recording the purchases or sales during the period.
5.4.2 The periodic system and the use of stock counts
When using the periodic system, the accountant does not The periodic system
have any idea of what his inventory balance or cost of
requires a stock count in order to
sales are until the physical inventory is counted and this calculate the closing inventory
inventory on hand is then valued. balance inventory & trading a/cs
Since we are using the stock count to calculate the inventory balance, there is no way of
knowing what the actual inventory balance should be.
Thus, when using the periodic system, the loss of inventory due to a theft will generally be
‘hidden’ in the cost of sales due to the fact that we will count a lower number of units during
the stock count and this will translate into a lower inventory closing balance.
For example:
Imagine we had no opening inventory, but had purchased C100 during the period. Then, if
after the stock count we calculated that the closing inventory should be C20, our cost of sales
would be C80 (Opening inventory: C0 + Purchases: C100 – Closing inventory: C20).
Now imagine the same example except that, unbeknownst to us, some of our inventory had
been stolen with the result that the count revealed that the closing inventory was only C5 (not
C20). In this case our cost of sales would reflect C95 (Opening inventory: C0 + Purchases:
C100 – Closing inventory: C5). Notice that the cost of sales is a higher amount because it
automatically includes the theft of C15.
However, if we were able to identify the loss at the time of the theft (e.g. we were unfortunate
enough to experience a significant armed robbery where it was possibly clear to us what was
being stolen), then we would process the following adjustment:
Debit Credit
Inventory loss (E) xxx
Purchases (Temporary account) xxx
Inventory loss recognised (theft of inventories)
Looking again at our example above:

If we were able to identify the loss of C15 at the time of the robbery, and had thus recognised
a journal that had reduced our purchases and recognised the inventory loss of C15, then our
purchases at the end of the year would have reflected only C85 (C100 – C15). In this case,
although the total expense is still C95, the cost of the sale calculated at year-end would reflect
C80 (Opening inventory: C0 + Purchases: C85 – Closing inventory: C5) and the inventory
loss would be C15.
Thus, when using the periodic system, we are generally unable to calculate the balance on the
inventory account without the use of a stock count. Obviously, if the accountant does not
know what the balance should be, the stock count is not able to detect any stock thefts.
The fact that stock thefts generally remain undetected when using the periodic system is
shown in this next example.
Example 19: Perpetual versus periodic system and stock theft
C Units
Opening inventory balance 24 000 3 000
Purchases during the year (cash) 96 000 12 000
Stock count at year-end (cost per unit C8) 4 000
Required: Show the ledger accounts using
A. the periodic system;
B. the perpetual system, assuming that the company sold 10 000 units during the year.
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Solution 19: Perpetual versus periodic system and stock theft

Comments:
Whereas the periodic system in Part A indicates that cost of sales is C88 000, the perpetual system in Part B
indicates that cost of sales was C80 000 and that there was a cost of theft of C8 000.
In other words, the periodic system assumes that all the missing stock was sold.
The periodic system is thus less precise in describing its expense but it should be noted that:
- The total expense is the same under both systems:
o periodic: C88 000 and
o perpetual: C80 000 + C8 000 = C88 000
- The inventory balance is the same under both methods: C32 000
Solution 19A: The periodic system does not identify stock theft
Bank (2) 96 000 Inventory o/b(3) 24 000 Inventory c/b (4) 32 000
Cost of sales (5) 96 000 Purchases (5) 96 000 Total c/f (6) 88 000
96 000 96 000 120 000 120 000
Total b/f 0 Total b/f (6) 88 000

O/ balance(1) 24 000 Cost of sales (3) 24 000 Purchases (2) 96 000
Cost of sales (4) 32 000

(1) This balance remains C24 000 for the entire period until such time as the stock count is performed.
(2) The purchases are recorded in the purchases account during the year.
(3) In order for the inventory closing balance to be recorded, the opening balance (C24 000) first needs to be
removed from this account. This is done by transferring it out and into the cost of sales account.
(4) The closing balance of the inventory account is determined at the end of the period by physically counting the
inventory on hand and valuing it (4 000u x C8 = C32 000). This figure is debited to the inventory account
with the credit-entry posted to the cost of sales account.
(5) The total of the purchases during the period is transferred to the cost of sales account.
(6) If you balance the cost of sales account now reflects the cost of sales expense of C88 000.
Solution 19B: The perpetual system does identify stock theft

O/ balance 24 000 Cost of sales (2) 80 000 Inventory (2) 80 000
Bank (1) 96 000 Subtotal c/f 40 000
120 000 120 000
Subtotal (3) 40 000 Cost of theft (4) 8 000
C/ bal c/f 40 000 Inventory losses: theft (Expense)
40 000 90 000 Inventory (4) 8 000
C/ bal (5) 32 000
(1) The purchases are debited directly to the inventory (asset) account (credit bank or payables).
(2) The cost of the sale is calculated: 10 000u x C8 = C80 000. The inventory and cost of sales accounts are
generally updated immediately for each sale that takes place. For simplicity, this example processes the
cumulative cost of sales for the year.
(3) The final amount of inventory that should be on hand at year-end is calculated as the balancing figure by
taking the opening balance plus the purchases less the cost of the sales:
C24 000 + C96 000 – C80 000 = C40 000
(4) A stock count is performed and whereas there should have been 5 000 units on hand at year-end (3 000u +
12 000u – 10 000u), there are only 4 000 units. It is therefore clear that 1 000 units have been stolen. The cost
of this theft is therefore C8 000 (1 000u x C8).
(5) The closing balance of inventory must reflect the reality and therefore the balance has been reduced from
what it should have been (C40 000) to what it is (C32 000).
Chapter 13 667
5.4.3 Presenting inventory losses due to theft (IAS 2.34 and .38)
Inventory losses refer to the theft of inventory. If inventory has been stolen, the cost of the
stolen inventory must be recognised as an expense.
As explained above, it is easier to detect thefts when using the perpetual system than when
using the periodic system since the perpetual system provides us with a theoretical inventory
closing balance against which we can check the results of our physical count.
Depending on the circumstances, however, we could still detect certain thefts when using the
periodic system. For example, although constant petty theft may be difficult or impossible to
detect using the periodic system, we may be able to identify the exact inventory stolen if, for
example, we happen to have witnessed a robbery (see section 5.4.2).
Irrespective of whether the periodic system or perpetual system is used, if a theft of inventory
has been identified, we need to consider how to present the inventory loss expense.
The standard is not definitive on whether an inventory loss expense should be presented
separately from or included with the cost of inventory expense (often called cost of sales
expense). The standard describes the cost of inventory expense (cost of sales) as including
the following three items:
the cost of the inventory items that have been sold; plus
any unallocated manufacturing costs; plus
any abnormal production costs (e.g. wastage).
However, it goes on to explain that the circumstances facing the entity may justify including
other amounts in this cost of inventory expense (cost of sales expense). Thus professional
judgement is required when deciding whether an inventory loss expense should be included in
the cost of inventory expense. It is submitted, that unless circumstances warrant a different
treatment, that a general rule of thumb would be that:
if the theft is considered to be a normal part of trading, this inventory loss expense could
be included in the cost of inventory expense (cost of sales expense)
if the theft is not normal (e.g. the theft took place during a significant armed robbery
rather than due to regular petty theft), this inventory loss expense should not be included
in the cost of inventory expense (cost of sales).
One of the reasons behind excluding the cost of an unusual and significant theft of inventory
from the cost of inventory expense is that the cost of this inventory loss would then distort the
gross profit percentage and would also damage comparability of the current year financial
results with those of the prior year and would also damage comparability with the results of
competitor businesses.
The following example shows how inventory losses can distort gross profit if they are
included in the cost of sales and also shows how to present an inventory loss that we consider
to be abnormal.
Example 20: Perpetual and periodic system: stock theft and profits
C Units
Inventory balance: 1 January 20X1 55 000 11 000
Purchases during 20X1 (cash) 100 000 20 000
Stock count results at 31 December 20X1 (cost per unit: C5) 16 000
Revenue from sales for 20X1 95 000
Required: Assuming that the entity prefers to present its inventory losses separately to its cost of sales:
A. Show the ledger accounts using the perpetual system: the company sold 13 000 units during 20X1.
B. Show the ledger accounts using the periodic system.
C. Prepare the extracts of the statement of comprehensive income for each of the two methods.
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Solution 20A: Perpetual system: stock theft and profits

O/ balance 55 000 Cost of sales 65 000 Inventory 65 000 Trade Acc (1) 65 000
Bank 100 000 Subtotal c/f 90 000
155 000 155 000
Subtotal b/f 90 000 Cost of theft 10 000
C/ bal c/f 80 000
90 000 90 000
C/ balance 80 000
Inventory loss: theft (Expense) Sales (Income)

Inventory 10 000 P&L (3) 10 000 Trade Acc (1) 95 000 Bank 95 000
Trading account (Closing account) Profit or loss (Closing account)

CoS (1) 65 000 Sales (1) 95 000 Cost of theft (3) 10 000 Trade a/c (GP) (2) 30 000
P&L (2) 30 000 Total c/f 20 000
95 000 95 000 30 000 30 000
(4)
Total b/f 20 000

(1) Sales and cost of sales are transferred to the trading account.
(2) The total on the trading account (gross profit) is transferred to the profit or loss account.
(3) All other income and expenses are closed off at the end of the year to the profit or loss account.
(4) If there were no other income and expense items, then this total represents the final profit for the year. It
would then be transferred to the equity account: retained earnings.
Solution 20B: Periodic system: stock theft and profits
Inventory (Asset) Sales (Income)

O/balance 55 000 TA 55 000 TA (2) 95 000 Bank 95 000

Bank 100 000 TA 100 000 Inv o/bal 55 000 Inv c/bal 80 000
Purchases 100 000 Bal c/f 75 000
155 000 155 000
Bal b/f 75 000 TA (1) 75 000
Trading account (Closing account) Profit or loss (Closing account)

Cost of sales (1) 75 000 Sales (2) 95 000 TA (GP) (3) 20 000
(3)
P&L 20 000
95 000 95 000
Comments:
(1) The balance brought forward on the cost of sales account is the cost of sales expense. This is closed off to the
trading account.
(2) Sales are closed off to the trading account.
(3) The balance on the trading account represents the gross profit and this is transferred to the profit or loss
account. All other income and expense accounts are then also transferred to (closed off to) the profit or loss
account. The profit or loss account therefore converts gross profit into the final profit for the period.
Chapter 13 669

Company name
For the period ended 31 December 20X1 (extracts)
Perpetual Periodic
C C
Revenue from sales 95 000 95 000
Cost of sales (65 000) (75 000)
Gross profit (1) 30 000 20 000
Inventory loss (10 000) (0)
Profit before considering other income and expenses 20 000 20 000
Comment:
(1) Notice how the gross profit in the statement of comprehensive income is C20 000 under the periodic system
but is C30 000 under the perpetual system. The final profit in both cases is, however, C20 000.
6. Subsequent Measurement: Inventory Movements (Cost Formulae) (IAS 2.23 - .27)
6.1 Overview
Inventory movements include purchases and subsequent Cost formulae:
sales thereof and, if applicable, the conversion into
SIM/ FIFOM/ WAM
another type of inventory or asset (i.e. in the case of a
If SIM doesn’t apply, you can choose
manufacturer, the conversion from a raw material into between FIFOM and WAM
work-in-progress and then into finished goods).
There are three different cost formulae allowed when measuring these movements, being:
specific identification (SI);
first-in, first-out (FIFO); and
weighted average (WA).
IAS 2 makes it clear that we must first assess whether the specific identification formula is
suitable for our specific type of inventory. If the description of our inventories means that the
specific identification formula is not appropriate, then we may choose between the first-in-
first-out formula and the weighted average formula.
The measurement of the cost of the initial recognition of inventory does not differ with the
method chosen but, if the cost of each item of inventory purchased (or manufactured) during
the year is not constant, then the measurement of the cost of goods sold or converted will
change depending on the formula chosen.
The same cost formula must be used for all inventories having a similar nature and use.
6.2 Specific identification formula (SI) (IAS 2.23 - .24)
If the inventories are made up of ‘items that are not

Specific identification is
ordinarily interchangeable’ or are ‘goods or services used for:
produced and segregated for specific projects’, then the
Items that are not interchangeable; or
specific identification method must be used. If is only
Goods/ services produced &
when the specific identification method is not
segregated for specific projects
appropriate, that we are able to choose between the
first-in-first-out and the weighted average formulae.
This formula is perfect, for example, for inventory that is made up of items that are dissimilar
in value, for example a retailer of exotic cars. Each item of inventory is assigned its actual
cost and this cost is expensed when this particular item is sold (using any of the above
methods would be materially inaccurate and misleading).
670 Chapter 13
Example 21: Specific identification formula - purchases and sales

C
January purchase 1 Beetle cost: 25 000
March purchase 1 Porsche cost: 150 000
April sold 1 Porsche selling price: 175 000
Required: Post the related journal entries in the ledger accounts using the SI formula.
Solution 21: Specific identification formula - purchases and sales

It would be unreasonable to use the first-in, first-out formula, in which case the cost of the Beetle would
be matched with the sale proceeds of the Porsche.
Similarly, the weighted average formula would not be suitable since the values of each of the vehicles
are so dissimilar that it would cause the cost to be distorted to unacceptable proportions.
The only formula that is suitable in this instance is the specific identification formula, which means just
that: specifically identify the actual unit sold and then use the actual cost of that unit to match against
the proceeds of the sale thereof.
Inventories (A) Bank
Beetle 25 000 Porsche 150 000 Beetle 25 000
Porsche 150 000 Balance 25 000 Porsche 150 000
175 000 175 000
Balance 25 000 Cost of Sales (E)
Porsche 150 000
The profit on sale can now be accurately determined as C175 000 – C150 000 = C25 000.
6.3 First-in, first-out formula (FIFO)

First-in-first-out formula
This formula may be used where the goods forming part assumes: oldest moves out first.
of inventories are similar in value. The general
assumption under this method is that the oldest inventory is used or sold first (whether or not
this is the actual fact). The formula is best explained by way of example.
Example 22: First-in-first-out formula - purchases
1 January purchases one kilogram of X C100
2 January purchases two kilograms of X C220
Required: Post the related journal entries in the ledger accounts using the FIFO method.
Solution 22: First-in-first-out formula - purchases (ledger accounts)

1 Jan 100 1 Jan 100
2 Jan 220 2 Jan 220
320 320
Comment:
There are now two balances in the inventory account. This is necessary in order that when the goods are sold,
the cost of the older inventory can be determined.
The inventory presented in the SOFP would be the total of the 2 balances (i.e. C320).
Example 23: First-in-first-out formula - sales

Use the information from the previous example together with a sale on 3 January 20X1 (see
below).
Required: Post the cost of sales journal in the ledger accounts using the FIFO method, if the sale was:
A. a sale of a 0.5 kilogram of X;
B. a sale of 1.5 kilograms of X.
Chapter 13 671
Solution 23A: First-in-first-out formula - sales (ledger accounts)

Inventories (A) Cost of Sales (E)
Balance 1 100 3rd Jan 50 3rd Jan 50(1)
Balance 2 220 Balance c/f 270
320 320
Balance 1 50
Balance 2 220
Comment:
The inventory bought earlier is assumed to be sold first. In other words, the cost of the inventory sold is
measured based on the cost of the oldest stock first.
Thus half of the first batch is sold and the cost of the sale is estimated at C100 x 0.5kg = C50(1)
The inventory account still has two balances, where the oldest balance (balance 1) has been reduced. None of
the second batch has been used yet and therefore balance 2 remains unchanged.
If the selling price was C150, the gross profit would be C150 – C50 = C100.
Solution 23B: First-in-first-out formula - sales (ledger accounts)

Balance 1 100 3rd Jan 155 3rd Jan 155(1)
Balance 2 220 Balance c/f 165
320 320
Balance 1 0
Balance 2 165
Comment:
The inventory purchased earlier is assumed to be sold first. In other words, the cost of the inventory sold is
measured based on the cost of the oldest stock first:
- the entire first batch (1 kilogram) is sold plus
- 0.5 kilogram of the second batch (which consisted of 2 kilograms).
The cost of the sale is thus estimated at 100 x 1 / 1 kilogram + 220 x 0.5 / 2 kilograms) = C155 (1)
The inventory account now only has one balance, since the first batch (balance 1) has been entirely used up. A
quarter of the second batch has been used and therefore balance 2 is now ¾ of its original value: ¾ x 220 =
165 or 220 x (2 – 0.5) / 2 kilograms.
If the selling price was C250, the gross profit would be C250 – C155 = C95.
6.4 Weighted average formula (WA)

Weighted average formula: we
As with the first-in, first-out formula, the weighted average the costs per unit.
average formula is suitable only when the goods are
similar in value.
Whenever goods are sold or converted, the cost of the sale is calculated by working out the
average cost of the goods sold, rather than simply assuming that the oldest goods were sold
first. The average costs incurred over a time period will therefore be used to calculate the cost
of inventory sold, rather than the actual cost incurred on the item.
This is best explained by way of example.
Example 24: Weighted average formula - purchases

1 January Purchases one kilogram of X C100
2 January Purchases two kilograms of X C220
Required:
Post the related journal entries in the ledger accounts using the weighted average method.
672 Chapter 13
Solution 24: Weighted average formula - purchases

1 Jan 100 1 Jan 100
2 Jan 220 2 Jan 220
Balance 320 320
Example 25: Weighted average formula - sales

Use the same information given in the previous example together with the following sale:
3 January Sales one kilogram of X Cost entity?
Required:
Post the cost of sale journal in the ledger accounts using the weighted average method.
Solution 25: Weighted average formula - sales

The weighted average cost per kilogram is calculated as follows:
total cost of inventories C320

= = C106,67 per kg
quantity of inventories on hand 3kg

Balance 320.00 3 Jan 106.67 3 Jan 106.67
Balance c/d 213.33
320.00 320.00
Balance b/d 213.33
Comments:
1. If the selling price was C150, then the gross profit would be C150 – C106,67 = C43,33.
2. When using the weighted average formula, there is only one balance in the inventory account (i.e.
we have 2 kg remaining on hand, costing C213.33 in total – or C106.67 per kg).
6.5 The cost formula in a manufacturing environment
Many students panic when faced with applying the cost formulae in the context of a
manufacturing entity with its three core inventory accounts: raw materials, work-in-progress
and finished goods. However, the principles explained above remain absolutely unchanged.
If, for example, the manufacturing entity applied the first-in-first-out formula, it simply means
that before you transfer the cost of raw materials used from the raw materials account to the
work-in-progress account, you need to stop and calculate what the cost per unit should be
based on the first-in-first-out principles explained above.
Complexities arise only when dealing with the work-in-progress account since this requires
application of cost accounting principles (process costing) that are not dealt with in financial
accounting. However, once having applied your process costing principles to your work-in-
progress account, you can easily calculate the amount to be transferred to finished goods.
Due to space constraints, process costing will not be explained in this text. Instead, the
following examples will provide you with the necessary amounts to be transferred from the
work-in-progress account to finished goods account as if you had applied your process
costing principles. The following examples will thus only require you to calculate the costs
per unit when transferring the cost of raw materials from the raw materials account to the
work-in progress account and when transferring the cost of finished goods that have been sold
from the finished goods account to the cost of sales expense account.
Chapter 13 673
The previous example that dealt with the inventory accounts of a manufacturing entity
(example 9) had been deliberately simplified in the following respects:
the cost per unit of the raw materials opening balance was the same as the cost per unit of
the raw material purchases during the year;
the cost per unit of the finished goods opening balance was the same as the cost per unit
of the finished goods completed during the year;
all the work-in-progress was completed during the year; and
all the finished goods were sold during the year; and
none of the manufacturing costs were fixed costs.
Example 9 was kept deliberately simple in these respects so as to avoid the issue of the cost
formulae and to avoid the issue of fixed manufacturing cost application rates, both of which
had not yet been explained. The following example is similar to example 9 but has been
changed in certain key respects so that the impact of the different cost formulae can be
demonstrated – and also includes a fixed manufacturing cost so that this becomes a
comprehensive example that also shows how the application rate works. The changes from
example 9 have been highlighted for your interest.
Example 26: Manufacturing ledger accounts – FIFO vs WA formulae

Arabia Limited manufactures sunhats. The following information applies:
C20 000 of raw materials were available on 1 January 20X1, (15 000 kilograms).
C40 000 of raw materials were purchased during January 20X1 (40 000 kilograms).
26 000kg of raw materials were used during January 20X1.
Wages of C100 000 were incurred and paid during January 20X1:
- 80% related to factory workers,
- 6% related to cleaning staff operating in the factory,
- 4% related to cleaning staff operating in the head office and
- 10% related to office workers in the administrative offices.
All factory-related wages were considered to be variable.
Electricity of C62 000 was incurred and paid during January 20X1. All of this related to
the factory operations. The entire electricity bill was considered to be variable.
- 80% relates to machinery used in the factory; and
- 20% relates to equipment used by head office.
The machinery was used 70% of the time in manufacturing inventory and the balance of
the time, the machinery was idle.
The factory building is rented at C40 000 per month (and always paid in cash).
Budgeted normal production for January 20X1 was 20 000 units.
21 000 units were put into production during January 20X1.
Work-in-progress on 1 January 20X1 was C35 000.
18 000 units were completed during January 20X1, at a cost of C162 000.
There was an opening balance of C30 000 of finished goods on 1 January 20X1
(representing 3 000 units).
80% of all finished goods were sold during January 20X1.
Required:
Show the ledger accounts for raw materials, work-in-progress and finished goods using the perpetual
system and assuming that:
A. the first-in-first-out formula is used.
B. the weighted average formula is used.
674 Chapter 13
Solution 26A: Manufacturing ledger accounts – FIFO formula

O/ balance Given 20 000 Work-in-progress W1 31 000
Bank Given 40 000 C/ balance c/f Balancing 29 000
60 000 60 000
C/ balance b/f Balancing 29 000

O/ balance Given 35 000 FMC suspense W3 2 000
Raw materials W1 31 000
Bank W4 86 000 Finished goods Given 162 000
Bank Given 62 000
Depreciation W5 28 000 C/ balance c/f Balancing 120 000
FMC suspense W2 42 000
284 000 284 000

O/ balance Given 30 000 Cost of sales W6 154 200
Work-in-progress Given 162 000 C/ balance c/f 37 800
192 000 192 000

Finished goods W6 154 200
Fixed manufacturing costs suspense (T)

Bank Given 40 000 Inventory: WIP W2 42 000
Inventory: WIP W3 2 000 C/ balance c/f 0
42 000 42 000
C/ balance b/f 0
Workings:
W1: The cost of the 26 000kg raw materials is allocated from RM to WIP using the FIFO formula:
Kg C C/kg Kg Calculation C
available used
Opening balance 15 000 kg 20 000 C1.3/ kg 15 000kg 15 000 kg x C1.3/ kg 20 000
Purchases 40 000 kg 40 000 C1/ kg 11 000kg (26 000kg – 15 000kg) x C1 11 000
55 000 kg 60 000 26 000kg 31 000
W2: Allocation of the fixed manufacturing costs to WIP using the budgeted rate:
W2.1: Budgeted fixed manufacturing cost allocation rate (BFMCAR)
Normal production
= C40 000
= C2 per unit
20 000 units
W2.2: Budgeted fixed manufacturing cost allocated during January 20X1
= BFMCAR x Actual production
= C2 x 21 000 = C42 000
Chapter 13 675

W3: Check for over or under-allocation of the fixed manufacturing costs at end January 20X1
= Fixed manufacturing costs total – Fixed manufacturing costs allocated
= C40 000 (Given) – C42 000 (W2) = C2 000 (Over-allocation)
W4: Wages related to the manufacturing process
= C100 000 x (80% + 6%) = C86 000
W5: Depreciation related to the manufacturing process
= C50 000 x 80% (machine) x (100% - 30% idle) = C28 000
1. Depreciation during idle time must be expensed. See IAS 2.13
2. The contra entry is depreciation expense because the total depreciation is first
expensed and then the portion to be capitalised is reallocated from the
depreciation expense account to the work-in-progress. This is done because we
are required to disclose the total depreciation as well as the depreciation
expense (if we had not debited depreciation expense first, it would have been
more difficult when looking at this depreciation expense account to determine
what our total depreciation was).
W6: The cost of the units sold from FG to cost of sales using the FIFO formula:
Units C C/ unit Units Calculation C
available sold
Opening 3 000 u 30 000 C10/ 3 000 u 3 000u x C10/ u 30 000
balance u
Purchases 18 000 u 162 000 C9/ u 13 800 u (80% x 21 000u – 3 000u) x C9 124 200
21 000 u 192 000 16 800 u 154 200
Solution 26B: Manufacturing ledger accounts – WA formula

O/ balance Given 20 000 Work-in-progress W1 28 364
Bank Given 40 000 C/ balance c/f Balancing 31 636
60 000 60 000

O/ balance Given 35 000 FMC suspense W3 2 000
Raw materials W1 28 364
Bank W4 86 000 Finished goods Given 162 000
Bank Given 62 000
Depreciation W5 28 000 C/ balance c/f Balancing 117 364
FMC suspense W2 42 000
281 364 281 364

O/ balance Given 30 000 Cost of sales W6 153 600
Work-in-progress Given 162 000 C/ balance c/f 38 400
192 000 192 000

Finished goods W6 153 600
676 Chapter 13

Fixed manufacturing costs suspense (T)
Bank Given 40 000 Inventory: WIP W2 42 000
Inventory: WIP W3 2 000 C/ balance c/f 0
42 000 42 000
C/ balance b/f 0
Workings:
All the workings in the previous solution (solution 26A) with the exception of the following two
workings (W1 and W6) are the same and are thus not repeated here.
W1: The cost of the 26 000kg raw materials is allocated from RM to WIP using the WA formula:
Kg C C/kg Kg Calculation C
available used
Opening balance 15 000 kg 20 000
Purchases 40 000 kg 40 000
55 000 kg 60 000 C1.09/kg 26 000kg 26 000 kg x C1.0909/ kg C28 364
W6: The cost of the units sold from FG to cost of sales using the WA formula:
Units C C/ unit Units Calculation C
available sold
Opening balance 3 000 u 30 000
Purchases 18 000 u 162 000
21 000 u 192 000 C9.14286 16 800 u (80% x 21 000u) x C9.14286 153 600
7. Subsequent Measurement: Year-End (IAS 2.9 and .28 - .33)
7.1 Overview
In the interests of ensuring that the inventory balance is not overstated and thus is a true
reflection of the expected future economic benefits (see asset definition), we measure the
inventory balance at the lower of cost and net realisable value. If the net realisable value is:
lower than cost, the inventories must be written Subsequent measurement
down to this lower amount. of inventories:
greater than cost, then no adjustment would be made: Lower of:
- Cost; or
the practice of valuing inventories to a net realisable - Net realisable value.
value that is higher than cost is not allowed.
7.2 Net realisable value (IAS 2.6 and IAS 2.28-.33)
Net realisable value is an entity-specific value based on Net realisable value is

defined as:
the entity’s estimation of the inventory’s selling price in
Estimated selling price in the
the ordinary course of business less the costs that the ordinary course of business
entity estimates that it will still need to incur in order to Less:
make such a sale, being: - estimated costs of completion &
- estimated selling costs.
any costs that may still need to be incurred in order
to make it saleable; (costs of completion) and
any costs that may need to incurred in order to secure the sale (selling costs). See IAS 2.6
Chapter 13 677
When estimating the net realisable value we must use the most reliable evidence available to
us. This may mean using information that comes to light due to events after the reporting
date but before the financial statements are finalised for issue (see chapter 18). Information
that arises during this period (i.e. before reporting date and the date on which the financial
statements are finalised) may be used on condition that it gives more information about events
that existed at reporting date.
When estimating the net realisable value we must also take into consideration the purpose for
which the inventory is held. If, for example, certain inventory has been set aside for a specific
customer at a specified contractual price but the remaining inventory has not been set aside
for specific customers, then:
the net realisable value for the part of the inventory that has been set aside for the specific
customer is based on the related contracted price while
the net realisable value for the remaining inventory is based on general selling prices.
Example 27: Net realisable value based on purpose of the inventory

At 31 December 20X1, Shaks Limited had inventory with a carrying amount C400 000
(being 100 000 widgets at a cost of C4 each).
Of this, 20 000 widgets had been set-aside for Era Limited in terms of a firm sales
commitment at C6 per widget.
The current selling price per widget is C4.50.
Selling costs for the 20 000 widgets is only C1 000 whereas the normal estimated selling
costs are C1 per unit.
The inventory represents finished goods.
Required:
Calculate the net realisable value at 31 December 20X1.
Solution 27: Net realisable value based on purpose of the inventory

C
Estimated selling price 20 000 x C6 + 80 000 x C4.50 480 000
Less estimated selling costs C1 000 + 80 000 x C1 (81 000)
Less estimated costs to complete N/A (0)
Net realisable value 399 000
Example 28: Net realisable value considers events after reporting period
Cold Limited has a branch in Woop Woop. There is very little infrastructure in Woop
Woop and, as a result, the Woop Woop factory manager only managed to send a fax
through to head office on 10 January 20X2 to let them know that the entire warehouse and
all the inventory of finished goods contained therein – with a carrying amount of C900 000
– had been destroyed in a series of storms.
The first storm hit the warehouse on 29 December 20X1 destroying 70% of the inventory.
He explained that the remaining inventory was quickly moved to higher ground but flood
waters from a second storm on 5 January 20X2 destroyed this too.
He estimates that the entire inventory will be saleable as scrap for C100 000. Costs to sell
the entire inventory as scrap is estimated at C1 000.
The normal sales value for the entire inventory would have been C1 500 000 and the
selling costs would have been 10% thereof.
Required:
Calculate the net realisable value at 31 December 20X1
678 Chapter 13
Solution 28: Net realisable value considers events after reporting period
C
Estimated selling price C100 000 x 70% + C1 500 000 x 30% 520 000
Less estimated selling costs C1 000 x 70% + 1 500 000 x 10% x 30% (45 700)
Less estimated costs to complete N/A (0)
Comment:
Although the entire inventory at Woop Woop has been destroyed, only 70% of the inventory was destroyed at
reporting date. This means that:
- the net realisable value of 70% of the inventory is based on scrap values; but
- the net realisable value for the remaining 30% of the inventory that existed at reporting date should be
based on normal prices.
7.3 Inventory write-downs (IAS 2.28)
If the net realisable value is less than its carrying amount, we write the inventory balance
down to the net realisable value.
The comparison between the carrying amount (cost) and the net realisable value should be
done on an item-for-item basis. In other words, at the end of each financial year, the inventory
balances on an item-for-item basis should be checked to be sure they do not exceed the lower
of cost or net realisable value.
Example 29: Lower of cost or net realisable value: write-downs

A company has inventory on hand at year-end (31 December 20X2) that it expects to be
able to sell in the ordinary course of business for C100.
In order to sell this inventory, the company expects to incur selling costs of C20 and expects to incur
further costs of C30 to put this inventory into a saleable condition.
Required:
A. Assuming that the cost of the inventory is C70:
i) Calculate the net realisable value;
ii) Calculate any possible write-down; and
iii) Journalise any write-down necessary.
iv) Show where the write-down would be included and disclosed in the financial statements.
B. Repeat Part A assuming that the cost of the inventory is C30 (not C70).
Solution 29: Net realisable value calculation

Ex 29A Ex 29B
i) Calculation: Net realisable value C C
Estimated selling price 100 100
Less estimated selling costs (20) (20)
Less estimated costs to complete (30) (30)
Ex 29A Ex 29B
ii) Calculation: Write-down C C
Cost 70 30
Lower of cost or net realisable value (29A: 70 or 50); (29B: 30 or 50) (50) (30)
Inventory write-down 20 0
Ex 29A Ex 29B
iii) Journal Dr/ (Cr) Dr/ (Cr)
Inventory write-down (E) Part (ii) above: C70 – C50 20 N/A
Inventories (A) (20) N/A
Write-down of inventories to net realisable value
Chapter 13 679

iv) Disclosure
Company name
Note Ex 29A Ex 29B
C C
Revenue X x
Cost of inventory expense (29A: cost of sales + write-down: 20) See note below (x + 20) (x + 0)
(29B: cost of sales + write-down: 0) See note below
Other costs disclosed using function or nature method (x) (x)
Profit before tax 3 (x) (x)
Company name
Ex 29A Ex 29B
Profit before taxation is stated after taking into account the following separately disclosable items:
- Write-down of inventories expense 20 N/A
Note: The inventory write-down could be included in cost of inventory expense or could be shown as
part of the entity’s other expenses – this is a choice based on professional judgement (see section 7.5)
7.4 Reversals of inventory write-downs (IAS 2.33)
If the inventory that was written down in a prior year is still on hand at the end of the current
year and the circumstances that led to the write-down have now reversed such that the net
realisable value has now increased, then the previous write-down may be reversed.
Be careful not to increase the inventory to an amount that exceeds its cost! In other words, if
the net realisable value exceeds the carrying amount, the carrying amount may be increased
back up to cost but not above cost. The write-back is limited since the principle of lower of
cost or net realisable value must always be observed.
Example 30: Lower of cost or net realisable value: reversal of write-downs

A company has inventory on hand at year-end that was written down in 20X1 to a net
realisable value of C50 (its original cost was C70).
Required: Process the journals in 20X1 and 20X2 and show how the write-back (if any) would be
disclosed in 20X2 assuming that the net realisable value of this stock at the end of 20X2 is:
A. C55;
B. C75.
Solution 30A: Lower of cost or net realisable value: write-back

Journals
End of 20X1: journal Debit Credit
Inventory write-down (E) 20
Inventories (A) 20
Write-down of inventories to net realisable value: W1
End of 20X2: journal
Inventories (A) 5
Reversal of inventory write-down (I) 5
Reversal of previous write-down of inventories: W1
680 Chapter 13

Disclosure
Company name
Note 20X2 20X1
C C
Revenue x x
Cost of inventory expense (x) (x)
Other costs Note 1 20X2: (x - 5) 20X1: (x + 20) Note 2 (x - 5) (x + 20)
Note 1: Other costs would need to be disclosed either by function or by nature.
Note 2: The inventory write-down and reversal could be included in cost of inventory expense or could be shown
as part of the entity’s other expenses – this is a choice based on professional judgement (see section 7.5).
Company name
20X2 20X1
Profit before taxation is stated after taking into account the following separately disclosable (income)/
expense items:
- Write-down/ (Reversal of write-down) of inventories (5) 20
Workings
W1: Calculation of write-down or reversal of write-down 20X2 20X1
Lower of cost or net realisable value (20X1: 70 or 50) (20X2: 70 or 55) (55) (50)
Write-down/ (reversal of previous write-down) (5) 20
Solution 30B: Net realisable value calculation and journal

Journals
End of 20X1: journal Debit Credit
Inventory write-down (E) 20
Inventories (A) 20
Write-down of inventories: W1
End of 20X2: journal
Inventories (A) 20
Reversal of inventory write-down (I) 20
Reversal of previous write-down of inventories: W1
Disclosure
Company name
Note 20X2 20X1
C C
Revenue x x
Cost of inventory expense (x) (x)
Other costs * 20X2: (x - 20) and 20X1: (x + 20) (x - 20) (x + 20)
Note 1: Other costs would need to be disclosed either by function or by nature.
Note 2: The inventory write-down and reversal could be included in cost of inventory expense or could be shown
as part of the entity’s other expenses – this is a choice based on professional judgement (see section 7.5).
Chapter 13 681
Company name
20X2 20X1
Profit before taxation is stated after the following separately disclosable (income)/ expense items:
- Write-down/ (Reversal of write-down) of inventories (20) 20
Workings
W1: Calculation of write-down or reversal of write-down 20X2 20X1

Lower of cost or net realisable value (20X1: 70 or 50) (20X2: 70 or 75) (70) (50)
Write-down/ (reversal of previous write-down) (20) 20
7.5 Testing for possible write-downs: practical applications (IAS 2.29)
As mentioned previously, when testing for possible write-downs, each item of inventory
should be tested separately. What this means is that an estimated percentage write-off would
not be acceptable. The write-down must be carefully estimated based on the actual
circumstances of the entity.
In certain circumstances, for example, a product line (e.g. a cutlery set) must be looked at as a
whole rather than on an individual item-by-item basis when these individual items cannot be
sold separately: e.g. if the knives, forks and spoons manufactured as part of the cutlery set are
not sold separately, then the cutlery set should be tested for impairment as a separate product-
line rather than trying to measure the individual knives, forks and spoons making up the set.
Inventory should generally not be tested for impairment based on general classifications, such
as raw materials, work-in-progress, finished goods and consumable stores. If, for example, the
category of raw materials has a net realisable value that is less than its cost, but the raw
materials are to be used in the manufacture of a profitable finished product and will therefore
not be sold in its raw state, then a write down of the raw materials would make no sense.
On the other hand, the testing for impairment of a general classification such as raw materials
would be appropriate if, for example, the finished product in which the raw materials are used
is not profitable and there is a chance that the raw materials (or work-in-progress) could be
sold in an unfinished state or even dumped.
If the price of raw materials has dropped to below cost, no write-down is processed unless the
drop in the price of the raw material has also resulted in the net realisable value of the finished
product dropping below the cost thereof. If the drop in the price of raw materials has resulted
in the net realisable value of the finished product dropping below cost, then the affected raw
materials on hand would need to be written down (the net realisable value of the raw material
will then generally be the replacement cost of the raw materials).
7.6 Presenting inventory write-downs and reversals of write-downs (IAS 2.34 & .38)
Inventory write-downs occur when the cost of the inventory exceeded the inventory’s net
realisable value. The inventory asset’s carrying amount is then reduced accordingly and
expensed as an inventory write-down. This write-down may subsequently be reversed, in
which case the reversal would be recognised as income. The write-down expense and the
reversal of write-down income are separately disclosable items.
682 Chapter 13
The standard is not definitive on whether an inventory write-down expense (or reversal of
inventory write-down income) should be presented separately from or included with the cost
of inventory expense (often called cost of sales expense). The standard describes the cost of
inventory expense (cost of sales) as including the following three items:
the cost of the inventory items that have been sold; plus
any unallocated manufacturing costs; plus
any abnormal production costs (e.g. wastage). See IAS 2.34
However, it goes on to explain that the circumstances facing the entity may justify including
other amounts in this cost of inventory expense (cost of sales expense). Thus professional
judgement is required when deciding whether an inventory write-down expense (or reversal
of inventory write-down income) should be included in the cost of inventory expense or
disclosed separately. It is submitted, that unless circumstances warrant a different treatment,
that a general rule of thumb would be that:
if the write-down is considered to be a normal part of trading, this inventory write-down
expense could be included in the cost of inventory expense (cost of sales expense); but
if the write-down is not normal, this inventory write-down expense should not be
included in the cost of inventory expense (cost of sales). See IAS 2.38
Sometimes write-downs are simply a normal part of an entity’s business. For example,
inventory represented by fresh vegetables with a short-shelf life may result in regular write-
downs. It could be argued in this case that such an inventory write-down should be included
in the cost of inventory expense (cost of sales). On the other hand, if a new technology was
released resulting in certain inventory on hand becoming obsolete and thus needing to be
written-down, this type of write-down may be considered significant and not a normal part of
business, in which case there would be justification for the write-down to be presented
separately from the cost of inventory expense (cost of sales).
One of the reasons behind excluding the cost of an unusual and significant inventory write-
down expense (or reversal income) from the cost of inventory expense is that the cost of this
inventory write-down expense would then distort the gross profit percentage and would also
damage comparability of the current year financial results with those of the prior year and
would also damage comparability with the results of competitor businesses.
It must be noted that the above distinction will need to be made by using your professional
judgement and this judgement needs to be based on the idea that we need to provide financial
information that is as useful and relevant as possible.
Example 31: Lower of cost or net realisable value – involving raw materials
A bookkeeper has provided you with the following working papers regarding inventory on
hand at 31 December 20X2. The company is a manufacturer of two product lines:
motorbikes and bicycles:
Cost NRV: Write-down
C C C
Raw materials 100 000 75 000 25 000
Motorbike parts 40 000 25 000
Bicycle parts 60 000 50 000
Work-in-progress 80 000 85 000 0
Incomplete motorbikes 30 000 25 000
Incomplete bicycles 50 000 60 000
Finished Goods 160 000 165 000 0
Complete motorbikes 80 000 55 000
Complete bicycles 80 000 110 000
340 000 325 000
Chapter 13 683
Due to the strengthening of the local currency, the parts used in the manufacture of both the
motorbikes and bicycles became cheaper. As a direct result thereof, the net realisable value of both
the finished motorbikes and bicycles also dropped.
Required: The bookkeeper asked that you explain whether his calculated write-down is correct.
Solution 31: Lower of cost or net realisable value – involving raw materials
Comments to the bookkeeper:
The calculation of possible write-downs of inventory must not be done based on the classifications
(raw materials, work-in-progress and finished goods) but should be assessed on an item-by-item basis.
Although both items of raw materials have net realisable values that are lower than cost, raw materials
should not be written-down unless the reason for the drop in the NRV of the raw materials has also
resulted in the NRV of the related finished product also dropping.
Since the NRV of the finished motorbikes has dropped below cost, motorbike parts (raw materials)
should be written-down to their net realisable value (the NRV in this case is usually the net
replacement cost).
Despite the NRV of the finished bicycles having dropped, the NRV of the bicycles has not dropped
below cost. The bicycle parts (raw materials) should therefore not be written-down.
The write-down is thus calculated as Cost NRV: Write-down Comment
follows: C C C
Motorbikes:
Motorbike parts (raw materials) 40 000 25 000 15 000 (a)
Incomplete motorbikes (work-in-progress) 30 000 25 000 5 000 30 000 – 25 000
Complete motorbikes (finished goods) 80 000 55 000 25 000 80 000 – 55 000
Bicycles:
Bicycle parts (raw materials) 60 000 50 000 0 (b)
Incomplete bicycles (work-in-progress) 50 000 60 000 0 NRV greater
Complete bicycles (finished goods) 80 000 110 000 0 NRV greater
45 000
Comments:
(a) A write-down of the raw material of motorbike parts is necessary because the NRV of complete
motorbikes has dropped below cost.
(b) No write-down of the raw material of bicycle parts is processed since the NRV of the complete
bicycles remained above cost.
8. Disclosure (IAS 2.36 - .39)
8.1 Accounting policies (IAS 2.36)
An accounting policy note is required indicating the accounting policy in respect of:
the measurement of inventories (i.e. lower of cost and net realisable value) and
the cost formula used (FIFO, WA or SI methods).
8.2 Statement of financial position and supporting notes
Inventories must be presented as a separate line item on the face of the statement of financial
position. IAS 1.54
The note supporting this inventories line item should indicate the:
Carrying amount of inventories broken down into classifications appropriate to the entity:
Merchandise or Finished goods
Work-in-progress
Raw materials
Other production supplies (e.g. cleaning materials & other consumables); See IAS 2.36 (b)
Carrying amount of inventories measured at fair value less costs to sell (this applies to
agricultural produce only – agricultural industries are not covered in this text); See IAS 2.36 (c)
Amount of inventories pledged as security. IAS 2.36 (h)
684 Chapter 13
8.3 Statement of comprehensive income and supporting notes

The following disclosure is required, either on the face of the statement of comprehensive
income or in a note supporting specific line items on the face:
The cost of inventories expense (often referred to as cost of sales), which constitutes:
cost of goods sold,
fixed manufacturing overheads expensed (i.e. due to under-production), and
abnormal production costs (e.g. abnormal wastage of raw materials); See IAS 2.36 (d) & .38
other costs, depending on ‘ the circumstances of the business’
Write-down of inventories; See IAS 2.36 (e) write downs may be included in cost of sales
depending on ‘the circumstances of the business’
Reversal of an inventory write-down, together with the circumstances that led to this
reversal. See IAS 2.36 (f and g)
The cost of inventories expense is disclosed whether the function or nature method is used.
Remember that the cost of inventories expense, which must be presented separately, includes
costs such as depreciation on factory-related property, plant and equipment (which are
capitalised to inventory), and which are line-items that must also be disclosed separately.
Example 32: Disclosure of the inventory asset and related accounting policies
The following were included in the trial balance at 31 December 20X2 (year-end):
Finished goods (tyres: styles XYZ and XXX): C500 000;
Work-in-progress: C100 000;
Raw materials: C300 000.
Finished goods of C50 000 have been pledged as security for a loan (the note on the loan is note 15).
Required: Disclose the above in the statement of financial position and related notes thereto.
Solution 32: Disclosure of the inventory asset and related accounting policies
Company name
Note 20X2 20X1
Current assets C C
Inventories 500 000 + 100 000 + 300 000 5 900 000 xxx
Accounts receivable xxx xxx
Cash xxx xxx
Company name
Note 20X2 20X1
2. Accounting policies C C
2.1 Inventories
Inventories are valued at the lower of cost and net realisable value, where the cost is calculated using the
actual cost/ standard cost/ retail method (selling price less gross profit percentage). Movements of
inventory are recorded using the weighted average formula (or FIFO or SI).
5. Inventories
Finished goods 500 000 xxx
Work-in-progress 100 000 xxx
Raw materials 300 000 xxx
900 000 xxx
The company pledged C500 000 of its finished goods as security for a non-current loan (see note # for
further details).
Chapter 13 685
Example 33: Disclosure of cost of sales and inventory related depreciation

A company earned sales income of C620 000 and listed the following expense accounts in
its trial balance at 31 December20X2 (year-end):
Cost of sales: C100 000;
Fixed manufacturing overheads: C80 000 (these were expensed due to under-
productivity);
Fixed administration overheads: C70 000;
Write-down of green paint (raw materials): C20 000
Write-down of green picket fences (finished goods): C30 000
Reversal of write-down of white paint (raw materials): C10 000 (New technology in
20X1 resulted in the write-down of white paint (raw materials) and related white
fencing (finished product). This technology was declared illegal during 20X2 due to
health concerns; as a result, the net realisable value of the white paint and white
fencing on-hand at the end of 20X2 increased.)
Depreciation – office equipment: C25 000
Depreciation – distribution vehicles: C35 000
Depreciation – plant: C5 000 (depreciation on plant of C75 000 was capitalised to
inventory during the year; the depreciation of C5 000 was due to plant being idle
during a strike by factory workers)
Salaries and commissions: sales representatives: C130 000
Salaries: administrative staff: C60 000
Interest expense: C15 000
Required: Disclose the above in the statement of comprehensive income and related notes thereto
assuming that the function method is used. Assume that the entity chooses to include write-downs of
inventory in the cost of inventory expense (cost of sales) line-item.
Solution 33: Disclosure of cost of sales and inventory related depreciation

Company name
Note 20X2
C
Revenue 620 000
Cost of inventory expense 100 000 + 80 000 + 20 000 + 30 000 – 10 000 + 5 000 (225 000)
Cost of administration 70 000 + 25 000 + 60 000 (155 000)
Cost of distribution 35 000 + 130 000 (165 000)
Finance costs Given (15 000)
Profit before tax 3. 60 000
Company name
20X2
3. Profit before tax C
Profit before tax is stated after the following separately disclosable (income)/ expense items:
Depreciation – office equipment 25 000
Depreciation – distribution vehicles 35 000
Depreciation – plant 5 000
- Total depreciation 5 000 expensed + 75 000 capitalised 80 000
- Less capitalised to work-in-progress Given (75 000)
Write-down of inventories 20 000 + 30 000 50 000
Reversal of write-down of inventories (10 000)
Reason for the reversal of the write-down of inventories: New technology in 20X1 resulted in the
write-down of white paint (raw materials) and related white fencing (finished product). This
technology was declared illegal during 20X2 due to health concerns; as a result, the net realisable
value of the white paint and white fencing on-hand at the end of 20X2 increased.
686 Chapter 13
Example 34: Disclosure: comparison between nature and function methods

The following schedule of costs for the year ended 31 December 20X2 is presented to you:
Raw materials: Balance: 1 January 20X2: C20 000
Balance: 31 December 20X2: C10 000
Purchases: during 20X2: C40 000
Work-in-progress: Balance: 1 January 20X2: C40 000
Finished goods: Balance: 1 January 20X2: C60 000
Production costs: Wages: during 20X2: C60 000
Factory depreciation: during 20X2: C80 000
Other income and Distribution & administration costs: C30 000 each
expenses during 0X2: Sales income: C290 000
Other income: C10 000 (there is no other
comprehensive income)
Interest expense: C10 000
Tax expense: C20 000
Actual production exceeded normal production.
Required: Disclose the above in the statement of comprehensive income in as much detail as
possible assuming that:
A. the function method is used;
B. the nature method is used.
Solution 34A: Disclosure – function method

Company name
Note 20X2
C
Revenue 290 000
Other income 10 000
Less cost of inventory expense W3 (180 000)
Less distribution costs (30 000)
Less administrative costs (30 000)
Less finance costs (10 000)
Taxation (20 000)
W1. Raw Materials O/bal + Purchases - Used = C/bal
20 000 40 000 (50 000) 10 000
(balancing)
W2. Work-in- O/bal + Production costs - Finished goods = C/bal
progress
W4
40 000 190 000 (200 000) 30 000
(balancing)
W3. Finished Goods O/bal + Finished goods - Cost of sales = C/bal
W2
60 000 200 000 (180 000) 80 000
(balancing)
W4. Production costs C
Wages 60 000
Depreciation 80 000
W1
RM used 50 000
190 000
Chapter 13 687
Solution 34B: Disclosure – nature method

Company name
Note 20X2
C
Revenue 290 000
Add other income 10 000
Add increase in inventory of finished goods W3. 80 000 – 60 000 20 000
Less decrease in inventory of work-in-progress W2. 30 000 – 40 000 (10 000)
Less Raw materials and consumables used W1. (50 000)
Less Staff costs (60 000)
Less Depreciation (80 000)
Less other operating expenses No detail given so 30 000 + 30 000 (60 000)
Less finance costs (10 000)
Taxation (20 000)
Note: please see workings in solution 34A
688 Chapter 13
9. Summary
Inventory measurement:
lower of cost and net
realisable value
Cost: Net realisable value:

Calculation techniques: Calculation:
- Actual; Estimated selling price
- Standard; or Less: estimated costs to complete
- Retail method. Less: estimated selling costs
Include Exclude
- The general rule: costs that are incurred in
order to bring the asset to its present - Abnormal wastage;
location and condition: - Storage costs (unless necessary mid-
- purchase cost (e.g. of raw material – a production);
direct cost);
- conversion cost - Administrative costs that do not
- other costs contribute to the ‘general rule’
- Purchase cost include, for example, - Selling costs;
purchase price, transport costs inwards, ,
non-refundable taxes and import duties, - Transport costs outwards (involved in
other directly attributable costs the sale);
- Conversion costs include for example: - Transaction taxes that are recoverable
- direct costs e.g. direct labour: these are (e.g. VAT).
normally variable but could be fixed);
- indirect costs (variable manuf.
overheads and fixed manuf. overheads)
- Other cost include, for ex., borrowing costs
- All discounts plus rebates that are designed
to reduce the purchase price should be set-
off against the costs
Inventory measurement involving:

*** Fixed manufacturing cost (FMC):
A FMC allocation rate must be used to measure how
much of the FMC’s to include in the cost of the
inventory asset.
The rate is based on:
Normal production if: Actual production if:

Actual production = / < Normal production Actual production > Normal production
- If AP < NP, then some of the FMC will not - If AP > NP, then all of the FMC will be
be capitalised and will be included as part capitalised (if normal production was
of the cost of inventory expense used as the base instead of actual
(considered to be abnormal wastage) production, then more costs would be
- If AP = NP, then all FMC’s are capitalised capitalised than is incurred!)
Inventory measurement:
The cost formulae used for measuring inventory movements
Same cost formulae for all inventory with similar nature and use
If goods are similar: use either If goods are not similar: use
- Weighted average (WA) formula - Specific identification (SI) formula
- First-in, first-out (FIFO) formula
Chapter 13 689
Inventory Systems:
Periodic: Perpetual:
Inventory account updated at the end of the Two accounts are used, both of which are
period (typically this is year-end) with the: updated immediately on purchases and sales
new closing balance (physically count) of goods:
old opening balance transferred out. Inventory account (and any sub-accounts
such as Raw Materials, WIP, Finished
Goods etc); and
Purchases during the period are debited to Cost of sales account.
purchases account. This is transferred out at
year-end.
All contra accounts: cost of sales
Disclosure of inventory
Statement of financial position and Statement of comprehensive income

related notes and related notes
SOFP face: SOCI face:
- Total carrying amount of inventories - Cost of inventory expense (often
called cost of sales):
Inventory note: show the carrying amt - cost of sales
Note 1
- Per class of inventory: - + cost of write-downs
- finished goods, - - reversals of write-downs Note 1
Note 1
- work in progress, - + inventory losses
- raw materials, - + fixed manuf costs expensed
(under-absorbed)
- consumables
- + abnormal wastage
- Of inventory carried at fair value less
costs to sell (this applies to commodity Note 1: these costs could be included in cost
brokers only) of inventory expense if we believed they were
a normal part of our trading activities –
- Of inventory pledged as security
otherwise, we could present them separately
- Inventory write-down
- Reversal of inventory write-down
(include conditions causing reversal)
- Depreciation capitalised to inventory
Accounting policies (notes)

Lower of cost and net realisable value
Cost formula used (FIFO, WA, SI)
690 Chapter 13
Gripping GAAP Borrowing costs
Chapter 14
Borrowing Costs
Reference: IAS 23 (including amendments to 10 December 2014)
Contents: Page
1. Introduction 692
2. Scope 692
3. Understanding the terms: borrowing costs and qualifying assets 692
3.1 Borrowing costs 692
3.2 Qualifying assets 693
4. Expensing borrowing costs 693
4.1 Recognition 693
4.2 Measurement 694
Example 1: Expensing borrowing costs 694
5. Capitalising borrowing costs 694
5.1 Recognition 694
5.1.1 Commencement of capitalisation 695
Example 2: Capitalisation of borrowing costs: all criteria met at same
time 695
Example 3: Commencement of capitalisation: criteria met at different
times 696
Example 4: Commencement of capitalisation: criteria met at different
times 696
5.1.2 Suspension of capitalisation 697
Example 5: Suspension of capitalisation: delays in construction 697
5.1.3 Cessation of capitalisation 698
Example 6: Cessation of capitalisation: end of construction 698
5.2 Measurement 699
5.2.1 Measurement: specific loans 699
Example 7: Specific loans 699
Example 8: Specific loans: costs paid on specific days 700
Example 9: Specific loans: costs paid evenly over a period 701
Example 10: Specific loans: loan raised before construction begins 702
5.2.2 Measurement: general loans 702
Example 11: General loan: the effect of when payments are made 703
Example 12: General loan: more than one general loan 706
5.2.3 Measurement: Foreign exchange differences 708
Example 13: Foreign exchange differences 708
6. Deferred tax effects of capitalisation of borrowing costs 710
Example 14: Deferred tax on a qualifying asset (cost model): deductible 710
Example 15: Deferred tax on a qualifying asset (cost model): non-deductible 711
7. Disclosure 713
8. Summary 714
Chapter 14 691
1. Introduction (IAS 23.1)
The term borrowing costs does not only refer to interest expense, but can include other costs
incurred in connection with the borrowing of funds. The various kinds of costs that could be
classified as a borrowing cost are described in more detail in section 3. However, in the
meantime, let us start by considering the most common borrowing cost: interest. During the
course of your studies, you have probably already come across interest and, no doubt, most of
your examples will have recognised the cost of interest as an expense. However, where
interest (or other borrowing cost) is directly related to creating or acquiring a qualifying asset,
the interest must actually be capitalised to the cost of the asset. In other words, the borrowing
cost would be recognised as part of the cost of the asset – it would not be expensed.
It was a big surprise to many when the revised IAS 23 was released back in 2007 because it
effectively removed the option to simply expense all borrowing costs incurred. In fact, many
expected that the option of capitalising borrowing costs would be removed instead! One of the
significant reasons in support of the capitalisation of borrowing costs was that the cost of
financing the construction of an asset is generally a significant cost and it is generally
necessary in order to bring an asset to a location and condition that makes it useable or
saleable. However, there were some good arguments against capitalising borrowing costs, of
course, such as: if all borrowing costs were expensed, it would mean improved consistency in
the treatment of borrowing costs, better matching since the expenses would be recognised in
the period in which they are incurred and better comparability of assets between entities
(capitalising interest means that an entity that needs to finance the acquisition or creation of
an asset would reflect its asset at a higher cost than an entity that could acquire or create the
asset without the use of financing – thus damaging comparability). Be this as it may, the new
standard removed free choice and now, if certain criteria are met, we have no choice but to
capitalise borrowing costs.
2. Scope (IAS 23.1 - .4)
Costs that meet the definition of borrowing costs and relate to the ‘acquisition, construction or
production of a qualifying asset’ must be accounted for in terms of IAS 23 (i.e. they must be
capitalised). However, you are not forced to apply IAS 23 if the qualifying asset is:
‘measured at fair value’; or is
inventory that is produced ‘in large quantities on a repetitive basis’. See IAS 23.1 and 4
The term borrowing costs does not include the costs of equity (e.g. dividends on shares).
3. Understanding the Terms: Borrowing Costs and Qualifying Assets
3.1 Borrowing costs (IAS 23.5 and .6)
As already mentioned, borrowing costs include not only interest incurred (also referred to as
finance costs), but also include other costs incurred in connection with borrowing funds.
Borrowings costs may include, for example: Borrowing costs are defined
brokerage fees; as:
legal fees; interest and other costs
that an entity incurs
finance charges on finance leases; in connection with
interest expense calculated using the effective the borrowing of funds. IAS 23.5
interest method described in IFRS 9 Financial
instruments; and
exchange difference on foreign loan accounts to the extent that they are regarded as an
adjustment to the interest on the loan. See IAS 23.6 and IFRS 9 Appendix A
692 Chapter 14
Notice that this list excludes certain costs associated with raising funds or otherwise financing
a qualifying asset. This suggests that costs that do not appear on this list may not be
capitalised. Borrowing costs therefore exclude:
cost of raising share capital that is recognised as equity, for example:
- dividends on ordinary share capital;
- dividends on non-redeemable preference share capital (note: dividends on redeemable
preference share capital would be capitalised because redeemable preference shares
are recognised as liabilities and not equity – thus these dividends are recognised as
interest calculated using the effective interest rate method described in IFRS 9);
cost of using internal funds (e.g. if one uses existing cash resources instead of borrowing
more funds, there is an indirect cost being the lost income, often measured using the
companies weighted average cost of capital or the market interest rates that could
otherwise have been earned).
Borrowing costs is a broad definition that encompasses interest expense. The implication of
this is that any costs recognised as an interest expense in terms of the effective interest rate
method (in IFRS 9 Financial instruments) may also be capitalised. Example: a premium
payable on the redemption of preference shares is recognised as an interest expense using the
effective interest rate method and therefore this
premium may also effectively be capitalised. Borrowing costs must be
capitalised to the cost of the
asset if they:
If borrowing costs are incurred as a direct result of are directly attributable
acquiring, construction or producing an asset that meets to the acquisition, construction or
the definition of a qualifying asset, these costs must be production
of a qualifying asset. Reworded IAS 23.8
capitalised-there is no choice.
Sometimes proving that borrowing costs are directly attributable is difficult because:
the borrowings may not have been specifically raised for that asset, but may be general
borrowings (i.e. the entity may have a range of debt at a range of varying interest rates);
the borrowings may not even be denominated in your local currency (i.e. the borrowings
may be foreign borrowings).
These issues are expanded upon in the section entitled ‘measurement’.
3.2 Qualifying assets (IAS 23.5 and .7)
A qualifying asset is simply an asset that requires a A qualifying asset is defined

long time to get ready for its intended use or sale. as:
Thus, qualifying assets could include a variety of asset an asset
types. Examples include plant and machinery, owner- that necessarily takes
a substantial period of time
occupied property or investment property, intangible to get ready for its intended:
assets and even inventories. See IAS 23.7 - use or
- sale. IAS 23.5
Qualifying assets do not include:
assets (including inventories) that are ‘ready for their intended use or sale’ on acquisition,
financial assets (e.g. an investment in shares), and
inventories that take a ‘short period of time’ to manufacture. See IAS 23.7
4. Expensing Borrowing Costs
4.1 Recognition (IAS 23.8 - .9)
If borrowing costs do not meet the conditions for capitalisation (see 4.1), they are expensed.
Expensing borrowing costs simply means to include the borrowing costs as an expense in
profit or loss in the period in which they were incurred (i.e. as and when interest is charged in
accordance with the terms of the borrowing agreement).
Chapter 14 693
4.2 Measurement (IAS 23.10)
The amount of borrowing costs expensed is simply the amount charged by the lender in
accordance with the borrowing agreement, being the interest calculated using the effective
interest rate method.
Example 1: Expensing borrowing costs
Yay Limited raised a loan of C1 000 000 on 30 June 20X5:

Yay has not made any capital repayments during 20X5.
The loan has an effective interest rate of 10%.
The loan was used to finance the construction of a factory plant.
The factory plant was not considered to be a qualifying asset.
Required: Journalise the interest in Yay Limited’s books for the year ended 31 December 20X5
Solution 1: Expensing borrowing costs
Comment: This examples shows:

When to recognise interest on a non-qualifying asset as an expense: when the interest is incurred.
How much to expense: the amount of interest calculated using the effective interest rate method.
Debit Credit
Finance costs (expense) 1 000 000 x 10% x 6/12 50 000
Interest incurred during the period is expensed
5. Capitalising Borrowing Costs
5.1 Recognition (IAS 23.8 - .9)
To capitalise borrowing costs simply means to include them Capitalise borrowing

in the cost of the related qualifying assets. In other words, costs only if they meet
the:
the borrowing costs are recognised as an asset.
definition of borrowing costs, and
recognition criteria of an asset.
Costs that meet the definition of borrowing costs must be IAS 23.8-9
capitalised to the cost of the asset if the recognition criteria

are satisfied:
the inflow of future economic benefits must be probable; and
the costs must be reliably measurable Reworded IAS 23.9
Directly attributable means: if the assets had not been acquired, constructed or produced then
these costs could have been avoided.
An example of an acquisition is the purchase of a building.
An example of the construction of an asset is the building of a manufacturing plant.
An example of the production of an asset is the manufacture of inventory.
Borrowing costs are recognised as part of the cost of the asset (capitalised) during what I refer
to as the capitalisation period. This capitalisation period has a start date and an end date and
may be broken for a period of time somewhere between these dates:
Commencement date: capitalisation starts from the date on which certain criteria are met;
Suspension period: capitalisation must stop temporarily when certain criteria are met;
Cessation date: capitalisation must stop permanently when certain criteria are met.
694 Chapter 14
Capitalisation occurs during the construction period
Start Pause Stop

The commencement date The suspension period The cessation date
(an official IAS 23 term): (not a defined term): (not a defined term):
When: When the construction of When the asset
BC’s are being incurred; the asset is: is ready for its intended
Expenditure on the production interrupted or delayed for use or sale; or
of the asset is being incurred; a long period of time; is substantially ready.
& (i.e. do not pause if the
Activities are in progress delay is necessary).
When borrowing costs are capitalised, the carrying amount of the asset will obviously be
increased by the borrowing costs incurred. The cost of these borrowings will eventually
reduce profits, but only when the qualifying asset affects profit or loss (e.g. through the
depreciation expense when the qualifying asset is an item of property, plant and equipment).
5.1.1 Commencement of capitalisation (IAS 23.17 - .19)
Assuming that the basic recognition criteria are met, an Capitalisation of BCs must
entity must start to capitalise borrowing costs from the commence when:
date that all the following criteria are met:
Borrowing costs are incurred; and
borrowing costs are being incurred; Expenditures are incurred; and
expenditure is being incurred by the entity in Activities necessary to prepare the
preparing the asset; and asset for its intended use or sale have
begun. IAS 23.17 (reworded)
activities are underway to prepare the asset for its
intended use or sale (activity is happening).
It is interesting to note that expenditures on a qualifying asset include only those for which
there have been payments of cash, transfers of other assets or the assumption of interest-
bearing liabilities. Thus, the expenditures incurred for purposes of capitalisation must be
calculated net of any government grants received (IAS 20) and any progress payments
received in relation to the asset.
The activity referred to above need not be the physical activity of construction, but could also
be associated technical and administrative work prior to the physical construction.
The date that all three criteria are met is known as the commencement date.
Example 2: Capitalisation of borrowing costs - all criteria met at same time
Yippee Limited incurred C100 000 interest during the year on a loan that was specifically
raised to finance the construction of a building, a qualifying asset:
The loan was raised on 1 January 20X5.
Construction began on 1 January 20X5 and related construction costs were incurred
from this date.
The recognition criteria would be met if the borrowing costs were capitalised.
Required: Journalise the interest in Yippee Limited’s books for the year ended 31 December 20X5
Solution 2: Capitalisation of borrowing costs - all criteria met at same time

Comment: Interest must be recognised as part of the cost of the qualifying asset. Interest is recognised
as part of the asset (capitalisation) from the time that all criteria for capitalisation are met. All criteria
for capitalisation are met on 1 January 20X5 and therefore the amount to be capitalised is calculated
from 1 January 20X5 (assuming the basic recognition criteria are also met):
a loan is raised on 1 January 20X5 from which date interest is being incurred;
activities start on 1 January 20X5;
construction costs are being incurred from 1 January 20X5.
Chapter 14 695
Solution 2: Continued:
Debit Credit
Finance costs (E) 100 000 x 12 / 12 100 000
Interest on the loan incurred first expensed
Building: cost (A) 100 000 x 12 / 12 100 000
Finance costs (E) 100 000
Interest on the loan capitalised to the cost of the building
Example 3: Commencement of capitalisation - criteria met at different times

Dawdle Limited borrowed C100 000 on the 30 June 20X5 in order to build a factory to store
its goods. The necessary building materials were only available on 31 August 20X5 and it
was then that Dawdle Limited began construction. The building is considered to be a qualifying asset.
Required: Discuss when Dawdle Limited may begin capitalising the interest incurred.
Solution 3: Commencement of capitalisation - criteria met at different times

Comment: This example shows when an entity may commence capitalisation on a qualifying asset
where borrowing costs are incurred before activities start and before expenditure is incurred.
All three criteria must be met before the entity may begin capitalisation. From the 30 June 20X5,
Dawdle Limited borrowed funds and began incurring borrowing costs, but had not yet met the other
two criteria (activities had not started and costs on the asset were not being incurred). On the
31 August 20X5 Dawdle both incurred the cost of acquiring the construction materials and began
construction thereby fulfilling all three criteria. Dawdle Limited may therefore only begin capitalising
the borrowing costs from the 31 August 20X5 (assuming that the recognition criteria were met).
Example 4: Commencement of capitalisation - criteria met at different times

Hoorah Limited incurred C100 000 interest for the year ended 31 December 20X5 on a loan
of C1 000 000, raised on 1 January 20X5.
The loan was raised specifically to finance the construction of a building, a qualifying asset.
Construction began on 1 February 20X5 and was not yet complete at 31 December 20X5.
Required: Show the related journals in Hoorah’s books for the year ended 31 December 20X5.
Solution 4: Commencement of capitalisation - criteria met at different times

Comment:
Borrowing costs are incurred from 1 January 20X5, but activities only start and related expenditure are
only incurred from 1 February 20X5.
Thus, all 3 criteria for capitalisation are only met from 1 February 20X5 with the result that
capitalisation may only occur from 1 February 20X5.
Bank 1 000 000
Loan payable (L) 1 000 000
Receipt of cash from loan raised
31 December 20X5
Finance costs (E) 100 000 x 12 / 12 100 000
Interest on loan incurred first expensed: total interest incurred
Building: cost (A) 100 000 x 11 / 12 91 667
Interest on the loan capitalised to the cost of the building; measured
from commencement date (1 February 20X5)
696 Chapter 14
5.1.2 Suspension of capitalisation (IAS 23.20 - .21)

We must temporarily suspend (i.e. stop for a time) the Capitalisation of BCs must
capitalisation of borrowing costs when active be suspended during:
development of a qualifying asset is interrupted or extended periods during which
delayed for a long period of time. Let’s call this the active development is suspended.
IAS 23.20 (reworded)
suspension period.
The capitalisation of borrowing costs will resume (i.e. capitalisation will start again) after the
suspension period has ended, assuming the criteria for capitalisation continue to be met.
In other words, borrowing costs are not capitalised during long periods when construction has
been delayed, but once the delays have ended and construction begins again, the
capitalisation of borrowing costs will continue.
When referring to the suspension of borrowing costs, IAS 23 specifically refers to the words
‘extended periods’ (see IAS 23.20 in grey pop-up above). This means that the capitalisation
of borrowing costs would not be suspended in cases when the delay is only a temporary delay.
The standard also clarifies that the capitalisation of Suspend capitalisation if
borrowing costs must not be suspended if the delay is a and only if, the delay:
necessary part of getting the asset ready for its intended is for a long period of time; and
use. A typical example of when borrowing costs should is not necessary in getting the asset
continue to be capitalised despite a delay is a wine farm ready for its intended use;
that has to wait for its inventory of wine to mature in is not for substantial technical or
administrative work. See IAS 23.20-.21
order to ensure a saleable condition. In this case,
borrowing costs that are incurred during this period of maturation would continue to be
capitalised to the cost of the inventory of wine.
The standard also clarifies that the capitalisation of borrowing costs must not be suspended if
the delay is due to substantial technical or administrative work. It is submitted that an
example of when borrowing costs should continue to be capitalised during a delay that is due
to substantial technical work would be the development and submission of engineering plans
necessary before the construction of the second stage of a particular project may begin.
Example 5: Suspension of capitalisation - delays in construction
The Halt Inn is constructing a hotel in the Durban area.
Construction began in 20X4 and was not yet complete at 31 December 20X5.
Borrowing costs of C300 000 were incurred during 20X5.
All of these borrowing costs were incurred on a loan that was raised on 1 January 20X5
with its purpose being specifically for the construction of the hotel.
Required: Discuss how much of the interest may be capitalised during Halt Inn’s year ended
31 December 20X5 assuming that:
A. The builders go on strike for a period of two months, during which no progress is made.
B. The builders of the hotel had to wait for a month for the cement in the foundations to dry.
Solution 5: Suspension of capitalisation - delays in construction

Comment:
Borrowing costs may not be capitalised during periods where active development has been stopped
if this delay is for an extended period (i.e. it is a long delay).
However, capitalisation of borrowing costs is not suspended during this period if the delay was a
necessary part of the construction process or due to substantial technical or administrative work.
A. The two months during which the builders staged a strike is an extended delay that is neither
necessary for the construction process nor due to substantial technical nor administrative work.
Thus capitalisation of borrowing costs during this two-month period is suspended.
B. The month during which active development was suspended so that the cement foundations could
dry is an extended delay but one that is a necessary part of the construction process. Thus we do
not suspend the capitalisation of borrowing costs incurred during this one-month period.
Chapter 14 697
5.1.3 Cessation of capitalisation (IAS 23.22 - .25)
Capitalisation of borrowing costs must end on cessation Capitalisation of BCs must

date, which is the date on which the asset is essentially cease when:
ready for its intended use or sale or substantially ready the activities that are necessary
and capable of being used or sold. to prepare the qualifying asset for its
intended use or sale
are substantially complete.
By way of an example, capitalisation would cease if the
only work that still remains includes routine These principles are applied to each
part of a QA if the QA is made up of
administration work or minor modifications (e.g. the parts that can be used separately.
painting of a new building) to bring the asset to a IAS 23.22 & .24 (reworded)
useable or saleable condition.
Please note that, after cessation date, the asset is technically no longer a qualifying asset as it
is now in the condition required for use or sale. As such, the criteria for capitalising
borrowing costs are no longer met and thus borrowing costs may not be capitalised.
For an asset completed in parts where each part is capable of being used separately, the
capitalisation of borrowing costs ceases on each part as and when each part is completed.
An example of an asset that would be capable of being used or sold in parts would be an
office park, where buildings within the park are able to be used by tenants as and when
each building is completed.
An example of an asset that would not be capable of being used or sold in parts is a
factory plant that requires parts to be made in sequence and where the plant becomes
operational only when all parts are completed.
Example 6: Cessation of capitalisation - end of construction

Flabby Limited began construction of a block of flats on 1 January 20X5:
The block of flats is to be leased out to tenants in the future.
On 30 September 20X5, the building of the block was complete but no tenants could
be found.
On 15 November 20X5, after lowering the rentals, the entire building was successfully
rented out to tenants.
Interest of C200 000 (at 10% on a C2 000 000 loan raised specifically for this construction) was
incurred during the 12-month period ended 31 December 20X5 and correctly capitalised.
Required: Explain when the capitalisation of the interest should cease and journalise the interest.
Solution 6: Cessation of capitalisation - end of construction

Comment: This example shows when to cease capitalising borrowing costs.
Capitalisation should cease when the asset is substantially ready for its intended use or sale.
The construction was completed on 30 September 20X5 and it was leased to tenants from
15 November 20X5. Although no tenants could be found to occupy the flats between 30 September
20X5 and 15 November 20X5, the asset was ready to be leased to tenants on 30 September 20X5.
Capitalisation must therefore cease on 30 September 20X5 (because one of the three criteria for
capitalisation is no longer met: activity has ceased).
All subsequent interest incurred must be expensed.
Debit Credit
Finance costs (E) Given 200 000
Interest incurred
Building: cost (A) 200 000 x 9 / 12 150 000
Finance costs (A) 150 000
Interest capitalised until completion date: 30/9/20X5
698 Chapter 14
5.2 Measurement (IAS 23.10 - .15)
The formula used to measure the borrowing costs that Measurement of borrowing
may be capitalised depends on the purpose of the costs to be capitalised
borrowings that are being used. depends on whether:
the borrowings are specific; or
The borrowings being used could have been raised for: the borrowings are general.
the ‘specific purpose’ of funding the construction,
acquisition or production of a qualifying asset (called specific borrowings) or;
a ‘general purpose’ such as for buying inventory, paying off creditors and a multitude of
other purposes in addition to the construction, acquisition or production of a qualifying
asset (called general borrowings).
It is important to remember that whilst a bank overdraft facility is often used as general
purpose borrowings, it is also possible for a bank overdraft facility to be arranged specifically
for a qualifying asset. The particular circumstances should, therefore, always be considered
when deciding whether the borrowing is specific or general.
5.2.1 Measurement: specific loans (IAS 23.12 - .13)
All of the borrowing costs incurred on a specific loan Borrowing costs to be

during the construction period (period between capitalised on specific loans
commencement date and cessation date, and excluding are measured as:
any suspension period – these dates are explained above) Interest incurred during the
construction period
are capitalised to a qualifying asset. Less interest earned during the
construction period.
If these funds are invested prior to the date they were
utilised, then any investment income earned during the construction period must be subtracted
from the interest incurred (borrowing costs), in which case only the net amount may be
capitalised.
Although the investment income is not limited to interest income, this text focuses on interest
income in order to simply explain the principles.
The borrowing costs on specific borrowings that must be capitalised would therefore be:
total interest incurred on specific borrowings during the construction period:
capital borrowed x interest rate x period borrowed
Less investment income earned on any surplus borrowings during the construction period:
amount invested x interest rate x period invested.
Example 7: Specific loans

Yahoo Limited borrowed C500 000 on 1 January 20X5 to fund the construction of a
building:
The interest payable on the loan during 20X5 was C50 000 (calculated at 10%).
All surplus borrowings during 20X5 were invested in a call account and earned
C24 000 interest during the year.
No capital portion of the loan was repaid during the year ended 31 December 20X5.
All criteria for capitalisation of borrowing costs were met on 1 January 20X5.
The building is a qualifying asset and was not yet complete at 31 December 20X5.
Required: Show the related journals for the year ended 31 December 20X5.
Solution 7: Specific loans

Comment: This example shows that interest income is used to reduce the amount of borrowings that
may be capitalised when the borrowing is a specific borrowing.
Chapter 14 699

Finance costs (E) Given 50 000
Interest incurred on the loan first expensed
Bank/ debtors Given 24 000
Interest income 24 000
Interest income earned on investment of surplus loan funds
Building: cost (A) W1 26 000
Portion of interest on the loan capitalised to the cost of the building
W1. Calculation of amount to be capitalised during the construction period C
Interest incurred during the construction period 500 000 x 10% 50 000
Investment income earned during the construction period Given (24 000)
Total to be capitalised 26 000
When calculating the interest income you may find that actual amounts invested can be used.
This happens when, for example, the expenditures are infrequent and/ or happen at the start or
end of a period. This means that the investment balance will remain unchanged for a period
of time. (See example 8).
Very often, however, average amounts invested need to be used instead of actual amounts
invested. This happens more frequently when the borrowing is a general borrowing, but can
apply to a specific borrowing where, for example, the expenditure is paid relatively evenly
over a period of time, with the result that the balance on the investment account (being the
surplus borrowings that are invested) is constantly changing. In this case, it is easier and
acceptable to calculate the interest earned on the average investment balance over a period of
time (rather than on the actual balance on a specific day). (See example 9).
The borrowing costs on specific borrowings to be capitalised could thus also be:
total interest incurred on specific borrowings during the construction period:
capital borrowed x interest rate x period borrowed
less investment income earned on any surplus borrowings during the construction period:
(investment o/ balance + investment c/ balance) / 2 x interest rate x period invested
Example 8: Specific loans – costs paid on specific days

Haha Limited raised a bank loan of C500 000 on 1 January 20X5 to construct a building,
a qualifying asset:
Construction began on 1 January 20X5 when all criteria for capitalisation of
borrowing costs were met.
The company paid construction costs of C400 000 on 1 March 20X5.
The interest rate payable on the loan was 10%.
Surplus funds were invested in a fixed deposit and earned interest at 6% per annum.
No capital portion of the loan was repaid during 20X5.
Required: Calculate the borrowing costs to be capitalised during the year ended 31 December 20X5.
Solution 8: Specific loans – costs paid on specific days

Comment:
The borrowings are raised 2 months before they were required. These surplus funds are invested
in January and February, the investment balance remaining stable at C500 000 over this period.
On 1 March 20X5, however, payments totalling C400 000 are made, thus reducing the investment
balance to C100 000. This balance remains stable for the remaining 10 months.
Since the expenditure is not incurred evenly over a period but is incurred on a specific day, the
interest income for the purposes of calculating borrowing costs to be capitalised is calculated using
the actual investment balances (C500 000 for 2 months and C100 000 for 10 months).
700 Chapter 14

Interest incurred on the loan is first expensed
Bank/ debtors W1 10 000
C
W1. Calculation of amount to be capitalised
Borrowing costs incurred during the construction period 500 000 x 10% x 12 / 12 50 000
Investment income earned during the construction period 500 000 x 6% x 2 / 12 + (10 000)
(500 000 – 400 000) x 6% x 10/ 12
Capitalised borrowing costs 40 000
Example 9: Specific loans – costs paid evenly over a period

Hooray Limited borrowed C500 000 from the bank on 1 January 20X5 in order to
construct a building (a qualifying asset).
Construction began: 1/1/20X5 (when all criteria for capitalisation of borrowing
costs were met).
The interest rate payable on the loan was 10%.
Construction costs of C400 000 were paid evenly between 01/03/20X5 and
31/12/20X5.
Surplus funds are invested in a fixed deposit and earned interest at 6% per annum.
Required: Show the related journals for the year ended 31 December 20X5.
Solution 9: Specific loans – costs paid evenly over a period

Comment:
Borrowings are raised 2 months before they were required. These surplus funds are invested for
Jan and Feb and the balance on this account for these 2 months remains stable at C500 000.
From March the amount invested gradually reduces as payments are made: the balance of
C500 000 on 1 March gradually decreases to C100 000 (C500 000 – C400 000) on 31 December.
Since the payments are incurred evenly over this 10-month period, the interest income for the
purposes of the calculation of the borrowing costs to be capitalised may be calculated using the
average of these two balances (C500 000 and C100 000).
Debit Credit
Finance costs (expense) W1 50 000
Interest incurred on the loan is first expensed
Bank/ debtors W1 20 000
Building: cost (asset) W1 30 000
Finance costs (expense) 30 000
W1. Calculation of amount to be capitalised C
Borrowing costs incurred during the construction period 500 000 x 10% x 12 / 12 50 000
Investment income earned during the construction period (500 000 x 6% x 2 / 12) + (500 000 + (20 000)
100 000) / 2 x 6% x 10/ 12
Chapter 14 701
Example 10: Specific loans – loan raised before construction begins

Yeeha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the
construction of a building (a qualifying asset).
Construction began on 1 February 20X5.
All criteria for capitalisation of borrowing costs were met on 1 February 20X5.
The interest rate payable on the loan is 10%.
The company paid construction costs of C400 000 on 1 March 20X5.
Surplus funds are invested in a fixed deposit and earned interest at 6% per annum.
Required: Calculate the amount of borrowing costs that may be capitalised.
Solution 10: Specific loans – loan raised before construction begins

Comment: Compare this to example 8, where the loan was raised and construction began on 1 January
20X5. In this example, the loan is taken out on 1 February 20X5, being before construction begins.
Thus, all criteria for capitalisation are only met on 1 February 20X5 (commencement date). Both
interest incurred and interest earned before this date must be ignored for the purpose of calculating the
portion of interest to be capitalised.
Debit Credit
Finance costs (E) 500 000 x 10% x 12/ 12 50 000
Interest incurred on the loan first expensed
Bank/ debtors (500 000 x 6% x 2 / 12) + (500 000 – 400 000) x 6% x 10 / 12 10 000
W1. Calculation of amount to be capitalised C
Interest incurred during the construction period 500 000 x 10% x 11 / 12 45 833
(i.e. excludes January interest expense)
Interest earned during the construction period (500 000 x 6% x 1 / 12) + (7 500)
(500 000 - 400 000) x 6% x 10 / 12
(i.e. excludes January interest income)
5.2.2 Measurement: general loans (IAS 23.14 - .15)

General loans are used for many purposes and therefore it Borrowing costs to be
cannot be said that all the interest incurred thereon was capitalised on general loans
‘directly attributable to the qualifying asset’. Therefore, are measured as:
not all the interest incurred on a general loan may be Expenditures incurred
capitalised to the asset. Multiplied by the capitalisation rate
If the entity has used a general loan for a qualifying asset, the finance costs eligible for
capitalisation are the weighted average cost of borrowings, calculated as follows:
The expenditure incurred on the qualifying asset:
For practical purposes, this expenditure may need to be averaged, for example:
Expenditure incurred evenly during a month
2
Multiplied by the capitalisation rate:
The capitalisation rate is the weighted average interest rate on the general borrowings
during the period:
Interest incurred on general borrowings during the period
Weighted average total general borrowings outstanding during the period
702 Chapter 14
The expenditures to which the capitalisation rate is applied must be net of any government
grants received (IAS 20) or progress payments received relating to the asset.
The capitalisation rate to be used is the weighted average interest rate on the general
borrowings during ‘the period’. IAS 23 does not clarify what is meant by ‘the period’ and
thus its meaning is open to interpretation. It is submitted that whilst ‘the period’ could mean
the financial period (e.g. 12 months), a more accurate answer may be achieved if the actual
construction period were used instead (this may be less than 12 months). It may be
impractical to calculate the rate for the relevant construction periods for each qualifying asset
and thus it may be necessary to simply calculate and use the rate relevant to the financial
period. This text assumes that ‘the period’ refers to the financial period.
Example 11: General loans – the effect of when payments are made
Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5
on which date it raised an additional general loan of C600 000 at an interest rate of 12.5%.
The terms of the loan agreement include the annual compounding of interest.
Bizarre Limited did not make any repayments on either loan during the year ended 31 December 20X5.
Construction on a building, a qualifying asset, began on 1 January 20X5.
The company incurred the following monthly amounts on the construction:
C per month
1 January – 31 July (7 months) costs paid evenly during this period 50 000
1 August – 30 November (4 months) costs paid evenly during this period 30 000
1 – 31 December (1 month) costs paid evenly during this period 100 000
Required:
A. Calculate the capitalisation rate.
B. Provide the journals for 20X5 assuming that the costs were paid evenly during each of the three
periods referred to above.
C. Provide the journals for 20X5 assuming that the total costs for each of the three periods referred to
above were paid on the last day of each of these three periods.
D. Show the journals for 20X5 assuming that the total costs for each of the three periods referred to
above were paid in advance on the first day of each of these three periods.
Solution 11A: General loans – the effect of when payments are made
General comment:
There are two borrowings, both of which are general borrowings and therefore our capitalisation
rate is calculated as a weighted average interest rate.
The loans are general loans and thus the formula is: ‘Capitalisation rate x Expenditures’.
Since the borrowings are general, investment income is ignored when calculating the amount to be
capitalised.
Capitalisation rate (weighted average interest rate):
= interest incurred on general borrowings/ general borrowings outstanding during the period
= [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings
= 10%
Solution 11B: General loans – payments are made evenly

Comment: Since the costs are paid evenly, we calculate the borrowing costs to be capitalised using the
capitalisation rate as follows: Capitalisation rate x Average expenditures.
Journals in 20X5: Debit Credit
Building: cost (A) See Note 1 570 000
Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1
Finance costs (E) 500 000 x 7% + 600 000 x 12.5% 110 000
Finance costs incurred
Chapter 14 703

Finance costs capitalised
Note 1: This journal would actually be processed separately for each and every payment but is shown here as a
cumulative journal for ease of understanding the ‘big picture’.
W1: Calculation of borrowing costs to be capitalised:
Period Accumulated Expenses Average Interest Accumulate
expenses: incurred during cumulative capitalised d expenses:
opening bal the period expenses closing bal
A B C D E
A + B/2 or + B C x % x m/12 = A + B + D (2)
+ 0 (1)
C C C C C
1 Jan – 31 July 0 350 000 (3) 175 000 (6) 10 208 (9) 350 000
1 Aug – 30 Nov 350 000 120 000 (4) 410 000 (7) 13 667 (10) 470 000
1 Dec – 31 Dec 470 000 100 000 (5) 520 000 (8) 4 333 (11) 598 208(12)
570 000 28 208
Calculations:
(1) B is divided by 2 if the payments occur evenly during the period /
B is added if the payments occur at the beginning of the period (i.e. B is not divided by 2) /
B is not added if the payments occur at the end of the period:
this example involved even payments and thus B is divided by 2
(2) D is only added when the interest is compounded in terms of the loan agreement (31 Dec in this example)
(3) 50 000 x 7 = 350 000
(4) 30 000 x 4 = 120 000
(5) 100 000 x 1 = 100 000
(6) 0 + 350 000/2 = 175 000
(7) 350 000 + 120 000/2 = 410 000
(8) 470 000 + 100 000/2 = 520 000
(9) 175 000 x 10% x 7/12 = 10 208
(10) 410 000 x 10% x 4/12 = 13 667
(11) 520 000 x 10% x 1/12 = 4 333
(12) 470 000 + 100 000 + interest to date: 10 208 + 13 667 + 4 333 = 598 208
Solution 11C: General loans – payments are made at the end of each month
Comment: Since the expenditures are incurred at month-end, we calculate the borrowing costs to be
capitalised using the capitalisation rate as follows: Capitalisation rate x Actual expenditures (i.e. a more
accurate measurement is achieved if actual expenditures are used instead – this is important if the
difference between actual and average expenses is considered to be material).
Building: cost (A) 50 000 x 7 + 30 000 x 4 + 100 000 x 1 570 000
Construction costs incurred: NOTE 1
Note 1: This journal would actually be processed separately for each and every payment but is shown
here as a cumulative journal for ease of understanding the ‘big picture’.
704 Chapter 14
Period Accumulated Expenses Average/ Actual Interest Accumulated

expenses: incurred during cumulative capitalised expenses:
opening bal the period expenses @ 10% closing bal
A B C D E
A + B/2 C x % x m/12 = A + B + D (2)
(or A+ B) (or A+ 0) (1)
C C C C C
31 January 0 50 000 0 0 50 000
28 February 50 000 50 000 50 000 417 100 000
31 March 100 000 50 000 100 000 833 150 000
30 April 150 000 50 000 150 000 1 250 200 000
31 May 200 000 50 000 200 000 1 667 250 000
30 June 250 000 50 000 250 000 2 083 300 000
31 July 300 000 50 000 300 000 2 500 350 000
31 August 350 000 30 000 350 000 2 917 380 000
30 September 380 000 30 000 380 000 3 167 410 000
31 October 410 000 30 000 410 000 3 417 440 000
30 November 440 000 30 000 440 000 3 667 470 000
(3)
31 December 470 000 100 000 470 000 3 917 595 835
570 000 25 835
Calculations:
(1) B is divided by 2 if the payments occur evenly during the period; or
B is added in full if the payments occur at the beginning of the period (i.e. B is not divided by 2); or
this example involved payments at the end of the month and thus B is not added
(3) 470 000 + 100 000 + 25 835 = 595 835 (interest accrues annually)
Solution 11D: General loans – payments are made at the beginning of each month
Comment:
Since the expenditures are incurred at the beginning of each month, we calculate the borrowing
costs to be capitalised as follows:
Capitalisation rate x Actual expenditures
In other words, a more accurate measurement is achieved if actual expenditures are used instead –
this is important if the difference between actual and average expenses is considered to be material.

Building: cost (A) 50 000 x 7 + 30 000 x 4 + 100 000 x 1 570 000
Construction costs incurred
Chapter 14 705

Period Accumulated Expenses Average Interest Accumulated

opening bal the period expenses @ 10% closing bal
A B C D E
A + B/2 C x % x m/12 = A + B + D (2)
(or A+ B) (or A+ 0) (1)
C C C C C
1 January 0 50 000 50 000 417 50 000
1 February 50 000 50 000 100 000 833 100 000
1 March 100 000 50 000 150 000 1 250 150 000
1 April 150 000 50 000 200 000 1 667 200 000
1 May 200 000 50 000 250 000 2 083 250 000
1 June 250 000 50 000 300 000 2 500 300 000
1 July 300 000 50 000 350 000 2 917 350 000
1 August 350 000 30 000 380 000 3 167 380 000
1 September 380 000 30 000 410 000 3 417 410 000
1 October 410 000 30 000 440 000 3 667 440 000
1 November 440 000 30 000 470 000 3 917 470 000
(3)
1 December 470 000 100 000 570 000 4 750 600 585
570 000 30 585
Calculations:
(1) B is divided by 2 if the payments occur evenly during the period
B is added if the payments occur at the beginning of the period (i.e. B is not divided by 2)
this example involved payments at the beginning of the month and thus B is added in full
(2) D is only added when interest is compounded per the loan agreement (31 Dec in this example)
(3) 470 000 + 100 000 + 30 585 = 600 585
Example 12: General loan: more than one general loan

Yipdeedoo Limited began construction on a qualifying asset on 1 January 20X1. The
construction was complete on 31 December 20X1.
The company had the following general loans outstanding during the year:
Bank Loan amount Interest rate Date loan raised Date loan repaid
A Bank C300 000 15% 1 January 20X1 N/A
B Bank C200 000 10% 1 April 20X1 30 September 20X1
C Bank C100 000 12% 1 June 20X1 31 December 20X1
The interest on the loans was paid for out of other cash reserves as it was charged to the loan.
Details of the construction cost incurred are as follows:
Details Amount Date incurred Details
Laying a slab 60 000 1 January 20X1
Waiting for slab to cure 0 6 weeks (a normal process)
Purchase of materials 120 000 1 February 20X1
Labour costs 330 000 1 Feb - 31 Dec 20X1 incurred evenly over the period but
paid at the beginning of each month
Required:
a) Calculate the interest incurred for the year ended 31 December 20X1.
b) Calculate the weighted average interest rate (i.e. the capitalisation rate).
c) Calculate the interest to be capitalised.
d) Show the journal entries to account for the interest during the year ended 31 December 20X1.
706 Chapter 14
Solution 12: General loan: more than one general loan
Comment: This example illustrates the situation where there are various general loans utilised in the
construction of the qualifying asset. Also, there is a suspension period, however, capitalisation continues
as it is necessary for the construction process of the qualifying asset.
a) Interest incurred
A Bank 300 000 x 15% x 12 / 12 = 45 000
B Bank 200 000 x 10% x 6 / 12 = 10 000
C Bank 100 000 x 12% x 7 / 12 = 7 000
62 000
b) Weighted average interest rate:
Interest incurred during the year / Average general loans outstanding during the year:
62 000 / 458 333 = 13.5273%
Average loan balances outstanding during the period of construction (apportioned for time):
A Bank 300 000 x 12 / 12 = 300 000
B Bank 200 000 x 6 / 12 = 100 000
C Bank 100 000 x 7 / 12 = 58 333
458 333
c) Borrowing costs to be capitalised
Period Accumulated Expenses Average Interest Accumulated

opening bal the period expenses closing bal
A B C D E
=E A + B/2 C x % x m/12 A + B + D (2)
(or A+ B) (or A+ 0) (1)
C C C C C
(3) (6) (9)
1 January 0 60 000 60 000 676 60 000
(4)
1 February 60 000 150 000 210 000 (7) 2 367 (10)
210 000
(5)
1 Mar – 31 Dec 210 000 300 000 375 000 (8) 42 273 (11)
375 000
510 000 45 316
(1) B is divided by 2 if the payments occur evenly during the period.

B is added in full if the payments occur at the beginning of the period (i.e. B is not divided by 2) /
B is not added if the payments occur at the end of the period.
(3) Payments on 1 Jan: 60 000 (slab) (payment at the beginning of the period, so no averaging)
(4) Payments on 1 Feb: 120 000 (materials) + 330 000 / 11 (labour cost) = 150 000
(5) Payments on 1 March and evenly from then to 1 Dec: 330 000 – 30 000 (pd 1 Feb) (labour costs) = 300 000
(6) Jan costs on which int to be estimated: 0 (opening costs) + 60 000 (pmts made on 1 Jan) = 60 000
(7) Feb costs on which int to be estimated: 60 000 (opening costs) + 150 000 (pmts made on 1 Feb) = 210 000
(8) March – Dec costs on which int to be estimated: 210 000 (opening costs) + 30 000 (pmt on 1 March) +
(330 000 – 30 000 (Feb pmt) – 30 000 (March pmt))/2 (payments made evenly during the period) = 375 000
(9) 60 000 x 13.5273% x 1/12 = 676
(10) 210 000 x 13.5273% x 1/12 = 2 367
(11) 375 000 x 13.5273% x 10/12 = 42 273
d) Borrowing costs to be capitalised

Building: cost (A) 60 000 + 120 000 + 30 000 x 11 510 000
Bank/ liability NOTE 1 510 000
Chapter 14 707

Finance costs (E) Calculation (a) 62 000
Building: cost (A) Calculation (c) 45 316
5.2.3 Measurement: foreign exchange differences

Foreign exchange differences on borrowing costs is a Capitalise foreign exchange
topic open to interpretation due to the wording of a differences between the:
particular sentence in the standard, which states that average rate for the year, and
borrowing costs may include ‘exchange differences the closing rate.
arising from foreign currency borrowings to the extent
that they are regarded as an adjustment to interest costs.’ See IAS 23.6 (e)
This wording appeared to mean that foreign exchange differences could only be capitalised if
they related to the interest element, and that any foreign exchange difference arising on the
principal amount owing would not be capitalised.
The IFRIC was asked to issue an interpretation because many argued that foreign exchange
differences on the principal amount should be capitalised. Despite the confusion, the IFRIC
did not think it was necessary to issue an interpretation, saying that the IFRS was clear
enough. However, in its deliberations, the IFRIC clarified the following (documented in the
‘IFRIC Update, January 2008’):
‘Some exchange differences relating to the principal may be regarded as an adjustment to interest
costs. Exchange differences may be considered as an adjustment to borrowing costs, and hence,
taken into account in determining the amount of borrowing costs capitalised, to the extent that the
adjustment does not decrease or increase the interest costs to an amount below or above,
respectively, a notional borrowing cost based on commercial interest rates prevailing in the
functional currency as at the date of initial recognition of the borrowing.’
In other words, this means that the total amount of borrowing costs relating to foreign
borrowings that may be capitalised should lie between the following 2 amounts:
a) the actual interest costs denominated in the foreign currency translated at the actual
exchange rate on the date on which the expense is incurred; and
b) the notional borrowing costs based on commercial interest rates prevailing in the
functional currency as at the date of initial recognition of the borrowing.
IFRIC emphasised that ‘how an entity applies IAS 23 to foreign currency borrowings is a
matter of accounting policy requiring the exercise of judgement’. This means that whether the
above principles are applied is an accounting policy choice and should be applied
consistently.
The application of the principle above is illustrated in the following example.
Example 13: Foreign exchange differences
Deon Limited has a functional currency of LC. During the 20X0 financial year, Deon
decided to build a new corporate head-office, a qualifying asset.
Construction started on 1 January 20X0 and ended on 31 December 20X0.
Construction costs totalled LC8 000 000 during 20X0.
Deon Limited secured foreign borrowings of FC1 000 000 for the construction of the building:
The loan attracts interest at 5% accrued over the year.
Interest rates available on similar borrowings in local currency as at the date of initial recognition
of the foreign loan were 10%.
708 Chapter 14
The capital plus all interest owing was repaid on 31 December 20X0.
The foreign currency rates for the 20X0 year were as follows:
1 January 20X0 FC1 : LC5
31 December 20X0 FC1 : LC7
Average for 20X0 FC1 : LC6
Required: Calculate the amount of borrowing costs to be capitalised to the corporate head-office and
show all related journals for the year-ended 31 December 20X0.
Solution 13: Foreign exchange differences

Building: cost (A) Given 8 000 000
Bank/ liability 8 000 000
Bank FC1 000 000 x LC5 (SR at TD) 5 000 000
Foreign loan (L) 5 000 000
Foreign loan received, translated at spot rate on date loan
received
31 December 20X0
Finance costs (E) FC1 000 000 x 5% x 12/12 x LC6 (AR 300 000
Interest payable over period of interest) 300 000
Forex loss: interest payable FC1 000 000 x 5% x 12/12 x LC7 (SR at 50 000
(E) YE) – LC300 000 (bal in this account)
Interest payable (L) 50 000
Interest payable is translated at spot rate at year-end
Forex loss: loan principal (E) FC1 000 000 x LC7 (SR at YE) – 2 000 000
Foreign loan (L) LC5 000 000 (balance in this account) 2 000 000
Loan principal payable is translated at spot rate at year-end
Interest payable (L) Interest 300 000 + Forex loss 50 000 350 000
Foreign loan (L) Principal 5 000 000 + Forex loss 2 000 000 7 000 000
Bank FC1 050 000 x LC7 (SR at PD) 7 350 000
Payment of foreign loan: principal plus interest for the year
Building: cost (A) 100% of the interest is capitalised 350 000
Finance costs (E) (300 000) and 100% of the forex loss on 300 000
Forex loss: interest payable the interest (50 000) is capitalised 50 000
(E)
Finance costs and related foreign exchange loss is capitalised
Building: cost (A) Maximum that may be capitalised: 150 000
Forex loss: interest payable LC500 000 (a) – already capitalised (int 150 000
(E) 300 000 + forex loss on int 50 000)
A portion of the forex loss on the loan principal is capitalised:
limited by IAS 23.6(a)
(a) The maximum that may be capitalised is the notional interest = LC5 000 000 x 10% = LC500 000
Explanation:
The forex loss on the loan principal (2 000K) may also be capitalised to the building, but only to the extent
that the total of the interest (300K) + forex loss on the interest (50K) + forex loss on the principal (2 000K)
does not exceed the notional interest that would have been charged had we raised a loan locally.
Notional interest: Loan amt: 5 000 000 x local interest rate at the time we raised the loan: 10% = 500 000.
Thus we may not capitalise the full 2 350 000. However, we may capitalise our actual costs (interest + total
forex losses) up to the maximum of the notional interest of 500 000.
Since we have already capitalised 350 000, we may capitalise a further 150 000 (maximum: 500 000 –
already capitalised: 350 000)
Chapter 14 709
6. Deferred Tax Effect of Capitalisation of Borrowing Costs
The tax authorities generally allow deductions for interest in the period in which it is incurred.
This means that if interest (or part thereof) was capitalised to the cost of a qualifying asset, a
difference between the asset’s carrying amount (which includes the borrowing cost) and its
tax base (which will not include the borrowing costs) will arise in the year in which the asset
is brought into use. This difference will reverse over the life of the asset.
Example 14: Deferred tax on a qualifying asset (cost model): deductible

Cheerleader Limited built a plant (a qualifying asset) during 20X1. The costs incurred
were as follows:
Construction costs: C300 000
Interest on a specific loan: C100 000 (all incurred during the construction period).
Other information:
The asset was complete and available for use from 1 October 20X1. It is to be
depreciated straight-line over its estimated useful life of 5 years to a nil residual value.
Surplus loan money was invested in a call account and earned interest income of
C10 000 evenly over a period of 5 months, 1 month of which was after construction
had ended.
The profit for 20X1, before recording the information above, was C800 000 (fully
taxable).
Levy income tax at 30%,
Tax interest income,
Allow the deduction of the interest incurred on the construction of an asset to be
deducted in the year in which the asset is brought into use,
Allow the deduction of the cost of the qualifying asset at 20% p.a., apportioned for
part of a year from the date on which it is brought into use.
Required: Journalise the current and deferred tax for the year ended 31 December 20X1
Solution 14: Deferred tax on a qualifying asset (cost model): deductible

Comment:
This example shows the integration of IAS 12 Income taxes with IAS 23 Borrowing costs, and the
current and deferred income tax where borrowing costs are capitalised to a deductible asset.
Journals:
Income tax expense W3 208 500
Current tax expense for 20X1
Deferred tax expense for 20X1
Workings:

Interest incurred during the construction period Given 100 000
Investment income earned during the construction period 10 000 / 5 m x 4 m during the (8 000)
construction period
710 Chapter 14

W2. Deferred tax table caused by plant (qualifying asset)
CA TB TD DT
O/balance 20X1 0 0 0 0
Construction Given 300 000 300 000
Borrowing costs W1 and Note 1 92 000 0
Depreciation 392 000 x 20% x3/12 (19 600) 0 (26 220) Cr DT; Dr TE
Deduction 300 000 x 20% x3/12 0 (15 000)
C/balance 20X1 372 400 285 000 (87 400) (26 220) L
Note 1: The tax base relating to the borrowing costs is nil because the total borrowing costs are allowed
as a deduction now (in 20X1), with the result that there are no future deductions that will be
allowed in this regard.
W3. Calculation of current income tax C
Profit before tax and before adjustments Given 800 000
Add: interest income 10 000
Less: interest expense 100 000 total – 92 000 capitalised (8 000)
Less depreciation 392 000 x 20% x 3/12 (19 600)
Add back depreciation expense 19 600
Add back interest expense 8 000
Less interest incurred on asset Allowed as a deduction when brought into use (100 000)
Less tax deduction on plant 300 000 x 20% x 3/12 (15 000)
Comment: proof that the differences are simply temporary:
Effect of plant on accounting profit 400 000
Total depreciation over the periods: Construction costs: 300 000 + b/ costs: 92 000 392 000
Total interest expense over the periods: Interest incurred: 100 000 – 92 000 capitalised 8 000
Effect of plant on taxable profits 400 000
Total tax deduction on cost of plant Construction costs: 300 000 300 000
Total interest deduction on plant Interest incurred: 100 000 100 000
Example 15: Deferred tax on a qualifying asset (cost model): non-deductible

Use the same information in example 14 except that the tax authorities:
levy income tax at 30%,
tax interest income,
allow the deduction of the interest incurred on the construction of an asset to be
deducted in the year in which the asset is brought into use, but
do not allow the cost of this construction to be deducted.
Required: Journalise the current and deferred tax for the year ended 31 December 20X1
Solution 15: Deferred tax on a qualifying asset (cost model): non-deductible
Comment: This example shows the integration of IAS 12 Income taxes with IAS 23 Borrowing costs,
and the current and deferred income tax where borrowing costs are capitalised to a non-deductible asset
Current tax expense for 20X1
31 December 20X1 continued ... Debit Credit
Chapter 14 711
Income tax expense W2: 27 600 – 1 380 26 220

Deferred tax expense for 20X1
Workings:
Interest incurred during the construction period Given 100 000
Investment income earned during the construction period 10 000 / 5 m x 4 m constr period (8 000)
W2. Deferred tax table caused by plant (qualifying asset)
CA TB TD DT
O/balance: 20X1 0 0 0 0
Construction Given; Note 1 300 000 0 (300 000) 0 Exempt
Borrowing costs W1 and Note 2 92 000 92 000 0 0
Tax deduction W1 and Note 2 0 (92 000) (92 000) (27 600) Cr DT; Dr TE
Depreciation 392 000 x 20% x 3/12 (19 600) 0
- cost 300 000 x 20% x 3/12 (15 000) 0 15 000 0 Exempt
- b/costs 92 000 x 20% x 3/12 (4 600) 0 4 600 1 380 Dr DT; Cr TE
C/balance: 20X1 372 400 0 372 400 (26 220) L
Note 1: The tax base relating to the construction costs is nil since these are not allowed as a deduction.
Since the carrying amount is the cost of construction, a taxable temporary difference arises.
Since the taxable temporary difference arises on acquisition, it is a taxable temporary
difference that is exempt in terms of IAS 12.15.
Note 2: The tax base relating to the borrowing costs starts off at C92 000 but is then reduced by
C92 000 because the total borrowing costs are allowed as a deduction now (in 20X1).
The net effect is that the tax base relating to borrowing costs at the end of the year is now nil
(because there are no future deductions that will be allowed in this regard).
Since the carrying amount is the cost of borrowing costs that are capitalised, a taxable
temporary difference arises.
This is a temporary difference which leads to deferred tax (i.e. it is not an exempt temporary
difference since it does not relate to a temporary difference arising on acquisition of an asset!)
W3. Calculation of current income tax C
Profit before tax and before adjustments Given 800 000
Add: interest income 10 000
Less: interest expense 100 000 total – 92 000 capitalised (8 000)
Less depreciation 392 000 x 20% x 3/12 (19 600)
Add back depreciation expense 19 600
Add back interest expense 8 000
Less interest incurred on asset Allowed as a deduction in full when brought into us (100 000)
Less tax deduction on plant Not deductible (0)
712 Chapter 14

Comment: proof that the differences are permanent in nature and therefore exempt from deferred tax:
Effect of plant on accounting profit 400 000

Total depreciation over the periods: Construction costs: 300 000 + b/ costs: 92 000 392 000
Total interest expense over the periods: Interest incurred: 100 000 – 92 000 capitalised 8 000
Effect of plant on taxable profits 400 000

Total tax deduction on cost of plant Not deductible 0
Total interest deduction on plant Interest incurred: 100 000 100 000
7. Disclosure (IAS 23.26)
The entity must disclose the following in the financial statements:

the total amount of borrowing costs capitalised;
the amount of borrowing costs expensed as finance costs in the statement of
comprehensive income (this is an IAS 1 requirement – not a requirement of IAS 23);
the capitalisation rate used to calculate the borrowing costs for a general loan.
Company name
3. Finance costs 20X5 20X4

C C
Interest incurred Z Z
Less interest capitalised at 15% IAS 23 requirement (Y) (Y)
Finance cost expense IAS 1 requirement X X

Net carrying amount: 01/01/X5 IAS 16 requirement C C
Gross carrying amount IAS 16 requirement A A
Acc depreciation IAS 16 requirement (B) (B)
Borrowing costs capitalised IAS 23 requirement Y Y
Other movements (e.g. depreciation) IAS 16 requirement Z Z
Net carrying amount: 31/12/X5 IAS 16 requirement C C
Gross carrying amount IAS 16 requirement A A
Acc depreciation IAS 16 requirement (B) (B)
Company name
20X5 20X4
Note C C
Profit before finance costs x x
Finance costs IAS 1 requirement 3. x x
Profit before tax x x
Tax x x
Profit for the year x x
Other comprehensive income for the year x x
Total comprehensive income for the year x x
Chapter 14 713
8. Summary
IAS 23
Borrowing costs
Recognition: Expense Recognition: Asset

If not related to a qualifying asset If it relates to a qualifying asset and
meets all criteria for capitalisation
Borrowing costs that may be capitalised

borrowing costs that relate to costs:
acquisition, construction or production of
a qualifying asset and if
future economic benefits are probable and
costs can be reliably measured
Qualifying asset
those that take a long time to get ready
Measurement
General borrowings Specific borrowings

Capitalise borrowing costs during the Capitalise the total amount of
construction period using the borrowing costs actually incurred
following formula: during the construction period
- capitalisation rate (CR) x Less any investment income earned on
- the construction costs; the temporary investment of any
but limit to the actual borrowing surplus borrowings during the
costs incurred construction period
CR = weighted average borrowing
costs divided by the general
outstanding borrowings
No investment income is deducted
from borrowing costs
Construction period
Start Pause Stop

The commencement date The suspension period The cessation date
(an official IAS 23 term): (not a defined term): (not a defined term):
When: When the construction of When the asset
Interest is being incurred; the asset is: is ready for its intended
Expenditure on the interrupted or delayed use or sale; or
production of the asset is for a long period of is substantially ready.
being incurred; and time;
Activities are in progress (do not pause if the delay
is necessary).
Disclosure
The amount of BCs capitalised IAS 23
The amount of BCs expensed IAS 1
For general loans only: the capitalisation rate IAS 23
714 Chapter 14
Some fiddly things to remember when measuring borrowing costs to be capitalised:
Measuring the borrowing costs to be capitalised is sometimes more fiddly than it first appears.
The basic questions that one needs to answer when measuring the borrowing costs to be
capitalised include:
are the borrowings specific or general or is there a mix of both specific and general?
is the borrowing a precise amount (e.g. a loan) or does it increase as expenditure is paid for
(e.g. a bank overdraft)?
are the expenditures (on which interest is incurred) incurred evenly or at the beginning or end
of a period or at haphazard times during a period?
how long are the periods during which capitalisation is allowed?
In considering whether the borrowings are specific or general or whether there is a mix of both
specific and general, remember that:
where the borrowings are specific:
you will need the actual rate of interest/s charged on the borrowing/s; and
you will need to know if any surplus borrowings were invested upon which investment
income was earned (if so, remember to reduce the interest expense by the investment
income);
where the borrowings are general:
you will need the weighted average rate of interest charged (assuming there is more than
one general borrowing outstanding during the period); and
you will need the actual expenditure.
In considering whether the borrowing is a precise amount (e.g. a loan) or whether it increases as
expenditure is paid for (e.g. a bank overdraft), bear in mind that:
if the borrowing is a loan ( a precise amount), you will use the capital sum; and
if the borrowing is an overdraft (a fluctuating amount), you will use the relevant/ actual
expenditures incurred on the construction of the qualifying asset and will need to know when
they were incurred (or whether they were incurred relatively evenly).
In assessing whether the expenditures (on which interest is incurred) are incurred evenly or at
the beginning or end of a period or at haphazard times during a period, bear in mind that:
interest expense can be measured using average borrowing balances if the costs are incurred
evenly, whereas actual borrowing balances should be used (whether specific or general
borrowings) if costs are incurred at the beginning or end of a period; and
if the investment income is interest, it should be measured using average investment balances
if the costs are incurred evenly, whereas actual investment balances should be used (if it is a
specific borrowing) if costs are incurred at the beginning or end of a period.
The construction period (during which capitalisation of borrowing costs takes place):
starts on the commencement date:
borrowings may be outstanding (and incurring interest) before commencement date in which
case interest expense (and investment income on any surplus funds invested) up to
commencement date must be ignored when calculating the portion to be capitalised;
ends on the cessation date:
borrowings may be outstanding (and incurring interest) after cessation date in which case
interest expense (and investment income on any surplus funds invested) after cessation date
must be ignored when calculating the portion to be capitalised; and
is put on hold during a suspension period between these two dates:
borrowings may be outstanding (and incurring interest) during a suspension period in which
case interest expense (and investment income on any surplus funds invested) during this
period must be ignored when calculating the portion to be capitalised.
Chapter 14 715
Gripping GAAP Government grants and government assistance
Chapter 15
Government Grants and Government Assistance
Reference: IAS 20, SIC 10, IFRS 13 and IAS 12 (incl. any amendments to 16 December 2014)
Contents: Page
1. Introduction 718
2. Scope 718
3. Recognition, measurement and presentation of government grants 718
3.1 Overview 718
3.2 Grants related to immediate financial support or past expenses 720
3.2.1 Overview 720
3.2.2 Recognition 720
3.2.3 Measurement 720
3.2.4 Presentation 721
Example 1: Grant for past expenses – primary and secondary conditions 721
3.3 Grant related to future expenses 722
3.3.1 Overview 722
3.3.2 Recognition 722
3.3.3 Measurement 722
3.3.4 Presentation 722
Example 2: Grant for future expenses - conditions met over two years 723
3.4 Grants related to assets 724
3.4.1 Overview 724
3.4.2 Recognition and measurement of a grant of a non-monetary asset 724
3.4.2.1 Initial recognition and measurement of a non-monetary asset 724
Example 3: Grant is a non-monetary asset: measurement 724
3.4.2.2 Subsequent recognition and measurement related to a non-
monetary asset 725
3.4.3 Recognition and measurement of a grant of a monetary asset 726
3.4.3.1 Initial recognition and measurement of a monetary asset 726
3.4.3.2 Subsequent recognition and measurement of a monetary asset 726
Example 4: Monetary grant related to a depreciable asset –
credit to income or asset 727
Example 5: Monetary grant related to a non-depreciable asset 728
Example 6: Monetary grant for a non-depreciable asset:
secondary condition: further expenses 729
Example 7: Monetary grant related to a non-depreciable asset:
secondary condition: further asset 730
3.4.4 Presentation of a grant related to assets 730
716 Chapter 15
Contents: Page
3.5 Grants related to loans 731
3.5.1 Overview of grants related to loans 731
3.5.2 Recognition of grants related to loans 731
3.5.3 Measurement of grants related to loans 731
3.5.4 Presentation of grants related to loans 731
Example 8: Grant related to a forgivable loan 731
Example 9: Grant related to a low interest loan 732
3.6 Grants received as a package 734
Example 10: Grant is a package deal 735
4. Changes in estimates and repayments 736
Example 11: Grant related to expenses – repaid 736
Example 12: Grant related to assets – repaid 738
5. Deferred tax 739
5.1 Overview 739
5.2 Grants related to income 740
5.2.1 Grant of immediate financial support or past expenses: taxable 740
5.2.2 Grant of immediate financial support or past expenses: not taxable 740
5.2.3 Grant to assist with future expenses: taxable 740
Example 13: Deferred tax: grant relating to future expenses: taxable 740
5.2.4 Grant to assist with future expenses: not taxable 741
Example 14: Deferred tax: grant relating to future expenses: exempt 741
5.3 Grants related to assets 742
5.3.1 Grant related to assets: taxable 742
Example 15: Deferred tax: grant relating to asset – taxable 724
5.3.2 Grant related to assets: not taxable 744
Example 16: Deferred tax: Cash grant relating to asset – not taxable 745
6. Disclosure 746
Example 17: Disclosure of government grants 746
Example 18: Disclosure of government grants related to assets – the asset note 747
Example 19: Disclosure of government grants and assistance: a general note 748
7. Summary 749
Chapter 15 717
1. Introduction (IAS 20.2 - .4 & .6)
Government assistance is provided to encourage an Government is defined as:

entity to become involved in certain activities that it may
otherwise not have involved itself in (or may even be government;
government agencies; or
used to discourage certain activities). Government similar bodies;
assistance therefore provides incentives for businesses to whether local, national or
engage in certain activities. international. IAS 20.3 (reworded)
It is often provided to assist businesses in starting up. This obviously benefits the business but
also benefits the government through creation of jobs and thus a larger base of taxpayers.
Government assistance is
Government assistance can come in many forms, for defined as:
example: grants of income, grants of a non-monetary action by government
asset, low interest loans or even advice. Grants are often designed to provide an economic
referred to by other names such as subsidies, subventions benefit to
and premiums. a specific entity (or range of
entities) that
From an accounting perspective, we split qualifies under certain criteria.
government assistance into: government grants e.g. )
IAS 20.3 (reworded
a grant of cash or another asset; and

other government assistance e.g. the receipt of Government grants are
government advice. defined as:
government assistance that is a
Whereas government grants are recognised and transfer of resources
disclosed, ‘other government assistance’ (i.e. in exchange for compliance with
government assistance that does not meet the definition conditions (past/ future)
of a government grant) will only be disclosed. This is excluding government assistance
that cannot be reasonably valued
because it is not possible to recognise government
and transactions that cannot be
assistance that is not a grant (e.g. government advice) separated from the entity’s
because the value of this ‘other government assistance’ normal trading transactions.
will not be determinable. IAS 20.3 (reworded)
2. Scope (IAS 20.2 and parts of IAS 20.3)
IAS 20 does not cover:

government actions that result in indirect benefits received by an entity. For instance, a
government may construct roads and provide electricity and water to areas that were
previously underdeveloped: these actions benefit the trading conditions of all entities
operating businesses in that area and are not provided specifically to an entity; See IAS 20.3
government actions that assist an entity to reduce its tax liability (e.g. a special
dispensation allowing it to calculate its taxable profit in a favourable manner, giving the
entity tax credits, tax holidays or reduced tax rates); See IAS 20.2 (b)
government participation in the ownership of the entity; IAS 20.2 (c)
government grants covered by IAS 41 Agriculture. IAS 20.2 (d)
3. Recognition, Measurement and Presentation of Government Grants (IAS 20.7 - .38)
3.1 Overview (IAS 20.7 – .29)

Government assistance is
Only government assistance that meets the definition of a split into two categories:
government grant is recognised. A government grant government grants:
may only be recognised when it is fairly certain that the - recognised and disclosed
conditions that the entity must meet in order to qualify other government assistance:
for the grant will indeed be met and that the grant will - not recognised but disclosed.
eventually be received.
718 Chapter 15
The mere fact that a grant is received does not mean that Government grants are
we can recognise the grant because we normally have to recognised when there is:
meet certain conditions to ‘earn’ the grant. Conversely, reasonable assurance that the entity
meeting the pre-requisite conditions doesn’t always will comply with the conditions; and
mean that the grant will ever be received. Thus there the grants will be received.
See IAS 20.7
must be reasonable assurance that both the recognition criteria will be met.
IAS 20 refers to the recognition of government grants on Government grants are
both the capital approach and the income approach but recognised on the income basis:
explains that we may only use the income approach. in profit or loss
in the same period/s in which the costs
Recognising government grants on the capital approach that the grant was intended to reduce
would mean recognising the grant directly in equity (i.e. are expensed. See IAS 20.12
without recognising it in profit or loss).
Recognising government grants on the income approach, means that the grant is:
recognised in profit or loss We can recognise a grant in
on a rational basis P/L by:
over the same periods in which the entity: crediting income (direct income)
- recognises as expenses crediting asset/ expense (indirect
- the costs that the grant was intended to income). See IAS 20.24 & .29
compensate. Reworded IAS 20.12
There are a variety of methods by which the grant could be recognised in profit or loss:
The grant could be recognised directly as income, or
The grant could be recognised indirectly as income, by crediting the cost of the related
asset or related expense that the grant was intended to subsidise. See IAS 20.24 and .29
As you would probably have gathered from the definitions, a government grant is a transfer of
resources (other than advice) that can essentially take the form of:
A grant related to income (although the standard may Grants related to income are
have been better advised to refer to it as a grant defined as: IAS 20.3
related to expenses): a government grant that is
not a grant related to an asset.
This is a grant of cash that need not be used to
purchase some sort of asset, but one that is simply received as either:
- compensation for immediate financial support or past expenses; or as
- compensation for future expenses still to be
incurred. Grants related to assets are
defined as: IAS 20.3 Reworded
A grant related to an asset: a government grant
This is a grant of either: with a primary condition requiring:
- a non-monetary asset (e.g. a tangible building or - the qualifying entity
an intangible right), or - to purchase, construct or
otherwise acquire long-term
- cash that must be used to purchase some sort of assets;
non-monetary asset. and may have a secondary
A grant related to a loan: condition/s restricting:
- the type or location of the
This is a grant that could either be: assets, and/ or
- a forgivable loan; or a - the periods during which the
- low-interest loan. assets are to be acquired or held..
The measurement of the grant is affected by both the period over which the grant is
recognised and the form of the grant. For example:
a grant in the form of a low interest loan is measured Recognition, measurement&
in accordance with IFRS 9 Financial instruments; presentation of government
grants depends on whether:
a grant that comes in the form of a non-monetary the grant relates to income, for:
asset is measured at its fair value in terms of IFRS 13 - immediate support/past expenses,
Fair value measurement or at its nominal amount; - future expenses;
a grant that comes in the form of cash is measured at the grant relates to assets; or
its cash amount. See IAS 20.10A and IAS 20.23 the grant relates to loans
the grant is a combination (a package)
Chapter 15 719
The recognition, measurement and presentation of government grants will be discussed in

respect of each of these forms of grants: grants related to income (immediate financial
support/ past expenses), assets, loans and the combinations thereof (packages).
3.2 Grants related to immediate financial support or past expenses
3.2.1 Overview
The grant may be receivable either as:
immediate financial support (unrelated to future costs); or
relief for expenses or losses already incurred.
3.2.2 Recognition (IAS 20.12, IAS 20.20-.22 and IAS 20.26 & .29)
The rule is that a government grant is recognised when the recognition criteria are met (i.e. it
is expected that the conditions will be met and that the grant will be received) at which point
we generally recognise the relevant portion of the grant in profit or loss on a systematic basis
over the periods in which the entity expenses the costs that the grant intended to compensate.
However, if the grant relates either to immediate Grants for immediate
financial support or relief from past expenses (and where financial support/ past
these expenses may have already been recognised in a expenses are recognised:
prior period), the principle of recognising the grant in a in profit or loss
way that achieves matching to the periods in which the - as a credit to expense; or
entity expenses the costs that the grant is intended to - as a credit to grant income
compensate isn’t appropriate. This is because: when the grant is receivable
a grant for immediate financial support does not See IAS 20.20 - .22
relate to any cost and similarly,

a grant to compensate for a past expense is related to an expense that would either have
already been recognised in a prior period (in which case the grant logically has no option
but to be recognised in the current period) or would have been recognised earlier in the
current year (in which case the grant would logically be recognised in the current period).
Thus, a grant that is received as immediate financial support or as relief from past expenses is
usually recognised as grant income as soon as it becomes receivable. See IAS 20.20 - .22
When recognising a grant as income in profit or loss, you could either recognise it as income:
indirectly, by crediting the expense; or
directly, by crediting grant income instead. See IAS Grants for immediate
20.29
. financial support/ past
expenses are credited to:
If the grant relates to a past expense that was incurred income or expense (can choose,
earlier in the current period, we could credit that but with this type of grant it may
not be possible or logical to credit
expense, but it is submitted that if it relates to a past an expense); or
expense that was incurred in a prior period, we would deferred income first (if
typically credit grant income instead. conditions are not yet met).
Always remember that there may be further conditions attaching to the grant and we will thus
need to use our professional judgement when deciding when to recognise the income. It may
be necessary to first recognise the receipt of a grant as a credit to a deferred income account,
where this will then make its way into profit or loss when the conditions are met. We may
even need to simultaneously recognise a provision (or disclose a contingent liability) for any
future costs in meeting these conditions. IAS 20.11 Grants for immediate
financial support/ past
3.2.3 Measurement (IAS 20.20) expenses are measured:
at the amount
The measurement of a grant for immediate financial received/receivable. See IAS 20.20
support or past expenses simply depends on whether any
conditions attaching to the grant have been met. If there are no conditions, it effectively
means that the grant will be measured at the full amount received/ receivable.
720 Chapter 15
3.2.4 Presentation (IAS 20.29)

The benefit of the grant that relates to immediate financial Grants for immediate
support or to compensate for past expenses must be financial support/ past
presented in profit or loss, either as: expenses are presented:
income (i.e. not presented as revenue), presented in P/L,
either as: either as
- a separate line item for grant income; or - income (separate income line item
- part of ‘other income’; or as a or part of ‘other income’); or
reduction of the related expense. See IAS 20.29 - reduction of the expense. See IAS 20.29
(unlikely to be credited to an expense)
However, a grant for immediate financial support does not relate to any expense and thus
would be presented as income. Similarly, a grant to compensate for a past expense that was
recognised in a prior year is obviously not able to be credited to that expense and thus would
normally be presented as income.
Example 1: Grant for past expenses – primary and secondary conditions
The government offered Giveme Limited a cash grant equal to 30% of certain specified
future labour costs.
Giveme Limited incurred C30 000 of these labour costs during its year ended 31 December 20X0 and
presented the government with an audited statement of expenses on 31 March 20X1 as proof thereof.
Required:
Show the related journal entries in the records of Giveme Limited assuming that the company
recognises grants as grant income and that the grant becomes receivable:
A. In the year in which the company incurs the specified expenses;
B. In the year in which the company provides the government with an audited statement of expenses.
Solution 1: Grant for past expenses – primary and secondary conditions

Sol to Ex 1A Sol to Ex 1B
31 December 20X0 Dr/ (Cr) Dr/ (Cr)
Labour expenses (P/L) 30 000 30 000
Bank/ Salaries and wages payable (30 000) (30 000)
Labour costs incurred during 20X0
Grant income receivable (asset) 30 000 x 30% 9 000 N/A
Grant income (P/L) (9 000) N/A
Grant income recognised when expenses incurred (only 1 condition)
31 March 20X1
Grant income receivable (asset) 30 000 x 30% N/A 9 000
Grant income (P/L) N/A (9 000)
Grant income recognised based on past expenses (condition 1) but
only recognised when the required audited expense statement was
presented to government (condition 2) – all conditions need to be met
Comment:
In both cases, the grant is received in relation to past expenses and is therefore classified as ‘a grant
related to immediate financial support or past expenses’ and will therefore be recognised as grant
income as soon as it becomes receivable:
In Part A: the grant becomes receivable as soon as the expenses are incurred and the grant income
is therefore recognised in 20X0 (when the expense is incurred);
In Part B, the grant only becomes receivable in 20X1 on presentation of an audited statement and
the grant income is therefore recognised in 20X1 (when the statement is presented).
Chapter 15 721
3.3 Grant related to future expenses (IAS 20.12 - .17 and .29)
3.3.1 Overview
It sometimes happens that the government gives an entity cash to either help subsidise future
expenses that the entity is expecting to incur or even to encourage the entity to incur certain
expenses that it might have otherwise avoided. Such grants, as with all other grants, may
come with certain conditions, which need to be considered when deciding when to recognise
the grant income and how much to measure it at.
3.3.2 Recognition (IAS 20.12 & .17)
Government grants are recognised when the recognition criteria are met (i.e. it is expected
that the conditions will be met and that the grant will be received).
Once the recognition criteria are met we begin to recognise the grant:
as income
in profit or loss
on a systematic basis over the periods in which
the entity expenses the costs that the grant intends to compensate. IAS 20.7&12
In the case of a grant to be used to subsidise certain future Grants for future expenses
expenditure, then it should be recognised in profit or loss are recognised:
when that related expenditure is incurred. IAS 20.12 & .17 in profit or loss Note
- as a credit to expense; or
When recognising this grant as grant income in profit or - as a credit to grant income
loss, you could either recognise it indirectly as income by when these future costs are
crediting the expense or recognise it directly as income by expensed. See IAS 20.12 & .17
crediting grant income instead. See IAS 20.29 Note: if conditions aren’t met, credit
deferred income before crediting P/L.
As always, we must remember that there may be further conditions attaching to the grant and
we need to use our professional judgement when deciding when to recognise the income. It
may be necessary to first recognise the receipt of a grant as a credit to a deferred income
account, where this will then make its way into profit as loss when the conditions are met.
3.3.3 Measurement (IAS 20.12 & .17)
The entire grant for future expenses is simply measured at Grants for future expenses
the amount of cash received, but the portion of this grant are measured as follows:
that is recognised as income in profit or loss is measured The portion of the amount
on a basis that reflects the pattern in which the expenses received/receivable to be recognised
are expected to be recognised. IAS 20.12 & .17 in P/L is measured
systematically
Obviously any conditions attaching to the grant may need over the period/s
to be considered as well. that these future costs are

expensed. See IAS 20.12
3.3.4 Presentation (IAS 20.29)
The benefit of a grant that relates to future expenses must Grants for future expenses
be presented in profit or loss, either as: are presented: See IAS 20.29
income (i.e. not presented as revenue), presented in P/L,
either as: either as
- income (separate income line item
- a separate line item for grant income; or or part of ‘other income’); or
- part of ‘other income’; or as a - reduction of the expense.
reduction of the related expense. See IAS 20.29
722 Chapter 15
Example 2: Grant for future expenses - conditions met over two years
A company receives a cash grant of C10 000 from the government to contribute 10%
towards future specified wages totalling C100 000.
The grant was received on 1 January 20X1 when certain conditions in 20X0 were met.
All conditions attaching to the grant (with the exception of the incurring of the future
wages) had all been met on date of receipt.
The year-end is 31 December.
C20 000 of the specified wages were incurred in 20X1 and C80 000 in 20X2.
Required:
Show the journal entries assuming that the company policy is to recognise government grants:
A. As a credit to income (directly as income);
B. As a credit to the related expense (indirectly as income).
Solution 2: Grant for future expenses - conditions met over two years
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Bank 10 000 10 000
Deferred grant income (L) (10 000) (10 000)
Recognising a government grant intended to reduce future expenses
31 December 20X1
Wage expenditure (P/L) 20 000 20 000
Bank/ Wages payable (20 000) (20 000)
Wage expenditure incurred
Deferred grant income (L) 10 000 x 20% 2 000 N/A
Grant income (P/L) Recognised directly as income (2 000)
Recognising 20% of the grant in profit & loss since 20% of the costs
that the grant was intended to compensate have been incurred
Deferred grant income (L) 10 000 x 20% N/A 2 000
Wage expenditure (P/L) Recognised indirectly as income (2 000)
31 December 20X2
Wage expenditure (P/L) 80 000 80 000
Bank/ Wages payable (80 000) (80 000)
Wage expenditure incurred
Deferred grant income (L) 10 000 x 80% 8 000 N/A
Grant income (P/L) Recognised directly as income (8 000)
Deferred grant income (L) 10 000 x 80% N/A 8 000
Wage expenditure (P/L) Recognised indirectly as income (8 000)
Recognising 80% of the government grant since 80% of the expenses
Comment:
In this example, the conditions were met over 2 years and thus the deferred income was amortised
(transferred) to profit or loss over the 2 years, apportioned based on the expenditure incurred per
annum relative to the total expenditure to be incurred.
In Part A, the profit or loss is adjusted by recognising an income account; whereas
In Part B, it is adjusted by reducing an expense account.
Notice how the effect on overall profits is the same irrespective of the company policy.
Chapter 15 723
3.4 Grants related to assets
3.4.1 Overview
A grant related to a non-monetary asset could take the Grants relating to an asset
form of the actual non-monetary asset itself or could be in can come in different
forms:
the form of a monetary asset to be used in connection a non-monetary asset
with a non-monetary asset (e.g. to acquire a non-monetary a monetary asset, to be used for
asset or to maintain that asset). the purchase or maintenance of:
- a depreciable asset
The recognition and measurement are inter-related and - a non-depreciable asset.
are affected by whether the grant is received as the non-
monetary asset itself (and whether you were given it entirely for free or whether you were
required to pay a nominal (small) amount for it) or whether the grant is received as a
monetary asset. The subsequent recognition and measurement as grant income in profit or
loss is affected by whether the related non-monetary asset is depreciable or non-depreciable.
3.4.2 Recognition and measurement of a grant of a non-monetary asset
3.4.2.1 Initial recognition and measurement of a non-monetary asset
If we received a grant of an asset that is a non-monetary asset, we must ascertain whether we

were given it entirely for free or whether we were required to pay a nominal (small) amount
for it. A grant of a non-monetary
asset is journalised as
follows:
The answer to this question will affect both the initial
If asset acquired for free:
recognition and initial measurement:
Dr: Asset: cost (FV)
If we received it for free, we would: Cr: Deferred income
- Measure the asset at fair value and thus: If asset acquired for nominal
Recognise: the non-monetary asset, and amount:
Recognise: deferred grant income / income If we use Nominal amount paid:
Dr: Asset: cost (nominal amt)
If we were required to pay a nominal amount for it,
Cr: Bank (nominal amount)
we could choose to either:
If we use FV:
- Measure the asset at nominal amount and thus: Dr: Asset: cost (FV)
Recognise the non-monetary asset, and Cr: Bank (Nominal amount)
Recognise the payment. Cr: Deferred income (FV – Pmt)
Note: in this case, grant income would not be recognised at all.
- Measure the asset at fair value and thus: Grant of a non-monetary
Recognise the non-monetary asset, measured asset is measured as
follows:
at fair value,
measure assets acquired for free:
Recognise the payment, measured at the
- at fair value
nominal amount paid and
measure assets acquired for
Recognise the deferred grant income, nominal payment, either:
measured as the resultant savings (fair value - at fair value or
less nominal amount paid). - at nominal amount paid.
Example 3: Grant is a non-monetary asset: measurement: fair value or

nominal amount
A government grants a company a licence to fish off the coast of Cape Town, South Africa:
The fair value of the licence is C50 000.
The company was required to pay a small sum of C1 000 for the licence.
A. The company chooses to measure the licence at its fair value.
B. The company chooses to measure the licence at its nominal amount.
724 Chapter 15
Solution 3A: Grant is a non-monetary asset: measurement: fair value
Debit Credit
Fishing licence (asset) Given 50 000
Deferred grant income (liability) 50 000 – 1 000 49 000
Bank Given 1 000
Recognising the licence granted by the government at fair value
Solution 3B: Grant is a non-monetary asset: measurement: nominal amount
Comment: Notice how, when measuring the asset at nominal amount, no grant income is recognised!
Debit Credit
Fishing licence (asset) Given 1 000
Bank Given 1 000
Recognising the licence granted by the government at nominal value
3.4.2.2 Subsequent recognition and measurement related to a non-monetary asset
If the non-monetary asset was initially recognised and Grants of non-monetary

measured at the nominal amount paid, then there will be assets are subsequently
recognised:
no deferred grant income to subsequently recognise as
in profit or loss
grant income in profit or loss.
- as a credit to expense; or
- as a credit to grant income
However, if the non-monetary asset was initially when these future costs are
recognised and measured at the asset’s fair value, then expensed.
See IAS 20.12 & .17
we will have initially recognised the grant as deferred

grant income.
Although the grant was initially recognised as deferred grant income, all grants must
eventually be recognised as income in profit or loss. This subsequent transfer of the deferred
grant income to profit or loss as grant income (by debiting deferred grant income and
crediting grant income directly or by crediting a related expense) must be done in a way that
the grant income matches the pattern in which the asset is expensed. The subsequent
recognition and measurement of the grant is thus affected by whether the asset is depreciable
or not depreciable.
If the asset is depreciable, then the grant initially recognised as deferred grant income will be
subsequently recognised as income in profit or loss in a manner that reflects the pattern in
which the non-monetary asset is expensed. In other words, the grant income will normally be
recognised and measured at the same rate as the related depreciation.
A grant of a non-monetary
If the non-monetary asset is not depreciable (e.g. the asset is subsequently
receipt of land), we will need to subsequently recognise recognised & measured in
the grant as grant income in profit or loss as and when P/L as follows:
the related conditions are met. In other words, if all the If the asset is depreciable,
conditions are met when the asset is received, the receipt subsequently recognise in P/L as:
of the asset would be recognised as grant income in grant income or reduced expense
profit or loss immediately whereas if half of the (e.g. lower depreciation)
conditions were subsequently met, then half of the over the useful life of the asset
deferred grant income would be subsequently recognised If the asset is non-depreciable,
recognise in P/L as:
as grant income in profit or loss and the balance would
grant income
remain deferred.
as and when conditions are met.
The journal for subsequent recognition of deferred grant income as income in profit or loss is:
debit deferred grant income and
credit grant income / related expense (e.g. depreciation).
Chapter 15 725
3.4.3 Recognition and measurement of a grant of a monetary asset
3.4.3.1 Initial recognition and measurement of a monetary asset
If we received a grant of an asset that is a monetary asset Grant of a monetary asset is

(e.g. cash) to be used in relation to a non-monetary asset measured as follows:
(e.g. to acquire a non-monetary asset or maintain it), this The cash amount
grant would be measured at the amount received or received/ receivable.
receivable and would be recognised either as deferred
grant income or as a reduction of the cost of the related non-monetary asset.
Note: If the related non-monetary asset is non- A grant of a monetary asset

depreciable, then the monetary grant may not be credited is journalised as follows:
to that non-monetary asset because the receipt of this Dr Cash; Cr: Deferred income, or
grant must eventually be recognised as income in profit Dr Cash; Cr: Asset: cost (only if
or loss: if the non-monetary asset is not depreciable and the asset is depreciable).
yet the grant is recognised as a credit against the asset’s cost, this grant will remain outside of
profit or loss forever (i.e. it will remain as a reduction to the asset’s cost). Thus, a monetary
grant for a non-monetary asset that is non-depreciable, must be credited to deferred grant
income (or directly to grant income if all conditions attached to this grant are met).
3.4.3.2 Subsequent recognition and measurement of a monetary asset
As with all grants, we must eventually recognise the A grant of a monetary asset
is subsequently recognised &
grant as income in profit or loss. The subsequent measured in P/L as follows:
recognition and measurement is affected by whether the If the related asset is depreciable,
grant of a monetary asset was initially recognised as: subsequently recognise in P/L as:
deferred grant income; or as a grant income or reduced expense
reduction to the cost of the related non-monetary (e.g. lower depreciation)
asset. over the useful life of the asset
If the grant was initially recognised as
If the monetary grant was initially recognised as deferred a credit to the asset’s cost, then no
grant income, the subsequent recognition as income in journal would be needed to achieve the
above.
profit or loss can be done directly as income by crediting
grant income or can be recognised indirectly as income If the asset is non-depreciable,
recognise in P/L as:
by crediting the related expense (e.g. depreciation).
grant income
as and when conditions are met.
If the monetary grant was initially recognised as a
reduction in the cost of a depreciable non-monetary asset, then no further journal will be
required to recognise this grant as grant income in profit or loss because this grant will thus
automatically and indirectly be recognised and measured as grant income in profit or loss (i.e.
indirect income) by way of a reduced depreciation expense.
When subsequently recognising and measuring deferred grant income as income in profit or
loss we must remember that it must be done in a way that the grant income matches the
pattern in which the asset is expensed.
With this in mind, we need to ask ourselves whether the non-monetary asset underlying the
monetary grant is a depreciable or non-depreciable asset. The answer to this question will
affect both the subsequent recognition and measurement:
If the related non-monetary asset is depreciable, then any deferred grant income initially
recognised is subsequently recognised and measured as grant income in P/L in a way that
the grant income matches the pattern in which the asset is expensed (e.g. the amount of
grant income recognised in profit or loss each year would match the rate of depreciation).
If the related non-monetary asset is non-depreciable, then any deferred grant income
initially recognised must be subsequently recognised and measured as grant income in
profit or loss as and when the conditions related to the grant are met.
726 Chapter 15
Example 4: Monetary grant related to a depreciable asset – credit to income

or asset
The government grants a company a cash sum of C12 000 on 1 January 20X1 to assist in
the acquisition of a nuclear plant.
The nuclear plant was:
- acquired on 1 January 20X1 for C90 000,
- was available for use immediately,
- has a useful life of 3 years, and
- has a nil residual value.
The grant was received after compliance with certain conditions in 20X0 (the prior year).
All conditions attached to the grant, with the exception of the acquisition of the plant, had all been
met on date of receipt.
Required:
Show the journal entries in the years ended 31 December 20X1, 20X2 and 20X3 assuming:
A. The company has the policy of recognising government grants as grant income.
B. The company has the policy of recognising government grants as credit to the related asset.
Solution 4: Monetary grant for a depreciable asset – credit to income or asset

Journals Sol to Ex 4A Sol to Ex 4B
Debit/ Debit/
1 January 20X1 (Credit) (Credit)
Bank 12 000 12 000
Recognising a government grant intended to assist in the
acquisition of a nuclear plant
Nuclear plant: cost (asset) 90 000 90 000
Bank (90 000) (90 000)
Purchase of plant
Deferred grant income (L) N/A 12 000
Nuclear plant: cost (asset) (12 000)
Recognising the government grant as a reduction of the plant’s cost
31 December 20X1
Depreciation - plant (P/L) A: (90 000 – 0) / 3 years 30 000 26 000
Nuclear plant: acc depr (-A) B: (90 000 – 12 000 – 0) / 3 years (30 000) (26 000)
Deferred grant income (L) 12 000 / 3 years 4 000 N/A
Grant income (P/L) (4 000)
Grant income recognised on the same basis as plant depreciation
31 December 20X2
31 December 20X3
Chapter 15 727
Solution 4: Continued… Sol to Ex 4A Sol to Ex 4B

Debit/ Debit/
(Credit) (Credit)
Comment:
This example starts by reminding you that the receipt of the grant is initially recognised as deferred
income if the grant is not immediately recognisable.
Then it shows that the grant income can either be:
- Part A: recognised in profit or loss as income (i.e. directly as income) over the life of the
underlying asset (i.e. in a way that matches the expenses relating to the underlying asset); or
- Part B: recognised as a credit to the asset, thus automatically and indirectly affecting profit as
this asset affects profits (e.g. by reduced depreciation).
Notice how the impact on the annual profits is unaffected by the policy chosen:
- Part A: depreciation expense is C30 000 and grant income is C4 000, reflecting a net decrease
in profits of C26 000;
- Part B: depreciation expense is C26 000.
Example 5: Monetary grant related to a non-depreciable asset
The government granted a company a cash sum of C1 000 000 on 1 January 20X1 to fund
the purchase of farming land. This was purchased on 31 March 20X1 for C1 000 000.
A condition attached to this grant was that the company must have in its employ, at all times during the
next 5 years, at least 50 employees from the local community.
Required: Explain how the company should recognise and measure this grant.
Solution 5: Monetary grant for a non-depreciable asset

This cash grant was received to buy an asset.
Normally a grant to buy a non-monetary asset can be recognised either:
as grant income over the life of the asset (the grant having initially been recognised as deferred
income), or
as reduced depreciation (the grant having initially been recognised as a deduction against the non-
monetary asset).
But, since the land is not depreciated, it is not possible to choose between these two methods. Instead,
the grant must be recognised as grant income over the period in which the costs of meeting the
conditions are expensed. In this case the condition is to pay wages to 50 employees for 5 years. As we
do not know with reasonable certainty, the actual amount of the wages to be paid to these employees
over the 5-year period (consider issues such as wages increases, inflation etc), it is not possible to
reliably estimate the amount of the deferred grant income to be recognised in profit or loss using wages
as a basis. A more accurate (and simple) method is to recognise it as grant income on a straight-line
basis over the 5-year period during which the cost of meeting the 5-year obligation would be born.
The journals for a grant for a non-depreciable asset with secondary, but immeasurable, future expenses:
Bank 1 000 000
Deferred grant income (L) 1 000 000
Receipt of the government grant to be used to buy farm land
31 March 20X1
Land (asset) 1 000 000
Bank 1 000 000
Purchase of farm land
31 December 20X1
Deferred grant income (L) 1 000 000 / 5 years x 9/12 150 000
Grant income (P/L) 150 000
Recognising the government grant over the 5-year period of
meeting the obligation related to the grant: employment of 50
staff members from the local community for a period of 5-years
728 Chapter 15
Comment:
Whenever dealing with non depreciable assets, special consideration must be given to the conditions attached
to these grants.
Notice how, although the grant relates to the acquisition of land, the deferred grant income is only recognised
as income from the date that 1/5 of the conditions are met and not simply when the land is acquired.
Example 6: Monetary grant for a non-depreciable asset: secondary condition:

further expenses
The government grants a company a cash sum of C600 000 on 1 October 20X1 to help
fund the purchase of a plot of land. The land was duly purchased on 14 November 20X1 for C1 700 000.
A secondary condition to the grant (the primary condition being the purchase of the land) is that the
company must clear the land of alien vegetation. The company signed a contract with a garden service
company for a total cost of C150 000 (C100 000 was incurred and paid in December 20X1 and a further
C50 000 incurred and paid in January 20X2).
Required:
Journalise assuming the company’s policy is to recognise grants as a credit to the asset.
Solution 6: Monetary grant for a non-depreciable asset: 2nd condition: further expenses
Comment:
Although the company policy is to recognise grants as a credit to the asset, this grant has been
credited to deferred income instead since the grant was for the acquisition of a non-depreciable
asset: a credit to this asset would mean the grant would never be recognised in profit or loss.
IAS 20.18 suggests that the grant be recognised in a manner that matches the periods in which the
costs to meet the obligation are borne. A second condition to this grant will result in future
expenses. These future costs are measurable and thus we can use them as a basis for transferring
deferred income to grant income. Compare this example to Ex 5 (the costs were immeasurable).

Bank 600 000
Deferred grant income (L) 600 000
Government grant received to assist in the acquisition of land
14 November 20X1
Land: cost 1 700 000
Bank 1 700 000
Purchase of land
31 December 20X1
Clearing vegetation expense (P/L) 100 000
Bank 100 000
Costs incurred in clearing alien vegetation from the land
Deferred grant income (L) 100 000 / 150 000 x 600 000 400 000
Recognition of a portion of the grant as income as and when the
costs of meeting the secondary condition are incurred
31 January 20X2
Clearing vegetation expense (P/L) 50 000
Bank 50 000
Costs incurred in clearing alien vegetation from the land
Deferred grant income (L) 50 000 / 150 000 x 600 000 200 000
Recognition of the balance of the grant as income as and when the
costs of meeting the secondary condition are incurred
Chapter 15 729
Example 7: Monetary grant related to a non-depreciable asset: secondary

condition: further asset
The government grants a company a cash sum of C120 000 on 1 January 20X1 to assist in
the acquisition of land.
A condition of the grant is that the company builds a factory on the land:
the land was acquired on 1 January 20X1 for C900 000 and is not depreciated;
the factory was completed on 31 March 20X1 (total building costs of C300 000 were paid in cash on
this date), was available for use immediately and has a useful life of 3 years and a nil residual value.
The grant was received after compliance with certain conditions in 20X0 (the prior year). With the
exception of the completion of a factory building, all conditions attaching to the grant had all been met
on date of receipt.
Required:
Show the journal entries in the year ended 31 December 20X1 assuming that the company’s policy is to
recognise grants as a credit to the asset.
Solution 7: Monetary grant related to a non-depreciable asset: secondary condition:

further asset

Bank 120 000
Government grant received to assist in the acquisition of land
1 January 20X1
Land: cost 900 000
Bank 900 000
Purchase of land
31 March 20X1
Factory building: cost 300 000
Bank 300 000
Construction costs related to factory building, paid in cash
31 December 20X1
Depreciation – factory building (P/L) 75 000
Factory building: acc depreciation (-A) 75 000
Depreciation on factory (300 000 / 3 years x 9/12)
31 December 20X1
Deferred grant income amortised to profit or loss (120 000/ 3 yrs x9/12)
Comment:
This example deals with the situation where a grant was received with the primary condition being
to acquire a non-depreciable asset.
Since the asset is non-depreciable, the grant may not be credited to the asset. IAS 20.18 suggests
that a grant for a non-depreciable asset is recognised as income over the periods that the costs of
meeting the obligations are met.
This grant had a second condition that required the construction of a depreciable asset: a factory
building. The grant should therefore be recognised as grant income over the life of the building.
3.4.4 Presentation of a grant related to assets (IAS 20.24)
The benefit of a grant related to assets can then either be presented separately:
on the face of the statement of financial position as deferred grant income, or
in the note to the non-monetary asset as a government grant. IAS 20.24
730 Chapter 15
3.5 Grants related to loans (IAS 20.10 – 10A)
3.5.1 Overview of grants related to loans
Grants needs not be in the form of an asset – the grant A forgivable loan is defined
could consist of a waiver of debt or a cheap loan. These as:
are referred to as: a loan
forgivable loans, and that the government may waive
low interest loans. assuming certain conditions are
met IAS 20.10 Reworded
3.5.2 Recognition of grants related to loans (IAS 20.10 and .10A)
A forgivable loan from government is recognised as a A low interest loan is

grant in profit or loss when there is reasonable assurance defined as:
that the entity will meet the necessary conditions. IAS 20.10 a loan
that the government offers
A low interest loan received from government is at a rate below that of the
recognised as a grant in profit or loss in accordance with markets See IAS 20.10
IFRS 9 Financial instruments. IAS 20.10A
3.5.3 Measurement of grants related to loans
A forgivable loan from government that is recognised as a Measurement:

grant is measured at the amount that is reasonably assured
of being forgiven (waived). IAS 20.10 Forgivable loan: measured as
amount reasonably assured of
A low interest loan received from government being waived
that is recognised as a grant is measured in terms
Low-interest loan: measured as per
of 1FRS 9 Financial instruments.
IAS 39 (financial instruments).
The carrying amount measured in terms of IFRS 9 is recognised as the loan, and the
difference between this carrying amount and the actual amount received is recognised as grant
income in profit or loss. IAS 20.10A
3.5.4 Presentation of grants related to loans
Grants related to loans received from government could be presented as:

Grant income; or
A decrease in the interest expense (e.g. in the case of a low-interest loan).
Notice always that the effect on overall profits remains unchanged.
Example 8: Grant related to a forgivable loan

A company receives a cash loan of C100 000 on 1 January 20X1:
40% of the loan is forgivable from the date on which certain conditions are met.
Interest is charged at the market rate of 10% and is payable annually.
Required:
A. Show the journal entries for the year ended 31 December 20X1 assuming that the conditions had
all been met by 1 January 20X1.
B. Show the journal entries for the year ended 31 December 20X1 assuming that the conditions had
all been met by 30 September 20X1.
Chapter 15 731
Solution 8A: Grant related to a forgivable loan – conditions met on receipt

Comment: Note how no interest is recognised on the portion of the loan that is forgiven.

Bank Given 100 000
Grant income (P/L) 40% x 100 000 40 000
Loan: government (L) 100 000 – 40 000 60 000
Government loan raised: 40% forgivable on date of receipt since all
conditions for waiving have already been met – therefore recognised as
income immediately
31 December 20X1
Interest expense (P/L) 100 000 x (100% - 40% forgiven) x 10% 6 000
Bank 6 000
Interest on only 60% of the government loan (the rest is ‘forgiven’)
Solution 8B: Grant related to a forgivable loan - conditions met later

Comment:
Note how the date on which the loan is waived affects the interest calculation.
Interest up to the date on which the conditions are met and a portion of the loan is forgiven is
recognised in full.
Thereafter, interest expense is recognised on the reduced loan balance.

Bank Given 100 000
Loan: government 100 000
Government loan raised: 40% forgivable if certain conditions are met
30 September 20X1
Loan: government (L) 100 000 x 40% 40 000
40% of the loan is forgivable now that the conditions are met
31 December 20X1
Interest expense (P/L) 100 000 x 10% x 9 / 12 + (100 000 – 9 000
Bank 40 000) x 10% x 3/12 9 000
Interest on 100% of the government loan to 30 September and on 60%
after this date (40% of the loan having been waived)
Example 9: Grant related to a low interest loan

A company receives a government loan of C100 000 on 1 January 20X1:
interest of 8% is charged
the market interest rate is 10%.
the capital and interest is repayable in one single instalment on 31 December 20X3.
The company does not intend to trade this loan and it was not designated as fair value
through profit or loss on acquisition. The loan is therefore measured at amortised cost.
Required:
A. Show the journal entries for the year ended 31 December 20X1 assuming that the low interest rate
was granted on certain conditions and that these conditions had all been met by 1 January 20X1.
B. Show the journal entries for the year ended 31 December 20X1 assuming that the low interest rate
was granted to meet general running costs over a 2-year period and that the company policy is to
recognise grants as a credit to income.
C. Show the journal entries for the year ended 31 December 20X1 assuming that the low interest rate
was granted to meet general running costs over a 2-year period and that the company policy is to
recognise grants as a credit to the related expense.
732 Chapter 15
Solution 9: Grant related to a low-interest loan – general calculations
Comment:
The amortised cost must be calculated per IFRS 9.
Per IFRS 9, the future value of a loan payable in a single instalment is the principal amount (C100 000) plus
interest for n years (in this case n=3) at the coupon rate (coupon rate = 8%).
W1. Calculation of the instalment due on 31 December 20X3

Effective interest rate table using the actual rate of interest: 8%
Year Opening balance Interest charged Repayment Closing balance
20X1 100 000 8000 108 000
20X2 108 000 8640 116 640
20X3 116 640 9331 125 971
31/12/20X3 (125 971) 0
25 971 (125 971)
W2. Calculation of the present value of the instalment due on 31 December 20X3
Year Payments PV factor Present value
20X1 0 0.909091 0
20X2 0 0.826446 0
31/12/20X3 125 971 0.751315 1 / 1.1 / 1.1 / 1.1 = 0.751315 94 644
94 644
Or using a financial calculator: N = 3 I = 10 FV = 125 971 Comp PV = 94 644
W3. Effective interest rate table:

using the CA of the instrument (W2) and the market interest rate: 10%
Year O/balance Interest @ 10% Repayment C/ balance
(W2)
20X1 94 644 9 464 104 108
20X2 104 108 10 411 114 519
20X3 114 519 11 452 125 971
31/12/20X3 (125 971) 0
31 327 (125 971)
Solution 9A: Grant related to a low-interest loan: all conditions met
Debit Credit
1 January 20X1
Bank Given 100 000
Loan: government (L) W2 94 644
Grant income (P/L) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%. All
conditions to this low interest rate were met on date of receipt so the
low interest benefit is recognised in profit or loss immediately
31 December 20X1
Interest expense (P/L) W3 9 464
Loan: government (L) 9 464
Interest on the government loan calculated at the market interest rate
Comment: Effect on profit or loss:

Interest expense over 3 years: 9 464 + 10 411 + 11 452 31 327
Grant income: recognised in full in 20X1 (5 356)
25 971
Chapter 15 733
Solution 9B: Grant related to a low-interest loan: conditions met later: credit to income
Bank Given 100 000
Deferred grant income (L) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%.
Conditions to this low interest rate were not met on date of receipt
so the low interest benefit is first deferred
Deferred grant income (L) 5 356 / 2 years 2 678
Grant credited to income over the 2 year condition: first year met
Note: Effect on profit or loss:
Interest expense over 3 years: 9 464 + 10 411 + 11 452 31 327
Grant income recognised in full over 20X1 – 20X2 2 678 + 2 678 (5 356)
25 971
Solution 9C: Grant related to a low-interest loan: conditions met later: credit to expense
Bank Given 100 000
Deferred grant income (L) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%.
Conditions to this loan were not met on date of receipt so the low
interest benefit is first deferred
Deferred grant income (L) 5 356 / 2 years 2 678
Interest expense (P/L) 2 678
Grant credited to expense over the 2 year condition: first year met
Note: Effect on profit or loss:
Interest expense over 3 years: (9 464 – 2 678) + (10 411 – 2 678) + 11 452 25 971
Grant income recognised Deferred grant income 5 356 – credit to expenses 5 356 (0)
25 971
3.6 Grants received as a package (IAS 20.19)

A grant may be received as a package deal, being a grant designed to provide financial relief
for a combination of items, for example:
A portion of the grant may be cash to cover past expenses;
A portion of the grant may be cash to cover immediate financial support;
A portion of the grant may be cash to cover future expenses;
A portion of the grant may be cash to cover the cost of an asset; and / or
A portion of the grant may be a non-monetary asset.
Each of the abovementioned portions of the grant may also come with their own unique set of
conditions. Depending on the materiality of each of these portions, it may be more
appropriate to recognise each portion in the grant package on a different basis, depending
what the grant relates to (as explained in earlier sections).
734 Chapter 15
Each portion of a grant package is therefore generally recognised separately, for example, the
part of the grant that relates to:
past expenses should be recognised in profit or loss:
in the same period that the grant becomes receivable and conditions are met;
general and immediate financial support should be recognised in profit or loss:
in the same period that the grant becomes receivable and conditions are met;
future expenses should be recognised in profit or loss:
in a way that reflects the pattern of future expenses; and
an asset should generally be recognised in profit or loss:
in a way that reflects the pattern of depreciation.
Example 10: Grant is a package deal
A company receives a cash grant of C120 000 on 1 January 20X1. The grant relates to 2
items:
C30 000 is a cash sum as immediate financial support with no associated future costs;
C90 000 is a cash sum to assist in the future acquisition of certain vehicles.
The vehicles were acquired on 2 January 20X1 for C210 000:

The vehicles were available for use immediately.
The vehicles each have a useful life of 3 years.
The vehicles each have nil residual values.
With the exception of the purchase of the vehicles, all conditions attaching to the grant had all been met
on date of receipt.
The company policy is to recognise government grants as grant income.
Required:
Show the journal entries in the year ended 31 December 20X1.
Solution 10: Grant is a package deal

Comment: Note how journal narrations are used to explain journal entries and provide additional detail.

Bank Total grant received = given 120 000
Grant income (P/L) Immediate financial support = income 30 000
Deferred grant income (L) Attached to a future condition = deferred 90 000
Recognising a government grant package deal:
Portion of the grant relates to immediate financial support with no
conditions attached: recognise income immediately: 30 000
Portion of the grant relates to acquiring an asset: deferred
2 January 20X1
Vehicles: cost 210 000
Bank 210 000
Purchase of vehicles
31 December 20X1
Depreciation – vehicles (P/L) (210 000 – 0) / 3 years 70 000
Vehicles: accumulated depreciation (-A) 70 000
Depreciation of vehicles
Deferred grant income (L) (120 000 – 30 000) / 3 years 30 000
Portion of grant income related to purchase of vehicles recognised on
the same basis as vehicle depreciation (i.e. over 3 years)
Chapter 15 735
4. Changes in Estimates and Repayments (IAS 20.32 - .33)
A change in estimate may be required:

if the grant is received after acquisition of a related asset (i.e. this may change the cost of
the asset in which case the depreciable amount will change if the grant is credited to the
asset’s cost account),
if the grant is provided on certain conditions and these conditions are later breached
causing the grant to be retracted, requiring the entity to repay some or all of the grant.
Repayments of government
Where a change in estimate is caused by having to repay grants result in:
some of the grant ,or the entire grant, the change in changes in estimates (IAS 8)
estimate must be accounted for using IAS 8 and the using the cumulative catch-up
cumulative catch-up method. method (i.e. cumulative additional
depreciation that would have been
recognised is recognised in P/L
In other words, if the grant related to a depreciable non- immediately)
monetary asset, the cumulative additional depreciation
on this asset that would have been recognised to date had the grant not been received, is then
recognised immediately as an expense. IAS 20.32
Where a grant must be repaid the treatment depends on whether the grant related to expenses
or assets.
If the original grant related to expenses, the repayment of the grant (credit bank) is:
first debited against the balance on the deferred income account, if a balance remains; and
then debited to an expense account (if a further debit is required). IAS 20.32
If the original grant related to an asset, the repayment of the grant (credit bank) is either:
debited against the balance on the deferred income account, if any; or
debited to the balance on the asset account. IAS 20.32
If we have to repay a grant that related to a non-monetary asset and as a result had to debit the
cost with the repayment of the grant, we will have effectively increased the carrying amount
of the asset. We thus need to ensure that we have not increased the asset above its
recoverable amount, in which case the assets would need to be adjusted for an impairment
Watch out for this! Impairments are explained in more detail in Chapter 11: Impairment of
assets. See IAS 20.33
Example 11: Grant related to expenses – repaid

The local government granted a company C10 000 on 1 January 20X1 to assist in the
financing of mining expenses. The grant was conditional upon the company mining for a
period of at least 2 years.
The company ceased mining on 30 September 20X2 due to unforeseen circumstances.
The terms of the grant required that the grant be repaid immediately and in full.
Mining expenses incurred to date were as follows:
20X1: 80 000
20X2: 60 000
Required:
Show the journal entries in 20X1 and 20X2 assuming:
A. The company recognises grants as grant income.
B. Show how your answer would change if grants were recognised by reducing the related expense.
736 Chapter 15
Solution 11: Grant related to expenses – repaid

Comment:
This example shows that a grant that is forfeited must first be reversed out of the deferred income
account, assuming it has a balance, and any remaining debit is recognised in profit or loss.
In Part A, the profit or loss is adjusted by recognising an income account; whereas
In Part B, it is adjusted by reducing an expense account.

1 January 20X1 Dr (Cr) Dr (Cr)
Bank 10 000 10 000

Recognising a government grant intended to reduce future expenses
31 December 20X1
Mining expenses (P/L) 80 000 80 000
Bank/ Accounts payable (80 000) (80 000)
Mining expenditure incurred
Deferred grant income (L) 10 000 / 2 years x 1 year 5 000 N/A
Recognising part of the grant in profit or loss since 1 of the 2-year
condition is met: recognised as income (part A)
Deferred grant income (L) 10 000 / 2 years x 1 year N/A 5 000
Mining expenses (P/L) (5 000)
Recognising part of the grant in profit or loss since 1 of the 2-year
condition is met: recognised as a reduced expense (part B)
30 September 20X2
Mining expenses (P/L) 60 000 60 000
Bank/ Accounts payable (60 000) (60 000)
Mining expenditure incurred
Deferred grant income (L) 10 000 / 2 years x 9 / 12 3 750 N/A
Recognising part of the grant in P/L since a further 9 months of the
2-year condition is met: recognised as income (part A)
Deferred grant income (L) 10 000 x 50% x 9 / 12 N/A 3 750
Mining expenses (P/L) (3 750)
Recognising part of the grant in P/L since a further 9 months of the
2-year condition is met: recognised as a reduced expense (part B)
Deferred grant income (L) Balance in this acc: 10 000 – 5 000 – 3 750 1 250 N/A
Grant income reversed 10 000 – 1 250 8 750
(P/L)
Bank 100% of the grant received is repayable (10 000)
Repayment of grant in full on cessation of mining (breach of
conditions): Pmt first reduces any deferred income balance and any
balance is recognised in P/L as a reduction of grant income
Deferred grant income (L) Balance in this acc: 10 000 – 5 000 – 3 750 N/A 1 250
Mining expense (P/L) 10 000 – 1 250 8 750
Bank 100% of the grant received is repayable (10 000)
Repayment of grant in full on cessation of mining (breach of
conditions): Pmt first reduces any deferred income balance and any
balance is recognised in P/L as an increase in expenses
Chapter 15 737
Example 12: Grant related to assets – repaid

The local government granted the company C10 000 on 1 January 20X1 to:
assist in the purchase of a manufacturing plant.
The grant was conditional upon the company:
purchasing the plant and
manufacturing for a period of at least two unbroken years.
If the conditions of the grant were not met, the terms of the grant required that the grant be
repaid immediately and in full.
The plant was:
purchased on 2 January 20X1 for C100 000; and was
depreciated on the straight-line basis over its useful life of 4 years to a nil residual
value.
Other information:
The company ceased manufacturing on 30 September 20X2 due to unforeseen
circumstances.
The asset was not considered to be impaired and the company intended to resume
manufacturing in the next year.
Required:
Show the journal entries for the years ended 31 December 20X1 and 20X2 assuming that:
A. the company recognises grants as grant income.
B. the company recognises grants as a reduction of the cost of the related asset.
Solution 12: Grant related to assets – repaid

Comment: First of all, please notice, in both parts, that the deferred grant income is recognised in profit
or loss in a manner that reflects the period over which the cost of the asset is recognised as an expense
even though the condition was simply a 2-year condition.
Part A shows that a grant that is forfeited must first be reversed out of the deferred income account,
assuming it has a balance, and any remaining debit is expensed. The principle behind the
repayment of the 10 000 in this example is the same as in example 11A: it is first debited to the
‘deferred grant income acc’ (reversing any balance in this account) and any excess payment is then
debited to a ‘grant income reversed expense account’.
In Part B, the deferred income account had no balance remaining on the date of repayment (since it
had all been transferred to the asset on 2 January 20X1), and therefore the full amount repaid was
simply debited to the cost of the asset.
Notice that the effect on profit or loss is the same in each year irrespective of the policy applied.

Bank 10 000 10 000
Recognising a government grant
2 January 20X1
Plant: cost 100 000 100 000
Accounts payable/ bank (100 000) (100 000)
Purchase of plant
Deferred grant income (L) N/A 10 000
Plant: cost (10 000)
Recognising grant income as a credit to the asset
31 December 20X1
Depreciation – plant (P/L) A: (100 000 – 0) / 4 years x 12 / 12 25 000 22 500
Plant: acc depr (-A) B: (100 000 – 10 000 – 0) / 4 years x 12 / 12 (25 000) (22 500)
738 Chapter 15
Solution 12: Continued… Sol to Ex Sol to Ex

12A 12B
Debit/ Debit/
(Credit) (Credit)
Deferred grant income (L) A: 10 000 / 4 years x 12 / 12 2 500 N/A
Recognising 25% of the government grant since the grant relates to the
acquisition of an asset that is depreciated over 4 years
30 September 20X2
Depreciation – plant (P/L) A: (100 000 – 0) / 4 years x 9 / 12 18 750 16 875
Plant: acc depr (-A) B: (100 000 – 10 000 – 0) / 4 years x 9 / 12 (18 750) (16 875)
Depreciation of plant: (manufacture ceases on 30 September 20X2)
Deferred grant income (L) A: 10 000 / 4 years x 9 / 12 1 875 N/A
Recognising 9 months of the remaining 75% of the government grant to
the date of repayment of the grant
Deferred grant income (L) A: Bal in this acc: 10 000 – 2 500 – 1 875 5 625 N/A
Grant income reversed (P/L) A: 10 000 – 5 625 4 375
Bank A: 100% of the grant received is repayable (10 000)
Repayment of the full grant required when mining ceased (breach of
conditions), first reducing the balance on the deferred income account
(5 625) and then expensing the balance of the 10 000 (4 375)
Plant: cost B: debit to asset (since originally credited) N/A 10 000
Bank B: 100% of the grant received is repayable (10 000)
Repayment of the full grant due to breach of the grant condition
Depreciation: plant (P/L) B: W1: 2 500 + 1 875 (difference column); N/A 4 375
Plant: acc depr (-A) or: 10 000 / 4yrs x (1.75 yrs) (4 375)
Extra cumulative depreciation that would been expensed on this extra
plant cost is now recognised (IAS 8: cumulative catch-up method)
For Part B only: W1: Change in estimate calculation (cumulative catch-up method)
Date Calculations Was Is Difference
Cost 1/1/X1 100 000 – 10 000 90 000 100 000 10 000
Depreciation X1 (90 000 – 0) / 4 x 1 (22 500) (25 000) (2 500)
(100 000 – 0) / x 1
Carrying amount 31/12/X1 67 500 75 000 7 500
Depreciation X2 (90 000 – 0) / 4 x 9 / 12 (16 875) (18 750) (1 875)
(100 000 – 0) /4 x 9/ 12
Carrying amount 30/09/X1 50 625 56 250 5 625
Depreciation Future (50 625) (56 250) (5 625)
Residual value 0 0 0
Check: 50 625 (CA) + 10 000 (increase cost due to repmt) – 4 375 (additional depreciation) = 56 250
5. Deferred Tax
5.1 Overview
The deferred tax consequences of receiving a government grant depend on many varying
factors i.e.:
if the government grant is exempt from tax; or
if the grant relates to the acquisition of an asset, whether tax deductions (e.g. wear and
tear) will be granted on the underlying asset.
Chapter 15 739
These consequences will be discussed under the following headings

Grants related to income:
for immediate financial support or past expenses,
for future expenses;
Grants related to assets.
5.2 Grants related to income
5.2.1 Grant of immediate financial support or past expenses: taxable
If the grant of immediate financial support is taxable, it will:
be recognised as income, in full, in profit before tax (accounting purposes); and
be recognised as income, in full, in taxable profit (taxation purposes).
Since the grant forms part of both sums, there will be no deferred tax consequences at all.
5.2.2 Grant of immediate financial support or past expenses: not taxable (i.e. exempt)
If the grant of immediate financial support is exempt from tax, it will:
be recognised as income, in full, in profit before tax (accounting purposes); but will
never be recognised as income in taxable profit (taxation purposes).
The amount received will therefore cause a non-temporary difference (i.e. permanent
difference) in the current tax calculation. Since the difference is permanent and not
temporary, there will be no deferred tax consequences.
5.2.3 Grant to assist with future expenses: taxable
If the grant related to future expenses is taxable upon receipt, it will:
be recognised as income in profit before tax (accounting records) in future years; but
be recognised as income in taxable profit (taxation purposes) now.
The accounting treatment of the government grant gives rise to deferred grant income (a
liability account). The treatment of this for deferred tax purposes is the same as that for
income received in advance i.e. there will be a carrying amount but the tax base will be zero.
Since the carrying amount and tax base are different and since this difference will reverse in
future when the deferred grant income is recognised as grant income in the accounting
records, the difference is said to be a temporary difference. Since we have a temporary
difference, we have deferred tax to account for.
Example 13: Deferred tax: grant relating to future expenses: taxable
On 1 January 20X1, a company receives a cash grant from the government of C10 000 to
contribute 10% towards future specified wages that must total C100 000.
The grant was received on 1 January 20X1 due to compliance with certain conditions in
20X0.
All conditions attaching to the grant (with the exception of the incurring of the future
wages) had all been met on date of receipt.
The company incurs C20 000 of the required wages in 20X1 and C80 000 thereof in
20X2.
The company earned profit before tax of 100 000 (fully taxable).
The grant received is taxable in the year in which it is received.
Required: Show the tax journals for the year ended 31 December 20X1.
Solution 13: Deferred tax: grant relating to future expenses: taxable

Comment: For deferred tax purposes, it does not matter whether the grant is credited against the
expense or a separate income account since deferred tax is based on the balances in the SOFP.
740 Chapter 15

Journals
Income tax expense: income tax (P/L) W1 32 400
Current tax payable (L) 32 400
Current income tax for 20X1 estimated
Deferred tax: income tax (A) W2 2 400
Tax expense: income tax (P/L) 2 400
Deferred tax on deferred grant income
W1: Current income tax 20X1

C
Profit before tax Given: (X – wages: 20 000 + grant income: 2 000 = 100 000) 100 000
Less grant income recognised Grant: 10 000 x Conditions met: 20 000 / 100 000 (wages) (2 000)
Add taxable grant income Grant is taxable when received 10 000
Current income tax 32 400

W2: Deferred income tax
Deferred grant income
Balance: 1/1/20X1 0 0 0 0
Grant income deferred (10 000) 0 10 000
2 400 Dr DT Cr TE
Grant income recognised 2 000 0 (2 000)
(1)
Balance: 31/12/20X1 (8 000) 0 8 000 2 400 A
(1) TB = CA – any amount which will not be taxable in future periods (the entire carrying amount will
not be taxable in future periods as it is taxable now), therefore TB = 0.
5.2.4 Grant to assist with future expenses: not taxable (i.e. exempt)
The grant received will initially be recognised as deferred grant income (a liability account).
If the grant is exempt from tax, however, the tax base for this liability will immediately be nil
(the tax base representing the portion that will be taxed in the future).
This therefore creates a temporary difference on initial recognition (which affects neither
accounting profit nor taxable profit). Such temporary differences are exempt from deferred
tax in terms of IAS 12 (i.e. there will be no deferred tax journal entries). IAS 12.15
When calculating the current income tax, remember that any grant income included in profit
before tax that is not taxable, will need to be reversed as income that is exempt from tax. This
will lead to the presentation of a reconciling item in our tax rate reconciliation.
Example 14: Deferred tax: grant relating to future expenses: exempt

Use the information in example 13 but assume that the grant is exempt from tax (i.e. it is
not taxable).
Required: Show the tax journals for the year ended 31 December 20X1.
Solution 14: Deferred tax: grant relating to future expenses: exempt

Income tax expense: income tax (P/L) W1 29 400
Current tax payable (L) 29 400
Current income tax for 20X1 estimated
Chapter 15 741

Workings:
W1: Current income tax C
Profit before tax Given: (X – wages: 20 000 + grant income: 2 000 = 100 000) 100 000
Less grant income recognised Grant: 10 000 x Conditions met: 20 000 / 100 000 (wages) (2 000)
Add taxable grant income Nil – exempt from tax 0
W2: Deferred income tax

Deferred grant income
Balance: 1/1/20X1 0 0 0 0
Grant income deferred (10 000) 0 10 000 0 Exempt: IAS 12.15
Grant income recognised 2 000 0 (2 000) 0 Exempt: IAS 12.15
(1)
Balance: 31/12/20X1 (8 000) 0 8 000 0 Exempt: IAS 12.15
(1) TB = CA – the amount that will not be taxed in future periods (the entire carrying amount will not
be taxable in future periods as it is exempt)
Comment: note that in ex. 13, the tax base was also nil but the temporary difference was not exempt.
In example 13, the tax base is nil because the grant had immediately been recognised as taxable
income (and was thus included in taxable profit).
In example 14, it is the initial tax base that is nil: the tax base is nil because no portion of the grant
will ever be taxed. Thus the resulting temporary difference, which arose on initial recognition, did
not affect taxable profits. It also did not affect accounting profits (debit bank, credit deferred
income liability). Where a temporary difference arises on initial recognition that affects neither
accounting profits nor taxable profits, the temporary difference is exempted from deferred tax.
5.3 Grants related to assets

5.3.1 Grants related to assets: taxable
Deferred tax will arise if the grant relating to an asset is taxable. This is irrespective of
whether the government grant is recognised as deferred grant income or as a credit against the
carrying amount of the asset:
If it is credited to deferred grant income (liability), deferred tax will arise on this liability
account (similar to example 13) and the related asset account (e.g. plant).
If it is credited to the related asset account, deferred tax will arise solely on this asset
account (remember depreciation will be lower than if a deferred grant income account had
been created).
Example 15: Deferred tax: cash grant relating to asset – taxable
A company receives C12 000 from the government on 1 January 20X1 to help buy a plant.
The grant was received after compliance with certain conditions in 20X0 (the prior year).
All conditions attached to the grant, with the exception of the acquisition of the plant,
had all been met on date of receipt.
The plant:
was acquired on 2 January 20X1 for C90 000,
was available for use immediately, has a useful life of 3 years and has a nil residual value.
The tax rate is 30% and the tax authorities tax the grant as income in the year of receipt and allow the
cost of the plant (i.e. 90 000) to be deducted over 5 years.
Profit before tax (correctly calculated) was C100 000 for 20X1.
There are no other temporary differences, exempt income or non-deductible expenses other than those
742 Chapter 15
Required:
Show the tax journals and tax expense note for the year ended 31 December 20X1, assuming:
A. The company has the policy of recognising government grants as deferred grant income.
B. The company has the policy of recognising government grants as credit to the related asset.
Solution 15: Deferred tax: cash grant relating to asset – taxable

Comments in general:
This example involves the grant being taxable and the related plant being deductible. It compares
the situation where the grant is:
is credited to deferred income (finally recognised in profit or loss as grant income); and
is credited to the asset (finally recognised in profit or loss as a reduced depreciation charge).
Either way, the grant is recognised in profit or loss over a period of time and the grant income will
also be recognised in taxable profit. Since this can only lead to possible temporary differences (no
exempt income), no rate reconciliation will be required in the tax expense note.
W1: Current income tax Ex 15A Ex 15B

Profit before tax Given: (X – depr + grant income = 100 000) 100 000 100 000
Less grant income in profit 15A: 12 000 / 3 yrs; 15B: not applicable (4 000) 0
Add depreciation in profit 15A: 90 000 / 3yrs; 15B: (90 000 – 12 000) / 3yrs 30 000 26 000
Less wear and tear 15A & 15B: 90 000 / 5 years (18 000) (18 000)
Add taxable grant income Total grant taxable when received 12 000 12 000
Taxable profit 120 000 120 000
Current income tax Taxable profit x 30% 36 000 36 000
W2: Deferred tax for Solution 15A only:

Comment: in 15A, there are 2 deferred tax workings that will be required because there are two
balances affected by the grant: 1) deferred grant income and 2) the plant purchased.
W2.1 DT on deferred income CA TB TD DT
Balance: 1/1/20X1 0 0 0 0
Grant income deferred (12 000) 0 12 000
(1) 2 400 Dr DT Cr TE
Grant income recognised 4 000 0 (4 000)
(2)
Balance: 31/12/20X1 (8 000) 0 8 000 2 400 Asset
(1) Grant income recognised in 20X1: 12 000 x 1/3 (recognised at year end)
(2) TB = CA – any amount which will not be taxable in future periods (the entire carrying amount will not be
taxable in future periods as it is taxable now – P.S. this means it affects taxable profit and thus the resulting
temporary difference of 12 000 is not an exempt temporary difference).
W2.2 Deferred tax on plant CA TB TD DT

Balance: 1/1/20X1 0 0 0 0
Purchase 90 000 90 000 0 0
(1) (2)
Depreciation/ deduction (30 000) (18 000) 12 000 3 600 Dr DT Cr TE
Balance: 31/12/20X1 60 000 72 000 12 000 3 600 Asset
(1) Depreciation: (90 000 – RV: 0) / 3 years x 12/12 = 3 000

(2) Deduction (wear and tear): 90 000 / 5 years = 18 000
W3: Deferred tax for Solution 15B only:

Comment: There is no deferred tax working for deferred grant income as no deferred grant income was
raised: the grant received was simply credited to the related asset (plant). The deferred tax will
therefore arise purely from the plant.
W2.1: Deferred tax on plant CA TB TD DT
Balance: 1/1/20X1 0 0 0 0
Purchase 90 000 90 000 0 0
Grant received (12 000) 0 12 000
(1)
Depreciation/ deduction (26 000) (2) (18 000) 12 000 6 000 Dr DT Cr TE
Balance: 31/12/20X1 52 000 72 000 20 000 6 000 Asset
Chapter 15 743

Calculations supporting W2.1:
(1) (90 000 - 12 000 – RV: 0) / 3 years x 12/12 =26 000
(2) Deduction (wear and tear): 90 000 / 5 years = 18 000
Journals: Ex 15A Ex 15B

31 December 20X1 Dr/ (Cr) Dr/ (Cr)
Tax expense: income tax (P/L) W1 36 000 36 000
Current income tax payable (L) (36 000) (36 000)
Deferred tax: income tax (A) Ex 15A: W2.1; Ex 15B: N/A 2 400 N/A
Tax expense: income tax (P/L) (2 400) N/A
Deferred tax: income tax (A) Ex 15A: W2.2; Ex 15B: W3 3 600 6 000
Tax expense: income tax (P/L) (3 600) (6 000)
Deferred tax on plant
Disclosure:
Name
Ex 15A Ex 15B
5. Income taxation expense C C
Current W1 or journals 36 000 36 000
Deferred W2/3 or journals (6 000) (6 000)
Tax effects of:
Profit before tax 100 000 x 30% 30 000 30 000
Reconciling items 0 0
Effective tax rate 30 000 / 100 000 30% 30%
5.3.2 Grants related to assets: not taxable (i.e. exempt)

The grant received will initially be recognised as a credit to the related asset (e.g. the plant
cost account) or a credit to deferred grant income.
If the grant is exempt from tax, however, the tax base for this credit will immediately be nil
(the tax base representing the portion that will be taxed in the future).
This thus creates a temporary difference on initial recognition and affects neither accounting
profit nor taxable profit. Temporary differences that arise on initial acquisition and affect
neither accounting profit nor taxable profit are exempt from deferred tax in terms of IAS 12
(i.e. there will be no deferred tax journal entries).
Thus, grants that are not taxable (i.e. exempt from income tax) will not lead to deferred tax
because the resulting temporary differences are exempt from deferred tax.
The only deferred tax which will result is in the difference between depreciation (calculated
on the cost of the asset and ignoring the grant received) and the related tax deductions.
When calculating the current income tax, remember that any grant income included in profit
before tax by way of a reduced depreciation charge will lead to a permanent difference (i.e.
also referred to as a non-temporary difference). In other words, the reduction in the
depreciation will appear in the tax expense as a reconciling item.
744 Chapter 15
Example 16: Deferred tax: Cash grant relating to asset – not taxable
Use the same information in example 15 except that the tax authorities:
Do not tax the receipt of the grant; and
Allow the deduction of the cost of the plant (i.e. 90 000) over 5 years.
Required: Show the tax journals and the tax expense note in the year ended 31 December 20X1
assuming that the company has the policy of recognising government grants as a credit to the related
asset (i.e. as in example 15B)
Solution 16: Deferred tax: grant relating to asset – not taxable

Journals
Tax expense: income tax (P/L) W1 32 400
Current income tax payable (L) 32 400
Deferred tax: income tax (A) W2 3 600
Tax expense: income tax (P/L) 3 600
Disclosure:
Name
20X1
5. Income taxation expense C
Current W1 32 400
Deferred W2 (3 600)
Tax expense per the statement of comprehensive income 28 800
Tax effects of:
Profit before tax 100 000 x 30% 30 000
Exempt temporary difference:
depreciation reduction due to exempt grant 4 000 (W2) x 30% (1 200)
Tax expense charge per statement of comprehensive income 28 800
Effective tax rate 28 800 / 100 000 28.8%
Workings:
20X1
W1: Current income tax C
Profit before tax Given: (X – depr + grant income 0 = 100 000) 100 000
Add depreciation (90 000 – 12 000) / 3yrs 26 000
Less wear and tear 90 000 / 5 years (18 000)
Add taxable grant income Nil – exempt from tax 0
W2: Deferred tax: plant CA TB TD DT

Balance: 1/1/20X1 0 0 0 0
Purchase 90 000 90 000 0 0
(1)
Grant received (12 000) 0 12 000 0 Exempt
(2) (2)
Depreciation/ deduction (26 000) (18 000)
- Cost (3)
(30 000) (18 000) 12 000 3 600 Dr DT Cr TE
- Grant (4)
4 000 0 (4 000) (5)
0 Exempt
Balance: 31/12/20X1 52 000 72 000 20 000 3 600 Asset
Chapter 15 745
Solution 16: Deferred tax: grant relating to asset – not taxable

Calculations supporting W2:
(1) The credit to the asset is exempt income from a tax perspective: since the credit affects neither
accounting profit nor taxable profit, the temporary difference is exempt from deferred tax.
(2) (90 000 - 12 000 – RV: 0) / 3 years x 12/12 =26 000
(3) Depreciation on cost: (90 000 – RV: 0) / 3 years x 12/12 =30 000
(4) Depreciation reduced due to exempt grant income: 12 000 / 3 years x 12/12 =4 000
(5) The reduction in the depreciation charge of 4 000, which is caused by the grant, results in a further
exemption in the opposite direction (it is simply the ‘unwinding’ of the original exemption of 12 000
that will occur over the 4 years).
6. Disclosure (IAS 20.39)
The following issues must be disclosed:

Accounting policy regarding both recognition and method of presentation, for example:
- Government grants are recognised in profit or loss over the period to which the grant
applies and in a manner that reflects the pattern of expected future expenditure; and
- The grant is presented as a decrease in the expenditure to which it relates (or: the
grant is presented as a separate line item: grant income);
The nature and extent of government grants recognised in the financial statements;
An indication of other forms of government assistance not recognised as government
grants but from which the entity has benefited directly (e.g. low or no interest loans and
assistance that cannot reasonably have a value placed upon them);
Unfulfilled conditions and other contingencies attached to recognised government grants.
Example 17: Disclosure of government grants
A government grant of C250 000 is received at the beginning of 20X4.
The grant was provided to help finance the costs of distribution over the 2-year period ended
31 December 20X5.
Required:
A. Prepare an extract of the statement of comprehensive income and related notes for the year ended
31 December 20X5 assuming that the entity recognises grants as grant income and discloses it in
the ‘other income’ line item together with rent income of C25 000 in 20X5 and C45 000 in 20X4.
B. Show how the note disclosure would change if the company recognised the grant as a reduction of
the related expense, where the following costs were incurred:
Cost of sales: C800 000 (20X4: C900 000)
Distribution costs: C315 000 (20X4: C325 000)
Administration costs: C210 000 (20X4: C300 000)
C. Show the disclosure of the grant in the statement of financial position at 31 December 20X5.
Solution 17A: Grant credited to income – SOCI disclosure
Company name
20X5 20X4
C’000 C’000
Revenue x x
Other income 40 150 170
Cost of Sales/Admin/Distribution/Other 41 x x
Finance costs 42 x x
Profit before tax 43 x x
746 Chapter 15
Solution 17A: Continued

Company name
Notes to the financial statement
2.15 Government grants:
Government grants are recognised in profit or loss:
over the periods, on a rational basis that
matches grant income with the costs that they were intended to compensate
Government grants are recognised when there is reasonable assurance that:
the conditions of the grant will be complied with; &
the grant will be received.
Government grants are presented as grant income
20X5 20X4
40. Other income C’000 C’000
Rent income 25 45
Government grant 50 125 125
Other income per the statement of comprehensive income 150 170
Solution 17B: Grant credited to expense – SOCI note disclosure

Company name
20X5 20X4
41. Costs by function C’000 C’000
Cost of distribution 190 200
Total 315 325
Government grant 50 (125) (125)
Cost of administration 210 300
1 200 1 400
Further adjustments to the disclosure in Ex17A:
There would be no grant income in the ‘other income note’.
The last line of the ‘accounting policy note’ (see Ex17A) would read the following instead:
Government grants are presented as a reduction of the related expense/ asset.
Solution 17C: Grant credited to expense – SOFP disclosure

Irrespective of whether the company presented the grant as a reduction of the expense or as grant
income, the following would be disclosed in the statement of financial position.
Company name
As at 31 December
20X5 20X4
LIABILITIES C’000 C’000
Example 18: Disclosure of government grants related to assets – the asset note
A government grant of C250 000 is received at the beginning of 20X4.
The grant was provided to help finance the costs of an existing plant.
The plant’s accumulated depreciation is C300 000 at 01/01/20X4 (cost: C900 000).
The plant has a remaining life of 2 years and a nil residual value.
Depreciation is provided on the straight-line method.
Required: Show the disclosure in the property, plant and equipment note as at the year ended
31 December 20X5 assuming that the company recognises grants as a reduction of the related asset.
Chapter 15 747
Solution 18: Disclosure of a grant in the asset note

Company name
20X5 20X4
20. Property, plant and equipment C’000 C’000
Plant:
Net carrying amount – 1 January 175 600
Gross carrying amount – 1 January 650 900
Accumulated depreciation – 1 January (475) (300)
Grant received 50 - (250)

Depreciation (CA: 600 – GG: 250 – RV: 0) / 2 years (175) (175)
Net carrying amount – 31 December 0 175
Gross carrying amount – 31 December 650 650
Accumulated depreciation – 31 December (650) (475)
Example 19: Disclosure of government grants and assistance: a general note

Read the disclosure requirements provided in IAS 20.39 carefully.
Required:
Prepare a skeleton note entitled ‘government grants and assistance’ that you believe will ensure that all
the general disclosure requirements are met.
Solution 19: Disclosure of government grants and assistance: a general note

Company name
20X5 20X4
50. Government grants & assistance C C
Nature:
Cash government grants have been received in return for ….. (e.g. mining in the ….area).
Extent:
The amounts of the grant have been presented (select one of the following):
as grant income (including in other income/ as a separate line item on the face of the
statement of comprehensive income)
as a deduction against the …..expense (see note …)
as a deduction against the…. asset in property, plant and equipment (see note ….).
Unfulfilled conditions:
The unfulfilled conditions at reporting date are as follows:
……. (e.g. the company must mine for a further 12 years).
There is no evidence to suggest that this condition will not be met (or give details of any evidence
that suggests that the unfulfilled conditions will probably not be met).
Other government assistance that is unrecognised :
Other government assistance from which the company has directly benefited includes ….. (e.g. a
government procurement policy that requires that the government buy 50% of all …. from us).
Contingent liabilities:
If the company fails to meet the conditions of the grant recognised in note …, the company will be
liable to repay C….. of the grant. These conditions must be met over the next …. years, after
which the company will no longer be exposed to this risk.
748 Chapter 15
7. Summary
Government assistance
Government grants Other government assistance
Monetary grants, for example: Where value cannot be reasonably

Forgivable loans or cash to be used to: allocated, for example:
Purchase an asset Free technical advice
Pay for current/future expenses
Reimbursement of past costs/ losses Transactions that can’t be separated from
Financial assistance (e.g. low interest normal trading activities, for example:
loan) Government procurement policy that
accounts for a portion of sales
Non-monetary grants, for example:
Land or The other forms of government assistance
Licence to operate are not recognised as government grants
Recognised Recognised
Yes No
When there is reasonable assurance that the:
entity will comply with the conditions and
grant will be received
Recognition
Recognised in profit or loss

over the period that the related costs are
expensed
Disclosed Disclosed
Yes Yes
Government grants
Measurement:
Non-monetary Monetary
Fair value of asset granted Fair value of asset granted
OR (i.e. cash amount received or receivable)
Nominal amount paid (if any)
Chapter 15 749
Government grants
Presentation:
Credit to income Credit to the related expense or asset
Initial journals:
Non-monetary Monetary
Debit:
Debit:
Bank
Non-monetary asset (e.g. land)
Credit:
Credit: Income (deferred/ realised)
OR Asset
Bank (nominal amount if any)
Asset acquired
Grant income (deferred or realised): (fair value –
nominal amount)
Income (deferred/ realised) Future
OR
expenses
Expense
Past expense
Income (realised) past losses or
OR
immediate
Expense
assistance
Loan
AND Loans
Income (deferred/ realised)
Disclosure requirements
1. The accounting policy re:

Recognition:
Government grants are recognised in profit or loss:
over the periods, on a rational basis that
matches grant income with the costs that they were intended to compensate
when reasonable sure that:
the conditions of the grant will be complied with; &
the grant will be received.
Presentation:
as a reduction of cost of the asset OR
as grant income/ deferred income OR
as reduction of expense/ deferred income
2. The nature and amount of grants recognised

3. Other government assistance not recognised
4. Unfulfilled conditions/ contingencies in respect of the grant
750 Chapter 15
Failing the conditions
Repay the grant/ part thereof
Change in estimate (IAS 8)

Cumulative catch-up method
Grant iro asset: indirect method only Other

Debit Debit
Asset: cost (bal) Deferred income
Credit: Expense (balancing)
Bank Credit:
Bank
AND
Debit
Depreciation
Credit:
Asset: acc depr
Chapter 15 751
Gripping GAAP Leases: lessee accounting
Chapter 16
Leases: Lessee Accounting
Main References: IAS 17, SIC 15, SIC 27, IFRIC 4 and Circular 12/ 2006 (including any amendments
to 10 December 2014)
Contents: Page
1. Introduction 753
2. Lease classification 754
2.1 Overview 754
Example 1: Leases: classification 755
2.2 Lease involving both land and buildings 757
2.2.1 The general rule 757
Example 2: Lease of land and buildings 757
Example 3: Lease of land and buildings 758
2.2.2 The rule applicable to leases of investment properties 760
2.3 Change in classification 760
2.4 Arrangements containing leases (IFRIC 4) 761
2.4.1 Overview 761
2.4.2 Right to use the specified asset 761
2.4.3 Dependence on the use of the specified asset 761
2.4.4 There must be a specified asset: explicit or implicit 761
2.4.5 If the arrangement contains a lease 762
3. Finance leases 762
3.1 Recognition of a finance lease 762
3.2 Measurement of a finance lease 762
3.2.1 Initial measurement of a finance lease 762
Example 4: Basic finance lease – initial measurement 763
3.2.2 Subsequent measurement of a finance lease 764
Example 5: Basic finance lease – subsequent measurement 765
3.3 Other measurement issues relating to a finance lease 768
Example 6: Financial period does not coincide with lease period: arrears vs advance 768
3.4 Tax implications of a finance lease – income tax only (no transaction tax) 770
Example 7: Finance lease with tax – income tax only (no VAT) 770
3.5 Tax implications of the finance lease: income tax with transaction tax 773
Example 8: Basic finance lease with VAT 773
Example 9: Finance lease with tax and VAT 774
3.6 Disclosure of finance lease 776
Example 10: Simple finance lease: disclosure – instalments in arrears vs advance 777
Example 11: Finance lease: disclosure – instalments in arrears with tax 780
Example 12: Finance lease: disclosure – instalments in advance 782
4. Operating leases 783
4.1 Recognition of an operating lease 783
4.2 Measurement of an operating lease 783
Example 13: Basic operating lease: contingent rentals and lease & reporting periods differ 784
4.3 Tax implications of an operating lease – income tax only 785
Example 14: Current tax on an operating lease 785
Example 15: Deferred tax on an operating lease 785
4.4 Tax implications of an operating lease – income tax with transaction tax 786
Example 16: Operating lease with tax and VAT 787
4.5 Operating lease incentive 788
Example 17: Operating lease incentive 789
4.6 Disclosure of an operating lease 789
5. Sale and leaseback 790
5.1 Overview 790
5.2 Sale and finance leaseback 790
Example 18: Basic sale and finance leaseback 791
5.3 Tax implications: sale and finance leaseback 793
Example 19: Tax on a sale and finance leaseback 794
5.4 Sale and operating leaseback 796
Example 20: Basic sale and operating leaseback 797
5.5 Tax implications: sale and operating leaseback 799
6. Exposure draft – expected impact thereof (ED 2013/6) 799
7. Summary 801
752 Chapter 16
1. Introduction
A lease transaction involves one party renting an item from another party. In other words a
lease is characterised by granting the right of use of an asset by a lessor to a lessee. The
substance of the lease may vary from its legal form, in that the lease agreement may actually
reflect a purchase/ sale rather than simply a right of use and it is this substance that must be
accounted for. Leases are thus separated based on their substance into operating leases (a true
lease, involving a right of use) and finance leases (which, in substance, involves a purchase/
sale). There is a third variation which, in substance, involves both a sale and a lease, called a
finance sale and leaseback. Each of these will now be explained from the perspective of the
lessee. Leases from the perspective of the lessor are explained in the next chapter.
Amongst others, paragraph 4 of IAS 17 provides the following definitions:
A lease is defined as:

an agreement whereby the lessor conveys to the lessee
in return for a payment or series of payments
the right to use an asset
for an agreed period of time.
A finance lease is defined as:

a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset,
where title may or may not eventually be transferred.
An operating lease is defined as:
a lease other than a finance lease.
A non-cancellable lease is defined as:
a lease that is cancellable only:
a) upon the occurrence of some remote contingency;
b) with the permission of the lessor;
c) if the lessor enters into a new lease for the same or an equivalent asset with the same lessor; or
d) upon payment by the lessee of such an additional amount that, at inception of the lease, continuation
of the lease is reasonably certain.
The commencement of the lease term is defined as:

the date from which the lessee is entitled to exercise its right to use the leased assets.
It is the date of initial recognition of the lease (i.e. the recognition of the assets, liabilities, income or
expenses resulting from the lease, as appropriate).
The lease term is defined as:

the non-cancellable period for which the lessee has contracted to lease the asset
together with any further terms for which the lessee has the option to continue to lease the asset, with or
without further payment, when at the inception of the lease it is reasonably certain that the lessee will
exercise the option.
The term minimum lease payments, from the lessee’s perspective, is defined as:
the payments over the lease term that the lessee is or can be required to make,
excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor,
together with (the following part of the definition applies only to lessee’s – not lessors):
- any amounts guaranteed by the lessee or by a party related to the lessee.
However, if the lessee has an option to purchase the asset at a price that is expected to be sufficiently
lower than fair value at the date the option becomes exercisable for it to be reasonably certain, at the
inception of the lease, that the option will be exercised, the minimum lease payments comprise the minimum
payments payable over the lease term to the expected date of exercise of this purchase option and the
payment required to exercise it.
NOTE: The part of the definition relating to the guaranteed amount differs from the perspective of the lessor. Please see the next chapter.
Chapter 16 753
The guaranteed residual value, from the lessee’s perspective is defined as:
that part of the residual value that is guaranteed by the lessee or by a party related to the lessee
(the amount of the guarantee being the maximum amount that could, in any event, become payable).
The economic life is defined as either:
the period over which an asset is expected to be economically usable by one or more users; or
the number of production/ similar units expected to be obtained from the asset by one/ more users.
The interest rate implicit in the lease is defined as:
the discount rate that, at the inception of the lease, causes the aggregate present value of:
(a) the minimum lease payments and (b) the unguaranteed residual value
to be equal to the sum of:
(i) the fair value of the leased asset and (ii) any initial direct costs of the lessor.
The fair value is defined as:

the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
Initial direct costs are defined as:
incremental costs that are directly attributable to negotiating and arranging a lease,
except for such costs incurred by manufacturer or dealer lessors.
Contingent rent is defined as:
that portion of the lease payments that is not fixed in amount
but based on the future amount of a factor that changes other than with the passage of time (e.g.
percentage of future sales, amount of future use, future price indices, future market rates of interest).
The lessee’s incremental borrowing rate of interest is defined as:

the rate of interest the lessee would have to pay on a similar lease; or, if that is not determinable,
the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a
similar security, the funds necessary to purchase the asset.
2. Lease Classification (IAS 17.7 - .19)

2.1 Overview (IAS 17.7 - .13)
There are two types of leases: finance leases and operating leases. The type of
What differentiates the one type from the other is whether lease depends
substantially all the risks and rewards of ownership of an asset are on whether or
transferred from the lessor to the lessee. If the risks and rewards: not risks and rewards
of ownership have been
are transferred from the lessor to the lessee, the substance of transferred:
the transaction is a purchase rather than a true lease: a finance
if yes: finance lease
lease; if not: operating lease.
are not transferred from the lessor to the lessee, the substance
of the transaction is a true lease: an operating lease.
Guidance as to whether risks and rewards are transferred is given in If any one of these
paragraph 10 of IAS 17 by way of a list of examples of situations examples are met,
it is:
that individually, or in combination, would normally lead to a lease
being classified as a finance lease: normally a finance lease.
a) the lease transfers ownership of the asset to the lessee by the Note: this list is not
end of the lease term; exhaustive.
b) the lessee has the option to purchase the asset at a price that is expected to be lower than
the fair value at the date the option becomes exercisable. It must be reasonably certain, at
the inception of the lease, that the option will be exercised;
c) the lease term is for the major part of the economic life of the asset, even if title is not
transferred;
d) at the inception of the lease, the present value of the minimum lease payments amounts
to at least substantially all of the fair value of the asset; and
e) the leased assets are of such a specialised nature that only the lessee can use them
without major modifications.
754 Chapter 16
Please note that the above list is not exhaustive. Just because a lease agreement is
characterised by some of the elements above does not, therefore, automatically imply that we
are dealing with a finance lease: if it is clear from other features that the lease does not
transfer substantially all risks and rewards incidental to ownership, the lease is classified as an
operating lease. For example, this may be the case if ownership of the asset transfers at the
end of the lease for a variable payment equal to its then fair value, or if there are contingent
rents, as a result of which the lessee does not have substantially all such risks and rewards.
Besides these examples, the standard gives a few extra indicators in paragraph 11 of IAS 17
that might suggest that a lease is a finance lease. The indicators suggested are:
a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee;
b) if gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
(e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the
lease);
c) if the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.
The use of these guidance examples is best illustrated with an example.
Example 1: Leases – classification
Company A leases a vehicle from Company B:
The lease became effective 1 January 20X4 and the lease term is for 4 years.
The annual lease payments are C10 000 per annum, in arrears.
There is no option of renewal (of the lease agreement).
The implicit interest rate is 10%.
The fair value of the motor vehicle at 1 January 20X4 is C31 700.
Required: For each of the scenarios, discuss whether the above lease agreement is a finance lease:
Scenario 1. The useful life of the vehicle is 8 years. At the end of the lease period, ownership of the
vehicle transfers from Company B to Company A.
Scenario 2. The useful life of the vehicle is 4 years. At the end of the lease period, ownership of the
vehicle remains with Company B.
Scenario 3. Ignore the above information: Payments are C 5 000 for 3 years in arrears, there is no
option of renewal, fair value of the vehicle was C40 000 and the interest rate implicit is
10%. The useful life of the vehicle is 8 years.
Scenario 4. From scenario 3, but after the 3 years have expired the lease may be renewed for a
further 3 years at a rental of C 2 500. The market rental rate is expected to be C 6 000.
Solution 1: Leases – classification

Considering situations provided in IAS 17.10 for consideration in classifying the lease:
Identifying the substance of a lease is done using the example situations given in IAS 17.10:
Scenario Scenario Scenario Scenario
1 2 3 4
a) Does ownership of the vehicle transfer to the lessee
Yes No No No
(Company A) by the end of the lease?
b) Does the lessee (Co. A) have an option to purchase the
vehicle at a price expected to be lower that the fair value No No No No
at the date the option became exercisable?
c) Is the lease term for the major part of the economic life
No Yes No No
of the vehicle?
d) At the inception of the lease, does the present value of
the minimum lease payments amount to at least
Yes Yes No No
substantially all of the fair value of the leased asset
(i.e. the vehicle)? (see working 1 and 2)
e) Is the vehicle of such a specialised nature that only the
No No No No
lessee (Co. A) can use it, without major modifications?
Chapter 16 755

Conclusion:
Scenario 1 and 2:
The substance of the leases (in both scenarios) is that of a finance lease, as substantially all risks and
rewards of ownership are effectively transferred to Company A at the inception of the lease.
Scenario 3:
The lease does not meet any of the criteria and is therefore an operating lease, as substantially all the
risks and rewards of ownership have remained with Company B.
Scenario 4:
According to the indicators in IAS 17.10 (see the table above) the lease does not qualify for
classification of a finance lease. However, IAS 17.11 provides further additional requirements which
may indicate that a lease is to be classified as a finance lease. IAS 17.11.c suggests that if the lessee has
the option to continue the lease for a second period at a rental substantially below market rental, the
lease should be classified as a finance lease. The lease is renewable at a rental of C2 500 when the
market rental is expected to be C6 000. The lease rental is thus substantially lower (58% lower) than
the market rental and thus it should be classified as a finance lease.
W1: For scenarios 1 and 2
W1.1: Present value of the minimum lease payments for scenarios 1 & 2
Date Amount Paid Present value factor (see W1.2) Present value
31/12/20X4 10 000 0.909091 9 091
31/12/20X5 10 000 0.826446 8 264
31/12/20X6 10 000 0.751315 7 513
31/12/20X7 10 000 0.683013 6 830
31 698
W1.2: Present value factors for interest rate of 10%

Present value factor = [1/(1+10%)]n ….. Where: n = number of years/periods
Or:
PV factor for an amount received: Calculations: PVF at 10%:
Immediately (now) 1.000000
After one year 1/ (1 + 0.10) 0.909091
After two years 0.909091/ (1 + 0.10) 0.826446
After three years 0.826446/ (1 + 0.10) 0.751315
After 4 years 0.751315/ (1 + 0.10) 0.683013
W1.3: Alternative calculation of present values using a financial calculator
The PV of the MLPs could be calculated with a financial calculator instead as follows:
n = 4 i = 10% PMT = -10 000
COMP PV ... and your answer should be: 31 698!
W2: For scenarios 3 and 4
W2.1: Present value of the minimum lease payments for scenarios 3 & 4
Date Amount Paid Present value factor (see W1.2 ) Present Value
31/5/20X5 5 000 0.909091 4 545
31/5/20X6 5 000 0.826446 4 132
31/5/20X7 5 000 0.751315 3 757
12 434
W2.2: Alternative calculation of present values using a financial calculator

The PV of the MLPs could be calculated with a financial calculator instead as follows:
n = 3 i = 10% PMT = -5 000
COMP PV ... and your answer should be 12 434!
Comment:
Remember that leases are classified based on the substance rather than the legal form of the agreement.
756 Chapter 16
2.2 Lease involving both land and buildings (IAS 17.10; and .15A - .19)
2.2.1 The general rule Recognise lease

of land
separately from
A lease of land and a lease of buildings are classified as operating or lease of buildings:
finance leases in the same way as leases of other assets. However, if a
lease agreement involves a property that combines land and buildings except in special cases
(e.g. IAS40)
(except in certain cases where the leased property is classified as substance over form!
investment property in terms of IAS 40 – see section 2.2.2), the
classification of the lease as either an operating or finance lease, must involve the separate
consideration and classification of the land element and the building element. This may result
in a single lease agreement involving land and buildings being recognised partly as an
operating lease and partly as a finance lease!
Now, an interesting feature of land is that its economic life is normally deemed to be
indefinite. Thus, unless we expect ownership to pass to the lessee at the end of the lease term,
we could not normally argue that the lessee receives substantially all the risks and rewards
incidental to ownership. Thus we normally classify a lease over land as an operating lease.
However, this is not to say that every lease of land where ownership does not pass is
automatically an operating lease. The standard discusses a scenario where a person leases land
over a 999 year period. It explains that even if legal ownership does not pass to the lessee, the
lessee will have effectively obtained the significant risks and rewards of ownership because,
under these circumstances, the present value of the lease payments over 999 years would, in
all practicality, approximate the fair value of the land. Thus, we would classify this lease of
land as a finance lease - which means we would treat the land as if it had been purchased.
As always, it is important to examine the substance of the arrangement. Where significant risk
and rewards have passed, we must account for the lease as a finance one, even if this is
inconsistent with the legal nature of the transaction.
It is interesting to note that there are many who argued against this aspect of the standard on
the grounds that a lease over land, even one as long as 999 years, cannot be economically
similar to the purchase of land since the appreciation of the value of the land does not accrue
to the lessee at the end of the lease, capital appreciation being a critical aspect to ownership!
Example 2: Lease of land and buildings
We enter into a 999-year lease (as a lessee) over a property constituting land and a building.
The building has a useful life of 80 years. Ownership does not transfer to us at the end of the lease.
Required: Discuss the classification of the lease based purely on the information provided above.
Note that the classification of a lease combining land and buildings as either finance or operating
would not normally be restricted to the information above: all factors affecting the lease would need to
be considered (e.g. fair values versus present values of future minimum lease payments etcetera).
Solution 2: Lease of land and buildings

The building would be classified as a finance lease since the lease period more than covered a
major part of the economic life of the building (which was only 80 years), so thus the risks and
rewards of ownership were, in substance, transferred.
The land would be classified as a finance lease because the long period of the lease (999-years)
means that a significant portion of the risks and rewards are transferred to the lessee and thus the
substance is that the lessee owns the land. IAS 17-BC8B&C
Lease contracts generally do not indicate what portion of the lease instalments relates to the
building and what portion relates to the land. However, the minimum lease payments must be
allocated between the two elements in proportion to the relative fair values of the leasehold
interests in the land and the building elements, measured as at the lease inception date.
Chapter 16 757
If the lease of one of the elements (i.e. land or the building) is recognised as a finance lease,
then the portion of the lease payment relative to that element must be separated into:
a capital repayment of the fair value of the element at the start of the lease; and
a finance charge relative to the fair value of the element at the start of the lease.
If the lease of one of the elements is recognised as an operating lease then the portion of the
lease payment relative to that element is simply recognised as an:
operating lease expense, measured using the element’s fair value at the start of the lease.
If we are not able to reliably allocate the lease payments, the entire lease is classified as:
an operating lease if it is clear that both the land element and the building element are
operating leases; or
a finance lease if it is not clear that both the land element and the building element are
operating leases.
Example 3: Lease of land and buildings
Lessee Limited leased land and buildings from Lessor Limited, the detail of which follows:
The lease contract became effective on 1 January 20X3, and is for 20 years.
The annual lease payment is to be C500 000 per annum, in arrears.
At the inception of the lease, the fair value of the land is C5 000 000 whilst the fair
value of the building is C2 240 832.
At the conclusion of the agreement, the fair value of the land is expected to be
C5 000 000, whilst the building is expected to be zero (i.e. the building will be
depreciated over its remaining useful life of 20 years, to a residual value of zero).
The interest rate implicit is given at 3,293512%.
Ownership of both the land and building is expected to remain with Lessor Limited.
Required: Prepare the journal entries for 20X3 and for 20X4 in the lessee’s accounting records.
Solution 3: Lease of land and buildings
Step 1: Assess whether the lease over the land and buildings is a finance or operating lease – or
whether the land is an operating lease and the building a finance lease.
An assessment of the general criteria provided in IAS 17.10 to the lease of the land:
a) ownership of the land does not transfer to Lessee Limited at the end of the lease term
(IAS 17.10(a)), suggesting it is an operating lease;
b) there is no option to purchase the land at the end of the lease (IAS 17.10(b)), suggesting it is an
operating lease;
c) land has an indefinite useful life and therefore the 20 year lease period does not constitute a
major portion of the life of the asset (IAS 17.10 (c)), suggesting it is an operating lease;
d) the present value of the minimum lease payments of C345 264 (W1) for 20 years is C5 000 000
(n=20 i=3.293512 PMT=-345 264 comp PV) and is equal to the land’s fair value today,
suggesting it could be a finance lease; and
e) the land is not specialised such that only Lessee can use it, suggesting it is an operating lease.
On balance, Lessor Limited has not effectively transferred the risks and rewards of ownership of
the land to Lessee Limited and therefore the lease of the land is classified as an operating lease.
An assessment of the general criteria provided in IAS 17.10 to the lease of the building:
a) ownership of the building does not transfer to Lessee Limited at the end of the lease term
(IAS 17.10(a)), suggesting it is an operating lease;
b) there is no option to purchase the building at the end of the lease (IAS 17.10(b)), suggesting it is
an operating lease;
c) the lease period is 20 years, which is a major part (in this case, equal to) the useful life of the
building (IAS 17.10 (c)), suggesting it is a finance lease;
d) the present value of the minimum lease payments of C154 736 (W1) for 20 years is C2 240 832
(n=20 i=3.293512 PMT=-154 736 comp PV), which is equal to its fair value today (IAS
17.10(d), )), suggesting it is a finance lease; and
e) the building is not specialised so that only Lessee can use it, suggesting it is an operating lease.
On balance, however, Lessor has effectively transferred the risks and rewards of ownership of the
building to Lessee and therefore the lease of the building is classified as a finance lease.
758 Chapter 16

Step 2: Splitting the lease payment into operating and finance portions (working 1)
Split instalments as follows: FV of the land/ building
X Lease instalment
FV of the land + FV of the building
5 000 000
Land: X 500 000 = 345 264 (operating lease)
7 240 832
2 240 832
Buildings: X 500 000 = 154 736 (finance lease)
7 240 832
Step 3: Effective interest rate table: finance lease (building only)

Finance charges Finance lease Finance lease liability
3,293512 % instalment (pmt) outstanding at year end
A: C x 3,293512% B: Step 2 C: O/bal + A – B
01/01/20X3 2 240 832
31/12/20X3 73 802 (154 736) 2 159 898
31/12/20X4 71 137 (154 736) 2 076 299
31/12/20X5 68 383 (154 736) 1 989 946
... ...
853 888 (3 094 720)
Comment:
This effective interest rate table shows only the years relevant to the question.
The total payments would be 154 736 x 20 years = 3 094 720
Total interest over 20 years: 3 094 720 – original amt owed: 2 240 832 = 853 888
Journals:
Building: cost (A) 2 240 832
Finance lease (L) 2 240 832
Capitalisation of leased building at fair value
31/12/20X3
Finance costs (E) Step 3 73 802
Finance lease (L) 73 802
Finance costs incurred on lease in 20X3
Operating lease expense (E) Step 2 345 264
Finance lease (L) Step 2 154 736
Payment of lease instalment: apportioned based on fair values
Finance lease (L) 20X4 instalment: 154 736 – 83 599
Finance lease: current portion (L) 20X4 int: 71 137 (Step 3) 83 599
Current portion of finance lease liability
31/12/20X4
Finance lease: current portion (L) 83 599
Reversing the current portion of lease liability recognised at the end
of the prior year
Finance costs (E) Step 3 71 137
Finance costs incurred on lease in 20X3
Operating lease expense (E) Step 2 345 264
Finance lease (L) Step 2 154 736
Payment of lease instalment: apportioned based on fair values
Chapter 16 759

31/12/20X4 continued ... Debit Credit
Finance lease (L) 20X5 instalment: 154 736 – 86 353
Finance lease: current portion (L) 20X5 int: 68 383 (Step 3) 86 353
Current portion of finance lease liability
Comment: Remember that we must recognise the operating lease element on a straight line basis over
the terms of the lease. Due to the absence of escalation or similar clauses, the cash payments relating to
the operating lease are considered to be equal to the operating lease costs.
2.2.2 The rule applicable to leases of investment properties

The requirement to separately classify the lease over land and the lease over buildings where
the single lease agreement involves both land and buildings does not apply if the land and
buildings that are being leased are classified as investment property (i.e. in terms of IAS 40)
and are measured under the fair value model. See IAS 17.18
Furthermore, investment property (land and/or buildings) that is leased by a lessee under an
operating lease but which would otherwise meet the definition of investment property may be
recognised as investment property on condition that the lessee accounts for all its investment
property under IAS 40’s fair value model. This would mean that the lease of this property
would be recognised as if it were held under a finance lease, when in reality it was leased
under an operating lease. See IAS 40.6
2.3 Change in classification (IAS 17.13)
The classification of a lease is decided upon at the start of the Lease classifications may
lease. The classification should only be changed during the need to change if:
lease period if: a change in terms is agreed to
changes are made to the lease agreement that are agreed which would’ve changed initial
to by lessor and lessee; and these classification – cancel old lease,
changes would have altered the classification had they establish new lease; or
existed at inception. a correction of error.
NOT due to changes in estimates.
If such changes are made, the original lease is considered cancelled and the changed lease is
considered to be a brand new lease. Any change in classification is done prospectively.
Worked example 1: Change in the contract
If an 8-year lease, originally classified as an operating lease, was altered at the beginning of
year 4 such that ownership now passes to the lessee at the end of year 8, the lease will be re-
classified as a finance lease from the beginning of year 4. No changes are made to the classification of
the lease as an operating lease in the preceding 3 years.
The approach above does not apply to normal renewals and to changes in estimates, for
example changes in estimates of the useful life or the residual value of the leased property.
Worked example 2: Change in the estimated useful life
An 8-year lease was originally classified as an operating lease on the basis that the useful
life of the leased asset was 45 years. The remaining useful life of the asset was then re-
estimated to be 3 years, calculated from the beginning of year 6 (5 years past + 3 years remaining = 8
years useful life). This change in estimate results in the lease becoming a finance lease (on the basis
that the remaining lease period is for a major part of the remaining economic life of the asset) from
year 6 onwards (prospectively). Adjustments and disclosures would be those relating to a change in
estimate. No changes are made to the classification of the lease as an operating lease in the preceding
5 years, in other words, the prior year figures would not be restated.
The only exception would be if the original classification was incorrect and we were thus
correcting an error. If the error was material and occurred in the prior year, the correcting
adjustments would be made retrospectively, with prior years restated. See IAS8.41 - .49
760 Chapter 16
2.4 Arrangements containing leases (IFRIC 4) IFRIC 4 helps

us apply the
2.4.1 Overview
principle of
At the best of times, the reality (the substance) of a legal agreement substance over form:
can be extremely difficult to assess – and yet as accountants, we if the substance of the
always need to account for the substance rather than the legal form. terms of an agreement =
As a result, IFRIC 4 was introduced in order to provide guidance in a lease, IAS17 applies.
deciding whether or not an agreement constitutes a lease, because
quite often, an agreement is:
structured to resemble a lease when it is actually not a lease; or is
structured in such a way that it seems to not be a lease when, in reality, it really is a lease.
The essence of the IFRIC is that the agreement includes a lease if:
fulfilment of the agreement is dependent on the use of specified asset/s; and
the agreement gives the right to use that asset/s. IFRIC 4.6 (slightly reworded)
2.4.2 Right to use the specified asset (IFRIC 4.9)
Essentially, the right to use an asset is said to exist if the lessee is able to control how this
asset is used. We would conclude that an agreement has given the lessee the right to use an
asset if any of the following applies:
a) the purchaser (lessee) controls the operation of the asset; or
b) the purchaser has the ability/ right to control physical access to the asset; or
c) only the purchaser is likely to receive a significant amount of the asset’s output and the
purchaser is not required to pay a contractually fixed price per unit of output or a price
that is equal to the current market price at time of delivery.
2.4.3 Dependence on the use of the specified asset (IFRIC 4.7)
For an arrangement (or part thereof) to be accounted for as a lease, the arrangement must
specify an asset and the arrangement must be dependent on the use of that asset. In other
words, an arrangement must identify an asset/s, but the asset/s would not be considered to be
leased unless ‘fulfilment of the arrangement’ depends on the use of that specific asset.
For example, if a party to the arrangement must provide services but has both ‘the right and
ability’ to provide those services using assets other than those specified in the arrangement,
then fulfilment of the arrangement does not depend on the specified asset/s. An arrangement
such as this would thus not involve a lease.
The IFRIC clarifies that an arrangement may need to be accounted for as a lease even if the
arrangement includes a ‘warranty obligation that permits or requires the substitution of the
same or similar assets if and when the specified asset is not operating properly’.
It also clarifies that a clause in the contract that allows or requires a ‘supplier to substitute
other assets for any reason on or after a specified date’ would not prevent the arrangement
from being accounted for as a lease before this date.
2.4.4 There must be a specified asset: explicit or implicit (IFRIC 4.8)
An agreement may not necessarily explicitly require the use of a specified asset. Instead, the
agreement may implicitly require the use of a specified asset. In other words, an arrangement
may legally allow the use of any asset but the economic or practical reality may mean that
there is no choice but to use a specific asset.
For example, an arrangement implicitly requires the use of a specific asset if it allows the use
of any asset to fulfil the arrangement but the relevant party owns only one asset that it could
possibly use to fulfil the arrangement and does not have the economic resources to use, or is
not practically able to use, any alternative asset.
Chapter 16 761
2.4.5 If the arrangement contains a lease (IFRIC 4.12 - .15)
If we consider an arrangement to be, or to include a lease, we must apply IAS 17 to the costs
that relate to the lease; any other costs will be accounted for in terms of other standards. Thus
the total costs of the arrangement must be separated into the lease costs and other costs on
inception date based on their relative fair values on this date. If the lessee in the agreement
cannot easily determine the relative fair values, then if the agreement is :
an operating lease: all payments will be accounted for as lease payments, but we’ll need to
disclose the fact that some of these payments may possibly include ‘other costs’;
a finance lease: recognise a leased asset and liability based on the fair value of the
specified asset/s and thereafter, reduce the liability, by recognising interest on the liability,
calculated using the lessee’s incremental borrowing rate.
Summary: Does the arrangement contain a lease? (IFRIC 4)
2) Is the arrangement If YES to

1) Is there a right to use a If NO to any
dependent on the use of the both criteria
specified asset? criterion
specified asset? (1 & 2)
Any of the 3 criteria must be Explicitly Or implicitly IAS 17
IAS 17 applies
satisfied identified identified doesn’t apply
3. Finance Leases (IAS 17.20 - .32)
3.1 Recognition of a finance lease (IAS 17.20 - .24) Definitions relating

to finance leases:
Assuming the relevant definitions and recognition criteria are finance lease
met, a finance lease is recognised as: commencement of lease term
an asset; with a corresponding fair value
finance lease liability. minimum lease payments
Please revise – see section 1.
For example, the initial recognition journal over a plant under a finance lease would be:
Debit Credit
Plant: cost (A) (held under a finance lease) xxx
Finance lease (L) xxx
Recognition of finance lease over a plant
3.2 Measurement of a finance lease (IAS 17.20 - .30)

3.2.1 Initial measurement of a finance lease (IAS 17.20 - .24)
The initial measurement of the leased asset and the lease liability at the start of the lease (i.e.
commencement of the lease term) is the lower of:
the fair value of the asset and
the present value of the minimum lease payments. Initial measurement
of asset and liability is
at the lower of:
This present value must be calculated using:
the interest rate implicit in the lease; or the fair value of the leased
asset; and
the lessee’s incremental borrowing rate if the implicit rate
the present value of the
is impossible to calculate. minimum lease payments.
Remember, the implicit rate is a defined term, and essentially means the rate (established at
the start of the lease term) that would make the following two figures equal one another:
present value of: future minimum lease payments; and
fair value of the asset.
The lessee’s incremental borrowing rate is defined but is essentially the rate of interest that
you would have had to pay had you needed to raise a loan to buy the asset.
762 Chapter 16
The term minimum lease payments is also defined. From the perspective of a lessee (it means
something different when we’re talking about a lessor), it is essentially:
the payments enforced by the lease contract,
including any guaranteed residual value, and
excluding: - any unguaranteed residual value,
- contingent rent,
- costs for services, and
- certain taxes.
Any initial direct costs are added to the cost of the asset (e.g. cost of negotiating and securing
a particular lease). Thus the initial measurement of the asset would be greater than the initial
measurement of the liability if the lessee also incurred initial direct costs. The credit entry
would be bank or accounts payable depending on whether these costs have been paid or not.
A guaranteed residual value is the amount that the lessee guarantees the lessor that the leased
asset will be worth at the end of the lease period. If at the end of the lease period, the leased
asset is worth less than the guaranteed residual value, the lessee will have to pay the lessor the
difference between the guaranteed residual value and what the asset is actually finally worth.
It is interesting to note that the guarantee (and any payment related to possible loss in value)
can be made either by the lessee or by a related third party.
It is also important to note at this stage, that if we are guaranteeing that the asset will be worth
a certain amount at the end of the lease period, then logically we need to use this amount as
the residual value when calculating the depreciation on the leased asset.
It makes sense that the lessor has his own private view of what the asset will really be worth
at the end of the lease. In this regard, the unguaranteed residual value is the portion of the
amount that the lessor believes the asset will be worth at the end of the lease that has not been
guaranteed by the lessee or a related party to the lessee.
Unguaranteed residual values are generally not known by the lessee, which is why they are
ignored by the lessee when he recognises and measures his lease.
Example 4: Basic finance lease – initial measurement
Bitty Limited was in need of a new specialised machine that can only be obtained from
Design Limited. As Bitty Limited was experiencing cash flow shortages, they were forced
to negotiate a lease agreement with Design Limited.
Negotiating this lease cost Bitty Limited C20 000, paid in cash on 1 January 20X6.
The terms of the agreement are as follows:
Lease term: 4 years, commencing 1 January 20X6.
Lease payments, due annually in arrears, of C150 000 each, commencing 31 December 20X6.
Required: Show the initial journal assuming that the fair value of the machine on 1 January 20X6 was:
A. C480 000
B. C450 000 and the unguaranteed residual value is not being disclosed by the lessor. Had Bitty raised
a loan from the local bank to purchase the machine the marginal interest rate would have been 15%.
C. C480 000 and assuming that the lease agreement includes a C50 000 guaranteed residual value.
Solution 4: Basic finance lease – initial measurement

Step 1: Calculate the implicit rate (depending on your level of study, your institution may not require
you to be able to calculate this, in which case, you would have to be given this rate).
Remember that the implicit rate for a lessee takes into account all amounts that could possibly be paid
(with the exception of a few costs, for example, contingent rentals):
instalments: reflected by PMT (payment) on most financial calculators
residual values (guaranteed): reflected by FV (future value) on most financial calculators.
The implicit interest rate is the one that, over the period, makes the present value of these possible
amounts equal the fair value at the start of the lease:
period: reflected by N (number of periods) on most financial calculators
fair value (at start of lease): reflected by PV (present value) on most financial calculators.
Chapter 16 763
For part B it was impracticable to determine the implicit interest rate since the lessor is not willing to
disclose the unguaranteed residual value. In such cases, the incremental borrowing rate may then be
used to find the present value of the minimum lease payments. IAS 17.20
Please note: If you read the definition of the implicit interest rate carefully, you will see that it explains
that it is the rate that makes the ‘present value of the minimum lease payments plus unguaranteed
residual value’ equal the total of the ‘fair value of the leased asset plus the initial direct costs incurred
by the lessor’. However, in this example, the initial direct costs of C20 000 were incurred by the lessee
and are thus ignored when calculating the implicit interest rate.
Calculation of the implicit interest rate Ex 4A Ex 4B Ex 4C

Not required
PMTS (lease instalments) Minimum : (150 000) N/A (150 000)
FV (residual value – guaranteed) lease : 0 N/A (50 000)
N (number of instalments) payments : 4 N/A 4
PV (the fair value at the start of the lease) : 480 000 N/A 480 000
Comp i And you should get the answer of ... : 9,5642% N/A 12,6962%
Step 2: Calculate the present value of the minimum lease payments (PV of MLP)
Calculation of the PV of the MLPs Ex 4A Ex 4B Ex 4C
Minimum lease payments Note 1
Instalments (PMT) : 150 000 150 000 150 000
Guaranteed residual value (FV) : 0 0 50 000
Number of instalments (N) : 4 4 4
Implicit interest rate (i) Per Step 1 : 9.5642% 15% 12.6962%
Present value (Comp: PV) : 480 000 428 247 480 000
Note 1: Notice that when calculating the PV, unguaranteed residual values are ignored by lessees.
Step 3: Calculate the initial measurement of the finance lease liability

Compare the present values (step 2) with the fair values (given) and choose the lower:
Initial measurement of lease liability Ex 4A Ex 4B Ex 4C
Present value of minimum lease payments Per step 2 480 000 428 247 480 000
Fair value Given 480 000 450 000 480 000
The lower of the above Note 2 480 000 428 247 480 000
Note 2: The present value would be lower than the fair value if there was an unguaranteed residual
value – this could apply in the case of a lessor.
Step 4: Process your journal entries – recognition and initial measurement

Ex 4A Ex 4B Ex 4C
1/1/20X6 Dr/(Cr) Dr/(Cr) Dr/(Cr)
Machine: cost (A) Note 3 480 000 428 247 480 000
Finance lease (L) Step 3 (480 000) (428 247) (480 000)
Capitalisation of leased asset and related liability
Machine: cost (A) Note 3 20 000 20 000 20 000
Bank/ creditor (A/L) Given (20 000) (20 000) (20 000)
Capitalisation of initial direct costs
Note 3: See how the machine ends up capitalised at a higher amount (500 000 = 480 000 + 20 000)
than the finance lease liability (480 000) since the initial direct costs are capitalised to the leased asset.
3.2.2 Subsequent measurement of a finance lease (IAS 17.25 - .30)

The bookkeeping relating to finance leases normally involves the following basic journals:
Initial journal: Jnl 1. Dr Asset: cost (capitalised lease asset)
Cr Finance lease (L)
764 Chapter 16
Subsequent journals: Jnl 2. Dr Finance charges (expense)

Cr Finance lease (L)
Dr Finance lease (L)
Cr Bank
Jnl 3. Dr Depreciation (expense)
Cr Asset: accumulated depreciation
Jnl 4. Dr Finance lease (L)
Cr Finance lease: current portion (L)
Journal entry 1
At the commencement of the lease term, a lessee shall record a finance lease by recognising
an asset and a corresponding liability, in its statement of financial position. The measurement
of this journal is what we refer to as initial measurement and was explained in 3.2.1 above.
Journal entry 2
The minimum lease payments (credit ‘bank’) are apportioned between the finance charge
expense (debit) and the reduction of the liability (debit). Or this can be done as two journals:
first recognise the finance charges owing for the period (debit expense and credit liability);
then recognise the instalments paid (debit liability and credit bank).
The finance charge is calculated by multiplying the remaining balance in the liability account
by an interest rate that will be constant over the period of the lease and which will result in the
opening balance of the lease liability gradually reducing to nil by the end of the lease period.
Please note that even if an instalment is not due to be paid during a particular period, the
finance charges owed on the lease liability must still be recognised.
Journal entry 3
Since an asset has been recognised (journal entry 1), the asset must be measured using the
relevant IAS. If, for example, it is a leased machine, then the machine would be measured
under the cost or revaluation model (IAS16).
The depreciation expense must be measured based on the depreciation policy of the lessee but
the following should be borne in mind:
if there is reasonable certainty that the lessee will obtain ownership by the end of the lease
term, the leased asset is depreciated over its expected useful life;
if, however, there is no reasonable certainty that the lessee will obtain ownership by the
end of the lease term, the leased asset shall be fully depreciated over the shorter of
- the lease term;
- and its useful life; IAS 17.27
if there is a guaranteed residual value (i.e. the lessee has promised that the asset will be
worth a certain amount at the end of the lease period), this should be used as the residual
value in the calculation of depreciation.
Journal entry 4
In accordance with IAS 1, paragraph 61, the amount expected to be settled within twelve
months after reporting date is presented separately as a current liability. This is measured as
the amount of the instalment/s due within the next 12 months less the interest that would have
accrued between reporting date and the date of this instalment/s.
This is best illustrated with an example.
Example 5: Basic finance lease – subsequent measurement

Use the same information as was provided in example 4. The machine is depreciated on the
straight-line basis over its useful life of 4 years to a nil residual value.
Required: Prepare the effective interest rate tables and the remaining journals that would be required
for the year ended 31 December 20X6 for each of part A, part B and part C of the previous example 4.
Chapter 16 765
Solution 5: Basic finance lease – subsequent measurement

Comment:
Example 4 showed how to recognise and measure the lease transaction at the start of the lease
(recognition and initial measurement) – in other words, it shows journal 1 referred to above.
Example 5 now shows how to process the journal relating to the subsequent measurement of the
lease liability – in other words, journal 2, referred to above.
The effective interest rate table is calculated using an interest rate that allocates the payments
between the finance charges incurred and repayment of the liability, in a way that results in a
constant periodic rate of interest. This is the implicit interest rate calculated in step 1 of example 4.
Also notice how, in each case, the total instalments paid less the opening liability balance equals the
total of the interest charged.
Step 5 (continues from example 4): Effective interest rate table (EIRT): finance lease
Ex Interest:
5A: Date 9.5642% Instalment Balance
(a): o/b x int rate (b) O/bal + (a) – (b)
01 January 20X6 480 000 FV
31 December 20X6 45 908 (150 000) 375 908
31 December 20X7 35 953 (150 000) 261 861
31 December 20X8 25 045 (150 000) 136 906
31 December 20X9 13 094 (150 000) 0
120 000 (600 000)
Notice: instalments of 600 000 – opening balance of 480 000 = interest of 120 000
Ex Interest: 15% Instalment Balance

Date
5B: (a): o/b x int rate (b) O/bal + (a) – (b)
PV
01 January 20X6 428 247 MLP*
31 December 20X6 64 237 (150 000) 342 484
31 December 20X7 51 373 (150 000) 243 857
31 December 20X8 36 579 (150 000) 130 436
31 December 20X9 19 565 (150 000) 0**
171 754 (600 000)
Notice: instalments of 600 000 – opening balance of 428 247 = interest of 171 754
*Recognise at the lower of fair value (C450 000) or PV of MLP (C428 247)
**Rounding error of C1
Ex Interest:
5C: Date 12.6962% Instalment Balance
(a): o/b x int rate (b) O/bal + (a) – (b)
01 January 20X6 480 000 FV
31 December 20X6 60 942 (150 000) 390 942
31 December 20X7 49 635 (150 000) 290 577
31 December 20X8 36 892 (150 000) 177 469
31 December 20X9 22 531 *(200 000) 0
170 000 (650 000)
* 150 000 + 50 000 (guaranteed residual value) = 200 000 (the residual value is included in the EIRT
since it is guaranteed). The 50 000 is either paid by handing back an asset to the value of C50 000, or
if it has become worthless or the lessee chooses to keep it, then C50 000 will have to be paid in cash.
Step 6: Journalise – subsequent measurement (journals 2, 3 and 4)
Ex 5A Ex 5B Ex 5C
31/12/20X6 Dr/(Cr) Dr/(Cr) Dr/(Cr)
Finance costs (E) Step 5 45 908 64 237 60 942
Finance lease (L) The cr & dr can be (45 908) (64 237) (60 942)
Finance lease (L) combined into a net debit 150 000 150 000 150 000
Bank (A) Given (150 000) (150 000) (150 000)
Interest accruing on lease to year-end and payment of lease
instalment – presented as two entries to the liability account
Finance lease (L) See calculations (d) – (f) 114 047 98 627 100 365
Finance lease: current portion (L) below (114 047) (98 627) (100 365)
Current portion of finance lease to be presented separately
766 Chapter 16

Step 6: Journals continued ...
Ex 5A Ex 5B Ex 5C
31/12/20X6 continued ... Dr/(Cr) Dr/(Cr) Dr/(Cr)
Depreciation (E) See calculations (a) – (c) 125 000 112 062 112 500
Machine: acc depr (-A) (125 000) (112 062) (112
500)
Subsequent measurement of leased asset: depreciation
31/12/20X7
Finance lease (L) Balancing: bank – finance costs 114 047 98 627 100 365
Bank (A) Given (150 000) (150 000) (150 000)
instalment – presented as one entry to the liability account
Finance lease: current portion (L) See the previous related jnl 114 047 98 627 100 365
Finance lease (L) or see calculations (d) – (f) (114 047) (98 627) (100 365)
Reversal: current portion of finance lease in prior year
Finance lease: current portion (L) (124 955) (113 421) (113 108)
Machine: acc depr (-A) (125 000) (112 062) (112 500)
31/12/20X8
Bank (-A) Given (150 000) (150 000) (150 000)
Finance lease: current portion (L) See the previous related jnl 124 955 113 421 113 108
Finance lease (L) or see calculations (d) – (f) (124 955) (113 421) (113 108)
Finance lease: current portion (L) (136 906) (130 435) (127 469)
31/12/20X9
Bank (A) Given (150 000) (150 000) (150 000)
Finance lease: current portion (L) See the prior related jnl or 136 906 130 435 127 469
Finance lease (L) see calculations (d) – (f) (136 906) (130 435) (127 469)
Depreciation (E) 125 000 112 062 112 500
Machine: acc depr (-A) See calculations (g) – (i) 500 000 448 247 450 000
Machine: cost (A) See calculations (g) – (i) (500 000) (448 247) (500 000)
Finance lease (L) 0 0 50 000
Return of leased asset
Chapter 16 767

Calculations:
a) 5A: (480 000 + 20 000 – 0)/ 4 years x 12/12 = 125 000
b) 5B: (428 247 + 20 000 – 0)/ 4 years x 12/12 = 112 062
c) 5C: (480 000 + 20 000 – 50 000)/ 4 years x 12/12 = 112 500
d) 5A: Instalment due within 12 months: Less: interest accrued to this date: Current portion of lease liability
31/12/20X6 150 000 35 953 See Ex 5A’s effective 114 047
31/12/20X7 150 000 25 045 interest rate table 124 955
31/12/20X8 150 000 13 094 (step 5) 136 906
e) 5B: Instalment due within 12 months: Less: interest accrued to this date: Current portion of lease liability
31/12/20X6 150 000 51 373 See Ex 5B’s effective 98 627
31/12/20X8 150 000 19 565 (step 5) 130 435
f) 5C: Instalment due within 12 months: Less: interest accrued to this date: Current portion of lease liability
31/12/20X6 150 000 49 635 See Ex 5C’s effective 100 365
31/12/20X8 150 000 22 531 (step 5) 127 469
g) 5A: Cost = 480 000 + 20 000 (per Ex 4A) = 500 000 & Accum depreciation: 125 000 x 4 years = 500 000
h) 5B: Cost = 428 247 + 20 000 (per Ex 4B) = 448 247 & Accum depreciation: 112 062 x 4 years = 448 247
i) 5C: Cost = 480 000 + 20 000 (per Ex 4C) = 500 000 & Accum depreciation: 112 500 x 4 years = 450 000
3.3 Other measurement issues relating to a finance lease
Finance charges must be recognised for as long as the related liability exists. If the entity
had a lease liability for 3 months in the accounting period, then there must be 3 months
worth of finance charges. If the finance charges haven’t been paid, it must simply be
classified as a current liability (accrued).
If the lease instalments are payable in advance, then the first instalment has no finance
charges component. The entire instalment is deducted from the balance owing.
Normally the interest rate given is an annual rate. If there is more than one instalment per
year then the annual rate must be divided by the number of instalments per financial year
in order to arrive at the rate to be used in the amortisation table.
Summary: Measurement of a finance lease (with no tax)

Initial measurement:
- Measure the leased asset and lease liability at lower of:
o FV of asset and
o PV of minimum lease payments at beginning of the lease
- PV calculated using implicit interest rate/ lessee’s incremental borrowing rate
Subsequent measurement:
- Depreciate asset
- Minimum lease payments to be apportioned between finance charges and reduction of outstanding liability
so that there is a constant periodic rate of interest on the O/S balance (i.e. use an EIR table)
- If advance pmts: in EIR table, deduct pmt the beg of period; calculate interest on adjusted beg balance
- If arrear pmts: in EIR table, deduct pmt at the end of period, calculate interest on beginning balance
Example 6: Financial period does not coincide with lease period: arrear vs advance
An asset with a fair value of C200 000 (equal to the present value of the future minimum lease
payments) is leased over a period of 4 years.
The asset is depreciated over 4 years to a nil residual value.
Four annual instalments of C71 475 are payable in arrears.
The discount rate (interest rate implicit) is 16% per annum.
The lease commenced on 1 March 20X5. The first instalment is payable on 28 February 20X6.
768 Chapter 16
Required: Draft the journals for the year ended 31 December 20X5 and 31 December 20X6:
A. using the information above.
B. assuming that the four instalments of C71 475 are payable in advance (not arrears) as follows:
three annual instalments of C71 475, first instalment due on 1 March 20X5; and
a final instalment of C21 526, payable on 1 March 20X8.
Solution 6: Financial period does not coincide with lease period: arrear versus advance
Comment: In this example, the year-end precedes the first instalment payment. The 20X5 implication
is that there must be an accrual of finance charges as the lease has been in existence for 10 months.
20X5 JOURNALS Ex 6A Ex 6B
Asset: cost Fair value (PV = FV: given) 200 000 200 000
Finance lease (L) (200 000) (200 000)
Capitalisation of leased asset and raising of corresponding liability
Finance lease (L) A: Not applicable 71 475
N/A
Bank (A) B: Given: (71 475)
Payment of instalment ( Note that no interest is provided for)
31/12/20X5
Finance charges (E) A: 32 000 (W1) x 10/12months 26 667 17 137
Finance lease (L) B: 20 564 (W2) x 10/12 months (26 667) (17 137)
Finance charges incurred (1 March 20X5 to 31 December 20X5
Finance lease (L) A: 71 475– 32 000 x 2/12 (W1) 66 142 68 048
Finance lease: current portion (L) B:71 475 – 20 564 x 2/12 (W2) (66 142) (68 048)
Transfer of current portion of liability: instalment due in next 12 months
less interest accruing in next year to date of that instalment
Depreciation (E) (200 000 – 0)/ 4yrs x 10/12 41 667 41 667
Asset: accumulated depreciation (-A) (41 667) (41 667)
Depreciation charged over 4 years
20X6 JOURNALS
01/01/20X6
Finance lease: current portion (L) 66 142 68 048
Finance lease (L) (66 142) (68 048)
Reversing current portion of finance lease raised at end of prior year
28/02/20X6 (A) or 01/03/20X6 (B)
Finance charges (E) A: 32 000 (W1) x 2/12 5 333 3 427
Finance lease (L) B: 20 564 (W2) x 2/12 (5 333) (3 427)
Finance charges incurred for January and February 20X6
Finance lease (L) 71 475 71 475
Bank (A) (71 475) (71 475)
Payment of instalment on 28 February 20X6 (A) or 1 March 20X6 (B)
31/12/20X6
Finance charges (E) A: 25 684 (W1) x 10/12 21 403 10 348
Finance lease (L) B: 12 418 (W2) x 10/12 (21 403) (10 348)
Finance charges incurred from 1 March 20X6 to 31 December 20X6
Finance lease (L) A: 71 475 – 25 684 x 2/12 (W1) 67 194 69 405
Finance lease: current portion (L) B:71 475 – 12 418 x 2/12 (W2) (67 194) (69 405)
Transfer of current portion of liability: instalment due in next 12 months
less interest accruing in next year to date of that instalment
Depreciation (E) (200 000 – 0)/ 4yrs x 12/12months 50 000 50 000
Asset: accumulated depreciation (-A) (50 000) (50 000)
Depreciation charged over 4 years
Chapter 16 769
W1: Part A ONLY: Effective interest rate table: finance lease: arrear instalments
Interest: 16% Instalment Balance
Date (a): o/b x int rate (b) O/bal + (a) – (b)
01/3/20X5 200 000
28/2/20X6 32 000 (71 475) 160 525
28/2/20X7 25 684 (71 475) 114 734
28/2/20X8 18 357 (71 475) 61 616
28/2/20X9 9 859 (71 475) 0
85 900 (285 900)
Comment re arrear instalments: From the above payment schedule, it can be seen that there is no
actual payment in 20X5 as the first instalment only occurs on 28 February 20X6.
W2: Part B ONLY: Effective interest rate table: finance lease: advance instalments
Interest: 16% Instalment Balance
Date (a): o/b x int rate (b) O/bal + (a) – (b)
01/03/20X5 200 000
01/03/20X5 (71 475) 128 525
28/02/20X6 20 564 149 089
01/03/20X6 (71 475) 77 614
28/02/20X7 12 418 0 90 032
01/03/20X7 (71 475) 18 557
28/02/20X8 2 969 21 526
01/03/20X8 (21 526)
35 951 (235 951)
Comment regarding advance instalments: The lease commencement date coincides with the first
instalment payable (advance). The 20X5 implications are:
The first instalment is deducted in full from the capital balance owing. The interest in 20X5 is
therefore based on a lower opening carrying amount than in Part A.
The second instalment of C71 475 will only be paid in 20X6. Since it will be paid after 2 months
into our 20X6 financial year, this payment will include 2 months of interest that only accrues in
20X6. When working out how much of our liability at the end of 20X5 will be payable in 20X6,
it will be this instalment less the 2 months of interest that only accrues in 20X6.
3.4 Tax implications of a finance lease – income tax only (no transaction tax)
Finance leases generally cause deferred tax since most tax For tax purposes,
authorities treat all leases as operating leases for tax purposes the lessee doesn’t
(i.e. they do not differentiate between finance and operating own the asset:
leases). Since the tax authorities do not recognise the substance asset: nil tax base
of a finance lease (i.e. the “sale”), they still view the asset as liability: nil tax base
belonging to the lessor and not the lessee with the result that the (exception: where there is
VAT – see later...)
lessee is not allowed to deduct a capital allowance (e.g. wear and
tear) against taxable profit (this is given to the lessor), but instead, is allowed to deduct the
lease instalments when they are paid.
This causes a temporary difference since the lessee is deducting depreciation and interest
when calculating profit or loss, whereas the tax authorities are deducting the payment of the
lease instalments instead.
Example 7: Finance lease with tax– income tax only (no VAT)
Dave Limited leases equipment with a cash cost of C748 000 (i.e. fair value) from Maeve
Limited in terms of a finance lease agreement. The terms of the lease are as follows:
The lease begins on 1 January 20X5.
There are 6 instalments of C166 744 each, paid annually in arrears (i.e. on 31 December).
The discount rate (interest rate implicit) is 9%.
Dave Limited depreciates equipment at 25% per annum on the straight-line basis to a nil residual value.
770 Chapter 16
The following tax-related information now also applies:

Profit before tax and before any adjustments is C800 000 (there are no differences between accounting
profit and taxable profit other than those evident in the question);
The local tax authority treats this lease as an operating lease and therefore only allows the lease
instalment as a deduction when paid;
No VAT is included in the lease (Maeve Limited does not charge VAT).
Required: Prepare the journals for the year ended 31 December 20X5 in Dave Limited’s books:
A. For the information provided above.
B. Assuming that the lease was entered into on 1 March 20X5 (not on 1 January 20X5) and thus that the
first instalment will be payable on 28 February 20X6 (not on 31 December 20X5).
Solution 7: Finance lease with tax – income tax only (no VAT)
Ex 7A Ex 7B
01/01/20X5 Dr/ (Cr) Dr/ (Cr)
Equipment: cost (A) 748 000 748 000
Finance lease (L) (748 000) (748 000)
Capitalisation of leased asset and corresponding liability
31/12/20X5
Finance charges (E) A:748 000 x 9% x 12/12 67 320 56 100
Finance lease (L) B: 748 000 x 9% x 10/12 (67 320) (56 100)
Interest payable on the lease to year-end, measured using EIRT (W1)
Finance lease (L) A: Given 166 744 N/A
Bank (A) B: 1st instalment only paid in 20X6 (166 744) N/A
Payment of instalment
Finance lease (L) A: W1: 166 744 – 58 372 108 372 155 524
Finance lease: current portion (L) B: W1: 166 744 – 67 320 x 2/12 (108 372) (155 524)
Transfer of current portion of liability – i.e. the portion of the liability
balance at year-end that will be paid within the next 12 months (i.e.
instalments due in next 12 months – interest accrued in next 12m)
Depreciation – equipment (E) A: (748 000 – RV: 0) x 25% x 12/12 187 000 155 833
Equip: accumulated. depr (-A) B: (748 000 – RV: 0) x 25% x 10/12 (187 000) (155 833)
Depreciation on equipment:
Income tax (E) W2 189 977 240 000
Current tax payable: income tax (L) (189 977) (240 000)
Current tax payable for the year
Deferred tax: income tax (A) W3 26 273 63 580
Income tax (E) (26 273) (63 580)
Deferred tax asset arising on the finance lease
W1: Effective interest rate table: finance lease

Date Interest (9%) Instalment Liability balance
Beginning of year 1 748 000
End of year 1 67 320 (166 744) 648 576
End of year 2 58 372 (166 744) 540 204
End of year 3 48 618 (166 744) 422 078
End of year 4 37 987 (166 744) 293 321
End of year 5 26 399 (166 744) 152 976
End of year 6 13 768 (166 744) 0
252 464 (1 000 464)
Chapter 16 771
W2: Current income taxation Ex 7A Ex 7B

Profit before depreciation and finance charges Given 800 000 800 000
Depreciation Per jnl (187 000) (155 833)
Finance charges Per jnl (67 320) (56 100)
Temporary differences:
Add back: depreciation Per jnl 187 000 155 833
Add back: finance charges Per jnl 67 320 56 100
Less: lease instalment paid A: Given B: 1st instalment not yet paid (166 744) (0)
Current income tax payable Taxable profit x 30% 189 977 240 000
Comment: The profit before tax could have been given after it had been adjusted for the lease
transaction in which case depreciation and finance charges would not still need to be subtracted.
W3.1: Deferred tax calculation – Part A only

Capitalised finance lease CA TB TD DT
Balance: 1/1/20X5 0 0 0 0
Leased asset: 0(1) 0(4) 0 0
Lease liability: 0(1) 0(4) 0 0
Balancing: 0 – 26 273
Adjustment (dr deferred tax, cr tax expense)
26 273
Balance: 31/12/20X5 (87 576) 0 87 576 26 273 A

Leased asset: 561 000(2) 0(4) (561 000) (168 300) L
Lease liability: (648 576) (3) 0(4) 648 576 194 573 A
1) CA on 01/01/20X5: Nil: the lease was not in existence at the end of 20X4.
2) CA on 31/12/20X5: Leased asset: cost: 748 000 – acc depreciation: 187 000 = 561 000
3) CA on 31/12/20X5: Lease liability: from effective interest rate table = 648 576
4) The TB of the asset is the amount allowed as a deduction in the future which will amount to nil given that
the tax authorities will not allow any deductions relating to the purchase of the asset (he does not believe
you own the asset but rather that you are simply renting an asset).
5) The TB of the liability is its CA (648 576) less the amount allowed as a deduction in the future. Since the
tax authority will not deny you any of the instalments, the full CA will be allowed as a deduction and
therefore the TB = CA: 648 579 – Portion of CA allowed as a deduction in future: 648 579 = 0
Note: there were no VAT implications – to see VAT implications please see example 8.
W3.2: Deferred tax calculation – Part B only

Capitalised finance lease CA TB TD DT
Balance: 1/1/20X5 0 0 0 0
Leased asset: 0(1) 0(4) 0 0
Lease liability: 0(1) 0(4) 0 0
Balancing: 0 – 63 580
Adjustment (dr deferred tax, cr tax expense)
63 580
Balance: 31/12/20X5 (211 933) 0 211 933 63 580 A

Leased asset: 592 167(2) 0(4) (592 167) L
Lease liability: (804 100) (3) 0(4) 804 100 A
1) CA on 01/01/20X5: Leased asset & liability: Nil: the lease did not exist at the end of 20X4.
2) CA on 31/12/20X5: Leased asset: cost: 748 000 – acc depreciation: 155 833 = 592 167
3) CA on 31/12/20X5: Lease liability: Because the year-end does not coincide with the annual lease periods,
you cannot pick this figure off directly from effective interest rate table, thus we calculate it: 748 000 +
interest accrued: 67 320 x 10/12 – instalment paid to date: nil = 804 100
4) The TB of the asset: is the amount deductible in the future. This will be nil given that the tax authorities
will not allow any deductions relating to the purchase of the asset (he does not believe you own the asset
but rather that you are simply renting an asset).
5) The TB for a liability: is its CA (804 100) less the amount allowed as a deduction in the future. Since the
tax authority allows the deduction of the instalments, the full CA will be deductible and thus the TB is: CA:
804 100 – Portion of CA allowed as a deduction in future: 804 100 = 0
772 Chapter 16
3.5 Tax implications of a finance lease –income tax with transaction tax
Transaction tax (e.g. VAT) in a finance lease has certain implications for the accountant:
the leased asset is capitalised at its cost, (which is exclusive of VAT if it can be claimed
back, or inclusive of VAT if not reclaimable).
the lease liability reflects the full lease instalments owing, including VAT (i.e. lower of
present value of minimum lease payments including VAT or fair value including VAT).
CA/TB with VAT notice
Most tax authorities treat the finance lease as if it were an effect of VAT being
claimable / not claimable:
operating lease, in which case:
asset:
the tax base of the leased asset is zero: Remember - CA = incl VAT if claimable,
that the tax base of an asset represents the future - CA = excl VAT if not claimable
- TB = nil
deductions that will be granted on the asset: most tax liability:
authorities deduct the lease rentals, rather than - CA = incl VAT
allowing deductions the cost of a leased asset, in - TB = if VAT claimable: (total
which case the tax base is zero. unpaid/ total instalments) x
total VAT
the tax base of the lease liability represents the VAT - TB = if VAT not claimable: nil
included in the carrying amount of the liability: This
is because the tax base of a liability is the portion of the carrying amount that the tax
authority will not allow as a deduction: since the carrying amount of the lease liability
represents the full lease instalments owing and the tax authority allows the deduction of
the lease instalments paid but does not allow the deduction of the VAT included in the
instalments, the tax base of the liability represents the VAT that is included in the
liability’s carrying amount since this will not be allowed as a deduction
Since the tax authorities allow the deduction of the instalments excluding VAT (if the VAT is
allowed to be claimed), the tax base equals the portion of the liability representing VAT. On
transaction date, the tax base represents the entire VAT portion. This tax base then gradually
decreases to nil over the lease period, in proportion to the payments paid (i.e. notional VAT):
In the current income tax calculation:
The part of the payment allowed as a deduction by the tax authority is calculated as:
Instalment – (Total VAT x This instalment / Total instalments)
In the deferred income tax calculation:
The tax base is calculated as follows:
Total VAT in the lease liability x Remaining instalments / Total instalments
In some cases, tax authorities do not allow the VAT to be claimed back by the lessee (the
acquiring company). This is the case in South Africa where, for example, the lessee is not a
VAT vendor, or the lessee is acquiring a passenger motor vehicle.
Example 8: Basic finance lease with VAT

An entity leases (as the lessee) an asset, with a cash cost of C57 000 (including VAT).
The lease agreement is for 4 years, and requires annual arrear lease payments of C17 982.
The lease is a finance lease.
Required:
A. Journalise the initial capitalisation of the leased asset and lease liability.
B. Calculate the lease liability’s tax base for each year of the lease term.
Solution 8A: Basic finance lease with VAT – journals

Journal: Year 1 Debit Credit
Asset: cost 57 000 X 100/114 (cash cost – VAT) 50 000
VAT account (input VAT) 7 000
Finance lease (L) (cash cost including VAT) 57 000
Recognising the leased asset, the VAT input asset and the liability
Chapter 16 773
Solution 8B: Basic finance lease with VAT – tax base

Calculation of the lease liability’s tax base C
Beginning of year 1 57 000 x 14/114 7 000
Movement (1 750)
End of year 1 [(17 982 x 3 years) / (17 982 x 4 years)] x 7 000 5 250
Movement (1 750)
Movement (1 750)
Movement (1 750)
End of year 4 [(17 982 x 0 years) / (17 982 x 4 years)] x 7 000 0
Comment: In the case of a VAT vendor:
the liability tax base is: (Total instalments still to be paid / total instalments) x VAT
the true cost of the asset is the purchase price less the VAT which may be claimed back from SARS .
Example 9: Finance lease with tax and VAT

V Limited, which has a 31 December year end, entered into a finance lease agreement over
a machine on 1 January 20X1, as the lessee:
Finance charges at 10% Payments Liability
01 Jan 20X1 114 000 Incl VAT at 14%
31 Dec 20X1 11 400 (35 964) 89 436
31 Dec 20X2 8 944 (35 964) 62 416
31 Dec 20X3 6 242 (35 964) 32 693
31 Dec 20X4 3 269 (35 964) 0
(143 856)
The profit before tax is C200 000 after taking into account the finance lease.
V Limited depreciates the machine over the lease term to a nil residual value.
There are no other temporary differences, no exempt income and no non-deductible expenses.
Required: Prepare the current and deferred income tax journals for V Limited for all 4 years.
Solution 9: Finance lease with tax and VAT

Comment: Notice how the introduction of VAT now creates a tax base for the liability (W2). Compare
this to example 7 where VAT was ignored and the tax base was therefore nil.
There are a number of ways in which the tax authorities may deal with the VAT. The tax base of the
asset and liability depend entirely on the relevant tax legislation
Journals: 20X1 20X2 20X3 20X4
31 December Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Income tax expense(E) W1 61 181 60 444 59 633 58 742
Current tax payable: income tax (L) (61 181) (60 444) (59 633) (58 742)
Current income tax payable
Deferred tax: income tax (A) W3 1 181 444 (367) (1 258)
Income tax expense (E) (1 181) (444) 367 1 258
Deferred income tax
W1: Current income tax 20X1 20X2 20X3 20X4
Finance charges 11 400 8 944 6 242 3 269
Depreciation (a) 25 000 25 000 25 000 25 000
Lease payments (b) (32 464) (32 464) (32 464) (32 464)
Taxable profit 203 936 201 480 198 778 195 805
Current tax (30%) 61 181 60 444 59 633 58 742
(a) Depreciation: (114 000 x 100 / 114 – RV: 0) / 4 years x 12/12 = 25 000
(b) Tax deduction: Lease payment – proportional amount of VAT
= 35 964 – (114 000 x 14 / 114 x 35 964 / 143 856) = 35 964 – 3 500 per year = 32 464
774 Chapter 16

W2: Liability tax base working:
1/1/20X1: 114 000 X 14/114 = 14 000

31/12/20X1: [(35 964 X 3) / (35 964 X4)] X 14 000 = 10 500
31/12/20X2: [(35 964 X 2) / (35 964 X4)] X 14 000 = 7 000
31/12/20X3: [(35 964 X 1) / (35 964 X4)] X 14 000 = 3 500
31/12/20X4: [(35 964 X 0) / (35 964 X4)] X 14 000 = 0
W3: Deferred tax CA TB TD DT

Balance: 1/1/20X1 (0) (0) 0 0
Asset: 0 0
Liability: (0) (0)
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 1 181
Balance: 31/12/20X1 (14 436) (10 500) 3 936 1 181 A
Asset: 75 000 0
Liability: (89 436) (10 500) W2
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 444
Balance: 31/12/20X2 (12 416) (7 000) 5 416 1 625 A
Asset: 50 000 0
Liability: (62 416) (7 000) W2
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (367)
Balance: 31/12/20X3 (7 693) (3 500) 4 193 1 258 A
Asset: 25 000 0
Liability (32 693) (3 500) W2
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (1 258)
Balance: 31/12/20X4 0 0 0 0
Asset: 0 0
Liability: 0 0 W2
Note 1:
The direction and amount of the journal are balancing (DT: opening balance – closing balance)
Summary: Finance lease including effects of income tax and VAT
Step 1: Initial Journal Step 4: Non-current liab vs. current liab

Dr Asset : Balancing CL: next year’s payment – next year’s interest
Dr VAT input : 14/ 114 x cash sale value NCL: closing balance on EIRT – current liability
(if claimable) Including: VAT, Step 5: Current income tax calculation
Excluding: finance charges
Profit before tax before adjusting for the lease
Cr Lease liability : Lower of FV including VAT or Less: Depreciation
PV of MLP including VAT Less: Finance costs
= Profit before tax (adjusted)
Step 2: Lease Schedule (EIRTable)
Add: Depreciation
Use the following headings: Add: Finance costs
Less: Lease payment net of VAT
Date Interest Instalment C/balance
payment - total VAT x value of instalment
Step 3: Depreciation total instalments
a) Transfer of ownership reasonably certain: =Taxable profit
cost (excl VAT if claimable, incl VAT if not x Tax rate
claimable) ÷ asset useful life =Current income tax
b) Transfer of ownership not reasonably certain: Step 6: Deferred income tax calculation
depreciate over shorter of useful life of asset or CA TB TD DT
lease term XX/(XX) (XX) XX/(XX) A/L
c) If there is a guaranteed residual value: CA = Asset carrying amount – Liability carrying
The guaranteed residual value in the lease amount (c/balance per the schedule)
contract must be the residual value for TB = Total unpaid instalments ÷ Total instalments
depreciation purposes x Total VAT
Chapter 16 775
3.6 Disclosure of a finance lease (IAS 17.31)

Lessees shall make the following disclosures for its finance leases (extract from IAS 17.31):
a) for each class of asset, the net carrying amount at the end of the reporting period;
b) a reconciliation between the total of future minimum lease payments at the end of the
reporting period, and their present value. In addition, an entity shall disclose this
reconciliation for each of the following periods separately:
not later than one year;
later than one year and not later than five years; and
later than five years;
c) contingent rents recognised as an expense in the period;
d) the total of future minimum sublease payments expected to be received under non-
cancellable subleases at the end of the reporting period;
e) a general description of the lessee’s material leasing arrangements including, but not
limited to, the following:
the basis on which contingent rent payable is determined;
the existence and terms of renewal or purchase options and escalation clauses; and
restrictions imposed by lease arrangements, such as those concerning dividends,
additional debt and further leasing. IAS 17.31
Please note that a lease arrangement would also be subject to the disclosure requirements laid
out in IFRS 7. This is not discussed further in this text.
Happy Limited
Statement of comprehensive income (extracts) 20X5 20X4
For the year ended 31 December 20X5 Note C C
Profit before finance charges X X
Finance charges 3 (X) (X)
Profit before tax 4 X X
Taxation (X) (X)
Happy Limited
Statement of financial position (extracts) 20X5 20X4
As at 31 December 20X5 Note C C
ASSETS
Non-current assets
Property, plant and equipment 15 X X
Non-current portion of finance lease liability 16 X X
Current liabilities
Current portion of finance lease liability 16 X X
Happy Limited
Depreciation is provided on all property, plant and equipment, except for land, over the expected
economic useful life to expected residual values, using the following rates and methods:
Vehicles 10% straight line method
Plant 15% straight line method
Property, plant and equipment is measured at cost less accumulated depreciation and impairment
loss. Owned and leased plant and equipment are regarded as having the same useful life.
776 Chapter 16
Happy Limited
Notes to the financial statements (extracts) continued ...
2. Accounting policies continued ...
2.2 Leases
Assets acquired under a finance lease are capitalised and depreciated over their useful lives. The
asset and liability are initially measured at the fair value of the asset or, if lower at the present
value of the future minimum lease payments. Lease payments are apportioned between finance
expenses and reduction of the lease obligation so as to achieve a constant rate of interest on the
remaining liability balance. Finance expenses are recognised in profit or loss, unless they are
directly attributable to qualifying assets, in which case they are capitalised in terms of IAS 23.
Contingent rentals are recognised as expenses in the periods in which they are incurred.
20X5 20X4
3. Finance costs C C
Finance costs include:
- Finance lease finance costs X X

This takes into account the following separately disclosable items:
Contingent rent expense X X
15. Property, plant and equipment (extracts)

4.1 Finance leased assets: vehicles See IAS 17.31(a)
Net carrying amount: 1 January 20X5 X X
Gross carrying amount: 1 January 20X5 X X
Accumulated depreciation and impairment losses: 1 January 20X5 (X) (X)
Depreciation (X) (X)
Additions
Other X X
Net carrying amount: 31 December 20X5 X X
Gross carrying amount: 31 December 20X5 X X
Accumulated depreciation and impairment losses: 31 December 20X5 (X) (X)
16. Finance lease liability

Capitalised finance lease liability This recon showing the total L broken X X
Less: current portion down into the CL & NCL is not an IAS 17 (X) (X)
Non-current portion requirement, but, it is submitted, it adds to X X
the completeness & usefulness of the note
The liability bears interest at 10% per annum and is repayable in 4 remaining equal arrear
instalments of C …., each payable on 31 December.
Reconciliation of the total future minimum lease payments to their total present value
Minimum lease Finance charges Present value
payment (balancing amts) of each payment
Due within 1 year X X X
Due between 1 and 5 years X X X
Due later than 5 years X X X
Total X X X
Ownership of all of the company’s finance leased assets pass to the company upon expiry of the
lease, except for the item of plant.
There is an option to renew the lease over the plant, once the current lease term expires.
The lease arrangements require that current liabilities do not exceed 125% of current assets.
Happy Limited signed a non-cancellable sub-lease agreement under which, as at reporting date, it
still expects to receive CXXX in total future minimum payments.
Chapter 16 777
Example 10: Simple finance lease: disclosure – instalments in arrears vsadvance

Bandy Limited leased an asset with a fair value of C200 000 (equal to the present value of the
future minimum lease payments) over a period of 4 years under a finance lease.
The discount rate (interest rate implicit) is 16% per annum.
The lease began on 1 January 20X5. The first instalment is payable on 31 December 20X5.
Required: Show how the finance lease liability will be presented in the statement of financial position
and prepare the reconciliation of the finance lease liability for inclusion in the notes to the financial
statements for the year ended 31 December 20X5:
A. Using the information above, with four annual instalments of C71 475 payable in arrears.
B. Assuming that the four instalments of C71 475 are payable in advance (not in arrears) as follows:
three annual instalments of C71 475, first instalment due on 1 January 20X5; and
a final instalment of C21 526, payable on 1 January 20X8.
Solution 10A: Simple finance lease: disclosure – instalments in arrears
Bandy Limited
EQUITY AND LIABILITIES Note 20X5
Non-current portion of finance lease liability 23 114 734
Current liabilities
Current portion of finance lease liability 23 45 791
Bandy Limited
23. Finance lease liabilities 20X5

C
Capitalised finance lease liability From EIR Table This recon showing the total L 160 525 (W1)
Less: current portion 71 475 – 25 684 broken down into the CL & (45 791) (W2)
Non-current portion Balancing NCL is not required by IAS 17 114 734
Reconciliation of future minimum lease payments to their present values:
Minimum lease payment Finance charges Present value
Due within 1 year 71 475 (W3) 9 859 61 616 (W4)
Due between 1 and 5 years 142 950 (W3) 44 041 98 909 (W5)
Due later than 5 years 0 0
Total 214 425 53 900 (W7)
160 525 (W6)
Workings and comments:
W1 Effective interest rate table (EIRT)

Date Interest: 16% Instalment Balance
01/1/20X5 200 000
31/12/20X5 32 000 (71 475) 160 525
31/12/20X6 25 684 (71 475) 114 734
31/12/20X7 18 357 (71 475) 61 616
31/12/20X8 9 859 (71 475) 0
85 900 (285 900)
W2 Current portion of finance lease liability:
Next instalment due: 71 475 (see EIRT: due on 31/12/20X6)
Less: Interest to the date of the next instalment that is not yet recognised as interest: 25 684 (see EIRT)
= C45 791
W3 Minimum lease payments – i.e. instalments due:
- within 1 year: C71 475 x 1 instalment = C71 475
- between 1 and 5 years: C71 475 x 2 instalments = C142 950
W4 PV of MLP due within 1 year: Use your financial calculator or:
- PV of instalment due 1 year from now (31/12/20X6): 1yr: 71 475 ÷ 1,16 = C61 616
778 Chapter 16
W5 PV of MLP due between 1 and 5 years: Use your financial calculator or:
- PV of instalment due 2 years from now (31/12/20X7): 2yrs away: 71 475 ÷ 1,16 ÷ 1,16 = C53 118
- PV of instalment due 3 years from now (31/12/20X8) 71 475 ÷ 1,16 ÷ 1,16 ÷ 1,16 = C45 791
.: C53 118 + C45 791 = C98 909
W6 The total of the present values: C61 616 + C98 909 = C160 525.
Notice that the total present value is the total liability recognised (current portion + non-current portion).
Unless this total liability balance was now entirely a current liability, this amount would not normally appear
on the face of the SOFP since it would be split on the face of the SOFP between the portion presented under
current liabilities and the portion presented under non-current liabilities.
W7 Finance charges in the reconciliation of MLP to their PVs: is a balancing amount.
Notice that this amount should equal the total interest remaining as at year-end per the EIRT:
- 25 684 + 18 357 + 9 859 = C53 900
Solution 10B: Simple finance lease: disclosure – instalments in advance

Bandy Limited
EQUITY AND LIABILITIES Note 20X5
Current liabilities
Bandy Limited
20X5
23. Finance lease liabilities C
(W1)
Capitalised finance lease liability From EIR Table This recon showing the total L 149 089
(W2)
Less: current portion 71 475 – 0 broken down into the CL & (71 475)
Non-current portion Balancing NCL is not required by IAS 17 77 614
Due within 1 year 71 475 (W3) 71 475 (W4)
Due between 1 and 5 years 93 001 (W3) 15 387 77 614 (W5)
Total 164 476 15 387 (W7) 149 089 (W6)
Workings and comments:
W1 Effective interest rate table (EIRT)
Date Interest: 16% Instalment Balance
01/01/20X5 200 000
01/01/20X5 (71 475) 128 525
31/12/20X5 20 564 149 089
01/01/20X6 (71 475) 77 614
31/12/20X6 12 418 90 032
01/01/20X7 (71 475) 18 557
31/12/20X7 2 969 21 526
01/01/20X8 (21 526) 0
35 951 235 951
W2 Current portion of finance lease liability:
Next instalment due: 71 475 (see EIRT: due on 01/01/20X6 – which means it is effectively due ‘now’)
Less: Interest to the date of the next instalment that is not yet recognised as interest: 0 (see EIRT)
= C71 475
PS: although this next instalment due on 01/01/X6 will effectively be paying not only capital but also interest
of C20 564, this interest will have already been recognised in the current year ended 31 December 20X5.
Chapter 16 779

W3 Minimum lease payments – i.e. instalments due:
- within 1 year: C71 475 x 1 instalment = C71 475
- between 1 and 5 years: C71 475 x 1 instalment + C21 526 x 1 instalment = C93 001
W4 PV of MLP due within 1 year: Use your financial calculator or:
- PV of instalment due on 01/01/20X6 (effectively due ‘now’): C71 475 x PVF: 1= C71 475
Notice that, because the instalments are payable in advance, the present value factor (PVF) for this
instalment is 1 because it is effectively payable now – it will be paid the day after the financial year ends.
W5 PV of MLP due between 1 and 5 years: Calculate as the sum of the following: use your financial calculator or:
- PV of instalment due on 01/01/20X7 (due one year from now): C71 475 ÷ 1,16 1 = C61 617 PLUS
- PV of instalment due on 01/01/20X8 (due two years from now): C21 526 ÷ 1,16 2 = C15 997
.: C61 617 + C15 997 = C77 614
W6 The total of the present values: C71 475 + C77 614 = C149 089.
Notice that the total present value is the total liability recognised (current portion + non-current portion).
Unless this total liability balance was now entirely a current liability, this amount would not normally appear
on the face of the SOFP since it would be split on the face of the SOFP between the portion presented under
current liabilities and the portion presented under non-current liabilities.
W7 Finance charges in the reconciliation of MLP to their PVs: is a balancing amount.
Notice that this amount should equal the total interest remaining as at year-end per the EIRT:
- C12 418 + C2 969 = C15 387
Example 11: Finance lease: disclosure – instalments in arrears with tax

Curtin Limited entered, as the lessee, into a finance lease agreement over a plant (entered
into on 1 January 20X1).
The effective interest rate table for this lease has been prepared:
Finance charges Payments Liability
01 Jan 20X1 at 19.4564% 467 400 Including 14% VAT
31 Dec 20X1 90 939 (220 000) 338 339
31 Dec 20X2 65 829 (220 000) 184 168
31 Dec 20X3 35 832 (220 000) 0
192 600 (660 000)
Curtin Limited depreciates the plant over the lease term to a nil residual value.
Curtin Limited has a 31 December year end.
The tax rate is 30% and there are no temporary differences other than those referred to above.
Required:
Disclose the above in the statement of financial position at 31 December 20X2 (no comparatives are
required) and disclose the following notes to be included in the financial statements of Curtin Limited
for the year ended 31 December 20X2:
Property, plant and equipment note
Finance lease liability
Deferred tax asset/ liability note
Solution 11: Finance lease: disclosure – instalments in arrears with VAT and deferred tax
Curtin Limited
Note 20X2 20X1
Deferred tax 24 8 511 8 022
Non-current portion of finance lease liability 23 0 184 168
Current liabilities
Current portion of finance lease liability 23 (184 168) (154 171)
780 Chapter 16
Curtin Limited
20X2 20X1
15. Property, plant and equipment C C
Plant held under a finance lease:
Net carrying amount – 1 January 273 333 0
Gross carrying amount 410 000 0
Less accumulated depreciation (136 667) 0
Acquisition 467 400 x 100/114 0 410 000
Depreciation (410 000 – 0)/ 3 x 12/ 12 (136 667) (136 667)
Net carrying amount – 31 December 136 666 273 333
Gross carrying amount 410 000 410 000
Less accumulated depreciation (273 333) (136 667)
This plant is held under a finance lease. Please see note 23 for further information.
20X2 20X1
23. Finance lease liabilities C C
Capitalised finance lease liability From EIR Table & the total PV below 184 168 338 339
Less: current portion 220 000 – 65 829 (184 168) (b) (154 171)(a)
220 000 – 35 832
Non-current portion Balancing 0 184 168
Due within 1 year 220 000 35 832 184 168(c)
Due between 1 and 5 years 0 0 0
Due later than 5 years 0 0 0
Total 220 000 35 832 (d) 184 168
The liability bears interest at 19.4564% per annum and is repayable in 2 remaining equal arrear
instalments of C220 000, each payable on 31 December.
The lease is over a plant (please see note 15 for further information).
There are no contingent rents payable.
There are no options to renew and no escalation clauses.
Ownership of the company’s finance leased plant passes to Curtin Limited upon expiry of the lease.
The lease agreement does not impose any restrictions on the company in terms of other financing
arrangements or liquidity.
Calculations supporting the finance lease liability note:
a) Current portion of finance lease liability at end 20X1:
Instalment due next year: 220 000 – interest to date of this payment not yet payable: 65 829 = 154 171
b) Current portion of finance lease liability at end 20X2:
Instalment due next year: 220 000 – interest to date of this payment not yet payable: 35 832 = 184 168
c) Present value of the minimum lease payment due within 1 year:
C220 000 ÷ (1 + 0,194564) 1yr = 184 168
d) Total remaining finance charges appearing in the reconciliation between MLP and PV thereof: balancing:
Total MLPs 220 000 – Total PV 184 168 = 35 832
Curtin Limited
20X2 20X1
24. Deferred tax asset / (liability) C C
Deferred tax comprises temporary differences caused by the following:
Finance lease W1 8 511 8 022
Balancing 8 511 8 022
Chapter 16 781

Workings:
W1: Deferred tax on:
Finance lease Carrying Tax Base Temporary Deferred
amount difference taxation
Balances at 1/1/20X1: 0 0 0 0
Leased asset 0 0 0 0
Lease liability 0 0 0 0
Movement 8 022 Dr DT Cr TE
Balances at 31/12/20X1: (65 006) (38 267) 26 739 8 022 Asset
Leased asset (a) 273 333 0
Lease liability (EIRT) (d) (338 339) (38 267)
Movement 489 Dr DT Cr TE
Balances at 31/12/20X2: (47 502) (19 133) 28 369 8 511 Asset
Leased asset (b) 136 666 0
Lease liability (EIRT) (e) (184 168) (19 133)
Movement (8 511) Cr DT Dr TE
Balances at 31/12/20X3: 0 0 0 0
Leased asset (c) 0 0
Lease liability (EIRT) (f) 0 0
Calculations supporting the deferred tax working (W1):

CA of leased asset:
a) Cost: 410 000 (g) – AD: (410 000 – 0) /3 years x 1 year = 273 333
b) Cost: 410 000 (g) – AD: (410 000 – 0) /3 years x 2 years = 136 666
c) Cost: 410 000 (g) – AD: (410 000 – 0) /3 years x 3 years = 0
TB of leased liability:
d) VAT still to be denied when claiming future lease instalments: 57 400(h) x (220 000 x 2) / (220 000 x 3) = 38 267
e) VAT still to be denied when claiming future lease instalments: 57 400(h) x (220 000 x 1) / (220 000 x 3) = 19 133
f) VAT still to be denied when claiming future lease instalments: 57 400(h) x (220 000 x 0) / (220 000 x 3) = 0
Supporting calculations:
g) Cost (excl VAT): 467 400 x 100/114 = 410 000

h) VAT included in lease agreement: 467 400 x 14/114 = 57 400
Example 12: Finance lease: disclosure – instalments in advance

Encore Limited entered, as the lessee, into a finance lease agreement over a plant.
The lease agreement was effective from 1 January 20X1.
The effective interest rate table for this lease has been prepared as follows:
Finance charges Payments Liability
at 14.7564%
01 Jan 20X1 342 000 Incl VAT at 14%
01 Jan 20X1 (130 000) 212 000
31 Dec 20X1 31 283 243 283
01 Jan 20X2 (130 000) 113 283
31 Dec 20X2 16 717 130 000
01 Jan 20X3 (130 000) 0
31 Dec 20X3 0 0
48000 (390 000)
Encore Limited depreciates the plant over the lease term to a nil residual value.
Required:
Disclose the interest bearing lease liability note to be included in the financial statements of Encore
Limited for the year ended 31 December 20X2.
782 Chapter 16
Solution 12: Finance lease: disclosure – instalments in advance

Encore Limited
20X2 20X1
22. Finance lease liabilities C C
Capitalised finance lease liability From EIR Table & the total PV below 130 000 243 283
Less: current portion (130 000) (b) (130 000) (a)
Non-current portion Balancing 0 113 283
Due within 1 year 130 000 130 000(c)
Due between 1 and 5 years 0 0
Total 130 000 0(d) 130 000
Other information relating to the lease liability:
The lease liability bears interest at 14.7564% per annum.
The lease is repayable in 1 remaining advance instalments of C130 000, payable on 31 December.
The lease is over a plant (please see note 15 for further information).
There are no contingent rents payable.
There are no options to renew and no escalation clauses. Ownership of the company’s finance
leased plant passes to Encore Limited upon expiry of the lease.
The lease agreement does not impose any restrictions on the company in terms of other financing
arrangements or liquidity.
Comment: a lease payment in advance means that the first payment will be purely paying the principal amount.
Calculations supporting the finance lease liability note:
a) Current portion of finance lease liability at end 20X1:
Instalment due next year (during 20X2): 130 000 – Interest to date of this payment not yet recognised: 0 = 130 000
b) Current portion of finance lease liability at end 20X2
Instalment due next year (during 20X3): 130 000 – Interest to date of this payment not yet recognised: 0 = 130 000
c) Present value of the minimum lease payment due within 1 year:
130 000 x 1 (PV factor for an amount due immediately) = 130 000
d) Total remaining finance charges appearing in the reconciliation between MLP and PV thereof: balancing:
Total MLPs 130 000 – Total PV of MLP 130 000 = 0
4. Operating Leases (IAS 17.33 - .35)
4.1 Recognition of an operating lease (IAS 17.33 - .34) Definitions relating

to operating leases:
Operating leases are generally simpler than finance leases. The operating lease
instalments are simply recognised as an expense. commencement of lease term
lease term
Please revise – see section 1.
4.2 Measurement of an operating lease (IAS 17.33 - .34
and Circular 12/2006)
Operating lease instalments, which are recognised as expenses, are measured by allocating the
total lease instalments over the lease period (in months) using
the straight-line method, unless another method gives a better Operating lease
reflection of how the leased asset is being used up. expenses are:
Recognised: as expenses
The essence of this is that although the lease agreement may be Measured: on a straight line
structured in such a way that the instalment amounts vary from basis
period to period, the rent expense that is recognised must - straight-line
- over the lease term
reflect the pattern in which the leased asset is being used. - unless another systematic
Generally speaking, assets are used evenly over the period of a basis better reflects the
lease and thus we generally use the straight-line method. time pattern of the user’s
benefit. IAS 17.33 (Reworded)
Chapter 16 783
Although contingent rentals are also expensed, when

Contingent rentals:
measuring the operating lease expense on the straight-line
basis, we ignore contingent rentals. are not included for purposes
of straight-lining
An expense payable (liability) or prepayment (asset) will be
recognised if the instalments paid during an accounting period differ from the amount to be
recognised as an expense. This is best illustrated with an example:
Example 13: Basic operating lease: contingent rents and lease & reporting
periods differ
Abbey Ltd entered into a 2-year operating lease on 1 April 20X1, as lessee, over a plant.
Both Abbey Ltd and the lessor are not registered VAT vendors.
The following are due per the lease agreement:
The first year: C2 000 per month
The second year: C3 000 per month
Contingent rent: C1 per unit of output sold, payable at 31 December each year.
Abbey Ltd sold 300 units in the 3 months between 1 January 20X3 to 31 March 20X3, 1 000 units in
20X2 and 1 500 units in 20X1 (1 April – 31 December 20X1).
Required:
Journalise the operating lease for the years ended 31 December 20X1, 20X2 and 20X3. Ignore tax.
Solution 13: Basic operating lease: contingent rents and lease & reporting periods differ
The total of all the payments amounts to C60 000 (C2 000 x 12 months + C3 000 x 12 months). If the
expected pattern of future usage of the leased asset is to be used equally in each of the two years, the
expense will be C2 500 per month (C60 000/ 24 months).
Operating lease expense (E) C2 500 x 9 22 500
Operating lease payable (L) Balancing (originating) 4 500
Bank (A) C2 000 x 9 18 000
Lease payment: raising the lease expense and the subsequent accrual
Operating lease expense (E) 1 500 x C1 1 500
Bank (A) 1 500
Contingent rent paid
31/12/20X2
Operating lease payable (L) Balancing (reversing) 3 000
Bank (A) C2 000 x 3 + C3 000 x 9 33 000
Lease payment: raising the lease expense and partly reversing the prior
year’s accrual
Operating lease expense (E) 1 000 x C1 1 000
Bank (A) 1 000
31/12/20X3
Operating lease payable (L) Balancing (reversing) 1 500
Bank (A) C3 000 x 3 9 000
Lease payment: raising the lease expense and reversing the prior year’s
accrual
Operating lease expense (E) 300 x C1 300
Bank (A) 300
Please note: the journals would actually have been processed as individual journals reflecting the:
Fixed rental of either C2 000 pm or C3 000 pm; and the
Contingent rent of C1 based on the units produced in that month.
784 Chapter 16
4.3 Tax implications of an operating lease – income tax only
Many tax authorities only allow the amount paid to be deducted Only deduct
when calculating taxable profits, in which case the operating lease rent from
expense calculated on the accrual basis would be reversed and taxable income
replaced with the deductible payment when calculating the current when paid:
income tax payable. if accrued rent: Dr DT
if prepaid rent: Cr DT
Any payable or receivable arising as a result of the accrual system would therefore constitute
a temporary difference since the tax authorities are effectively working on a cash basis
instead. This difference is multiplied by the tax rate to arrive at the deferred tax balance.
Example 14: Current tax on an operating lease

The facts from example 13 apply. The following tax-related information now also applies:
Profit before tax and before any of the lease-related journals is C100 000 in all years
There are no temporary differences, non-deductible expenses or exempt income other
than that which is evident in the question.
The local tax authority treats this lease as an operating lease and allows the lease
instalment as a deduction when paid.
Required:
Prepare the current tax journal for the years ended 31 December 20X1, 20X2 and 20X3
Solution 14: Current tax on an operating lease

Journals 20X1 20X2 20X3
Income tax expense(E) 24 150 19 800 27 210
Current tax payable: income tax (L) (24 150) (19 800) (27 210)
Recording the current tax for the year (W1)
W1: Calculation of current income taxation: 20X1 20X2 20X2

C C C
Profit before tax and before operating lease 100 000 100 000 100 000
Operating lease expense 20X1: (22 500 + 1 500) (24 000) (31 000) (7 800)
20X2: (30 000 + 1 000)
20X3: (7 500 + 300)
Temporary differences - movement:

Add operating lease Per above 24 000 31 000 7 800
Less instalments paid 20X1: (18 000 + 1 500 ) (19 500) (34 000) (9 300)
20X2: (33 000 + 1 000)
20X3: (9 000 + 300)
Taxable profit 80 500 66 000 90 700
Current tax Taxable profit x 30% 24 150 19 800 27 210
Comment:
The final profit before tax could have been given instead, in which case we would not have needed to
first deduct the operating lease expense to calculate profit before tax.
Example 15: Deferred tax on an operating lease

Assume the facts from examples 13 and 14 apply and that the tax rate is 30%.
Required:
Journalise the deferred tax implications of the above.
Chapter 16 785
Solution 15: Deferred tax on an operating lease

Comment:
Since the tax authorities simply grant the lease instalments as deductions when they are paid, there
is no tax base. (Remember that the tax base of a liability is the carrying amount less the amount
allowed as a deduction in the future. Since the full accrual balance will be allowed as a tax
deduction when it is paid, the tax base is C nil)
This example deals with an expense payable and thus a comparison of the carrying amount of the
expense payable and the nil tax base leads to a deferred tax asset.
Had the lease rentals been prepaid instead, it would have led to a deferred tax liability.
20X1 20X2 20X3
Journals Dr/(Cr) Dr/(Cr) Dr/(Cr)
Deferred tax: income tax (A) (W1) 1 350 (900) (450)
Income tax expense (E) (1 350) 900 450
Raising/ (reversing) a deferred tax asset on the operating lease
W1: Calculation of deferred income tax

Operating lease payable
amount base difference tax
Balance: 1/1/X1 0 0 0 0
Adjustment (balancing) (4 500) 1 350 Dr DT; Cr TE
Balance: 31/12/X1 (4 500) 0 4 500 1 350 Asset
Adjustment (balancing) 3 000 (900) Cr DT; Dr TE
Balance: 31/12/X2 (1 500) 0 1 500 450 Asset
Adjustment (balancing) 1 500 (450) Cr DT; Dr TE
Balance: 31/12/X3 0 0 0 0
4.4 Tax implications of an operating lease – income tax with transaction tax
The existence of a transaction tax (e.g. VAT) in an operating VAT & operating
lease is not as complex as in a finance lease. The principle is leases:
that if one is able to claim back any VAT included in the lease if VAT is claimable:
rentals, the operating lease expense is measured net of VAT. In for op lease exp: separate
other words, if the instalments include VAT, this VAT needs to VAT
be separated out. Fixed instalments, excluding VAT, are then for current tax: excl. VAT
if VAT is not claimable:
averaged out over the lease period in months. Any contingent for op lease exp: include
instalments, excluding VAT, are simply added to these averaged VAT
fixed instalments get to the total operating lease expense. for current tax: excl. VAT
The tax authorities deduct the operating lease instalments paid, also excluding VAT.
Summary: Operating lease with tax and VAT
Step 1: Calculate rent average net of VAT Step 3: Current income tax calculation
a) If VAT is claimable: Profit before tax before adjusting for the lease
each payment net of VAT i.e. x 100/114 Less: Rent expense for the year (Step 1)
b) If VAT is not claimable: = Profit before tax (adjusted)
each payment will remain inclusive of VAT Add: Rent expense for the year (Step 1)
c) Sum of all payments ÷ number of payments Less: Actually paid, excluding VAT
= Average rent = Taxable profit
(if per month x 12 to get an annual figure) x Tax rate
d) Ignore contingent rent in straight-lining =Current income tax
Step 2: Journals Step 4: Deferred income tax calculation
Dr Rent expense : Step 1 CA TB TD DT
Cr Bank : Paid including VAT Accrual/ Per SOFP TDx30%
0 TB - CA
Dr VAT input : Pmt x 14/114 (if claimable) Prepaid A/ (L) A/(L)
Dr Prepaid expense or :Balancing figure (if Note: This is the DT balance and not the DT journal. The
Cr Accrued expense applicable) journal is calculated as: DT c/b – DT o/b
786 Chapter 16
Example 16: Operating lease with tax and VAT

Larissa Limited entered into a 2-year operating lease on 1 January 20X1, over a plant
(where Larissa Limited is the lessee).
The following is the lease payment schedule from the lease agreement:
Further rentals are payable based on sales in units calculated at a rate of C1,14 per unit.
The agreement’s figures are inclusive of VAT.
Larissa plans to use the asset evenly over the period of the lease.
Larissa sold 1 500 units in 20X1 and 1 000 units in 20X2.
Required: Prepare journals for both years of the operating lease agreement assuming:
A. Larissa Limited and the lessor are VAT vendors
B. Only the lessor is a VAT vendor
Solution 16: Operating lease with tax and VAT

Comment: The total of all the payments amounts to C22 800 (C5 700 in 20X1, and C17 100 in 20X2).
If the asset is used equally in each of the two years, the expense that must be recognised will be
C11 400 (half of the total instalments). However, since this amount is inclusive of VAT, the portion of
the C22 800 that represents VAT must first be removed IF the lessee is a VAT vendor and the ex VAT
instalments will be expensed over the period of the lease. If the lessee is not a VAT vendor, the
instalments inclusive of VAT will be expensed over the period of the lease.
20X1 Part A Part B
Operating lease expense (E) 5 700 x 100/114; B: inclusive of VAT 5 000 5 700
VAT Receivable 5 700 x 14/114; B: no VAT can be claimed 700 -
Bank (A) Given (5 700) (5 700)
Fixed operating lease paid
Operating lease expense (E) A: C1.14 x 1 500 x 100/ 114; B: incl of VAT 1 500 1 710
VAT Receivable A: C1.14 x 1 500 x 14/ 114; B: no VAT claimed 210 -
Bank (A) C1.14 x 1 500 (1 710) (1 710)
Contingent operating lease paid
Operating lease expense (E) A: Should be (W1):10 000 – Is: 5 000 5 000 5 700
Lease payable (L) B: (5 700+17 100)/24 x 12 – 5 700 (5 000) (5 700)
Straight-lining the fixed operating lease instalments
Deferred tax: income tax (A) A: W3; B:W4 1 500 1 710
Income tax expense (E) (1 500) (1 710)
Raising a deferred tax asset
20X2
Operating lease expense (E) A: 17 100 x 100/114; B: inclusive of VAT 15 000 17 100
VAT Receivable A: 17 100 x 14/114; B: no VAT can be claimed 2 100 -
Bank (A) (17 100) (17 100)
Fixed operating lease paid
Operating lease expense (E) C1.14 x 1 000 x 100/114 1 000 1 140
VAT Receivable C1.14 x 1 000 x 14/114 140 -
Bank (A) C1.14 x 1 000 (1 140) (1 140)
Lease payable (L) A: Should be (W1) :10 000 – Is: 15 000 5 000 5 700
Operating lease expense (E) B: (5 700+17 100)/4 x 12 – 17 100 (5 000) (5 700)
Straight-lining the fixed operating lease instalments
Income tax expense (E) A: W3.1; B: W3.2 1 500 1 710
Deferred tax: income tax (A) (1 500) (1 710)
Reversing deferred tax asset at the end of lease term
Chapter 16 787

W1: Fixed lease payments excluding VAT
year 1: 5 700 x 100/114 5 000
year 2: 17 100 x 100 /114 15 000
20 000
W2: Straight-lined expense (excluding VAT): fixed rent only!
W2.1 (5 000 + 15 000) / 24 months = 833 pm
W2.2 Lease payable raised in 20X1 5 000
Fixed lease expense (excl VAT): 833pm x 12 m in 20X1 10 000
Fixed lease instalments paid (excl VAT): 5 000
W2.3 Lease payable reversed in 20X2 (5 000)
Fixed lease expense (excl VAT): 833pm x 12 m in 20X2 10 000
Fixed lease instalments paid (excl VAT): 15 000
W2.4 Lease payable balance on 31/12/20X2 0
Lease payable opening balance (raised in 20X1) 5 000
Lease payable reversed in 20X2 (W2.3) (5 000)
W3: Deferred tax
W 3.1 Ex A Lease payable CA TB TD DT
Balance: 1/1/20X1 0 0 0 0
Adjustment 1 500 Dr DT, Cr TE
Balance: 31/12/20X1 (W2.2) (5 000) 0 5 000 1 500 Asset
Adjustment (1 500) Cr DT, Dr TE
Balance 31/12/20X2 (W2.4) 0 0 0 0
W 3.2 Ex B Lease payable CA TB TD DT

Balance: 1/1/20X1 0 0 0 0
Adjustment 1 710 Dr DT, Cr TE
Balance: 31/12/20X1 (5 700) 0 5 700 1 710 Asset
Adjustment (1 710) Cr DT, Dr TE
Balance 31/12/20X2 0 0 0 0
Comments:
Both the lease payable and the deferred tax will reverse in the second year.
Note that, unlike a finance lease, there is no asset in the DT table.
Also, unlike the finance lease, the TB for a liability relating to an operating lease is nil: this is because:
The TB of a liability is the portion thereof that the tax authorities will not allow as a deduction;
The finance lease liability includes VAT and therefore a portion of this will not be allowed as a
deduction (thus the TB will have a balance)
The operating lease liability is simply an accrual of an expense, which is already exclusive of
VAT (in other words, the operating lease liability would not include VAT) and therefore no
portion of this liability would not be allowed as a deduction (and thus the TB would be nil).
4.5 Operating lease incentive (SIC 15)
In negotiating a lease the lessor may offer an incentive to the lessee to enter into the lease.
Such incentives must be accounted for in terms of SIC 15: Operating lease incentives.
SIC 15 requires that any incentive, irrespective of the nature or Operating lease
form or timing, be accounted for as part of the net consideration. incentive treatment:
This means that: Lessor:
The lessor must recognise the aggregate cost of incentives reduce incentive from
operating lease income
as a reduction in his rental income over the lease term. (“net consideration”)
The lessee must recognise the aggregate benefit of Lessee:
incentives as a reduction in the rental expense over the lease reduce incentive from
operating lease expense
term. (“net consideration”)
788 Chapter 16
Example 17: Operating lease incentive

A lessor, in negotiating a lease agreement with Tufcat Limited over office accommodation,
agrees to bear Tufcat’s relocation costs of C1 000 as an incentive to enter into a lease.
The lease was agreed to and signed, effective from 1 April 20X1.
Lease rentals are C2 000 per annum for a 10 year lease-period.
Required: Show Tufcat Limited’s journal entries for the year ended 31 December 20X1.
Solution 17: Operating lease incentive

Comment: The lessee will recognise as an expense the relocation costs of C1 000 in year one. Both the
lessor and the lessee will then recognise the net rental of C19 000 (C2 000×10 - C1 000) over the
remaining 10 years.

Relocation cost (E) 1 000
Relocation costs incurred
31 December 20X1
Operating lease expense (E) (C2 000 x 10 years – C1 000)/ 120 months x 9 months 1 425
Bank (A) C1.14 x 1 500 1 425
4.6 Disclosure of an operating lease (IAS 17.35)

The disclosure of operating leases is far less complicated than that of finance leases. Lessees
shall make the following disclosures for operating leases (IAS 17.35):
a) the total of future minimum lease payments under non-cancellable operating leases for
each of the following periods:
not later than one year;
later than one year and not later than five years; and
later than five years;
b) the total of future minimum sublease payments expected to be received under non-
cancellable subleases at the end of the reporting period;
c) lease and sublease payments recognised as an expense in the period, with separate
amounts for minimum lease payments, contingent rents, and sublease payments;
d) a general description of the lessee’s significant leasing arrangements including, but not
limited to, the following:
the basis on which any contingent rent payable is determined;
the existence and terms of renewal or purchase options and escalation clauses; and
restrictions imposed by lease arrangements, such as those concerning dividends,
additional debt and further leasing.
Sad Limited
Statement of comprehensive income(extracts)
Note 20X5 20X4
C C
Profit before finance charges X X
Finance charges (X) (X)
Profit before tax 4 X X
Taxation (X) (X)
Chapter 16 789
Sad Limited
2.5 Leases
Payments made in respect of operating leases are deducted (as an expense) in the calculation
of profit/loss for the year, on the straight-line basis over the lease term period.
20X5 20X4
Profit before tax includes the following disclosable items:
Operating lease expense payments include:
Minimum lease payments X X
Contingent lease payments X X
4. Operating lease
Sad entered into two operating leases: machine and equipment. Neither lease is renewable,
whilst both items remain with the lessor throughout the lease term and upon its expiration.
Future minimum lease payments under non-cancellable operating leases:
Due within 1 year X X
Due between 1 and 5 years X X
Due later than 5 years X X
Total X X
Contingent rent payable is determined based on 10% of turnover.
The lease includes no renewal or purchase options and no escalation clauses.
The lease does not impose restrictions on the company in terms of further financing or
liquidity issues.
5. Sale and Leaseback (IAS 17.58 - .66)
5.1 Overview
A sale and leaseback involves an entity selling an asset to raise cash, and then subsequently
leasing the asset back. The seller in a sale and leaseback agreement is thus also the lessee.
1)
Seller Purchaser
2)
Lessee Lessor
1) Firstly, the seller sells the asset to a purchaser

2) The purchaser (now a lessor) then leases the same asset back to the seller (now a lessee).
As with conventional lease agreements, it is important to identify the substance of a sale and
leaseback when classifying the lease as either a finance lease or an operating lease.
5.2 Sale and finance leaseback (IAS 17.59 - .60, IFRIC 4 and SIC 27)
A leaseback (i.e. where we lease an asset back after selling it) is A sale and
classified as a finance lease if this lease transfers substantially all finance
the risks and rewards of ownership back to us (i.e. from the lessor leaseback is
where:
to the lessee). In substance, the asset will have been sold and
We sell an asset; and
subsequently repurchased by the lessee. then
Deferred profit is recorded should the asset originally be sold (i.e. We lease it back, where
this lease gives us back
transaction 1 above) at a price above its carrying amount on selling all the risks and rewards
date. This deferred profit is then amortised over the lease term – of ownership.
meaning that it is recognised in profit or loss over the lease term.
790 Chapter 16
Please note that IAS 17 only requires profit to be deferred. It is Recognise

submitted that losses should not be deferred as these losses reflect deferred profit:
an impairment of the underlying asset. It is submitted, however, deferred profit = SP - CA
that if the sale and leaseback was not concluded on arms length amortised to P/L over the
terms that it is possible that the loss could be more reflective of a lease term
type of prepayment and that this may need to be deferred and that we would also need to
consider whether or not the arrangement is indeed a lease. (IFRIC 4 and SIC 27)
Ultimately, from the seller/lessee’s point of view, a sale and finance leaseback results in the
derecognition of the asset. The subsequent repurchase is accounted for in the same manner as
any other finance lease (i.e. the leased asset and finance lease liability is recognised). The
only difference is that deferred profit is recognised and then allocated to profit or loss over the
period of the lease.
It is inappropriate to recognise the excess over the carrying amount as a profit on sale since a
sale and finance leaseback, in substance, does not involve a sale but is a clever transaction
that provides the lessee with financing, with the asset given as security to the lessor.
Example 18: Basic sale and finance leaseback
Frown Limited entered into a sale and finance leaseback with Smile Limited over a machine
on 1 January 20X5. On this date the machine had a carrying amount (in Frown Limited’s
books) of C100 000, whilst the original cost was C150 000. The machine is depreciated over 15 years.
Frown Limited sold its machine for C150 000 to Smile Limited and then leased it back from Smile
Limited. Terms of the lease agreement are as follows:
Lease term: 5 years;
Lease payments: C30 000 per annum in arrears and a lump sum of C58 424 on 31 December 20X9;
Ownership of the machine will be transferred back to Frown Limited on 31 December 20X9; and
The interest rate inherent in the lease is 10%.
Required:
A Prepare the 20X5 and 20X9 journal entries of Frown Limited for the sale and leaseback of the
machine. Ignore tax. The journals for 20X6, 20X7 and 20X8 are not required.
B Prepare the statement of financial position and related notes for the year ended 31 December
20X5. The accounting policy note is not required.
Solution 18A: Sale and finance leaseback: journals

JOURNALS: for 20X5 Debit Credit
1/1/20X5
Bank (A) 150 000
Machine: cost (A) (this is the original cost of acquisition) 150 000
Deferred profit (Eq) SP: 150 000 – CA: (150 000 – 50 000) 50 000
Sale of machine
Machine: cost (A) (this is the new cost) 150 000
Capitalisation of leased asset and raising of corresponding liability
31/12/20X5
Finance charges (E) 15 000
Finance charges incurred on the lease during 20X5
Bank (A) 30 000
Payment of lease instalment
Deferred profit (Eq) (Proceeds 150 000 – CA 100 000)/5 years 10 000
Profit on sale and leaseback (P/L) 10 000
Amortisation of deferred profit (part of the deferred profit is
recognised as income)
Chapter 16 791

31/12/20X5: Continued … Debit Credit
Depreciation (E) 150 000 leased amount/10 remaining years 15 000
Machine: accumulated 10 years = CA 100 000 / Cost 150 000 x 15 000
depr (-A) Total useful life 15 years
Depreciation of machine
JOURNALS: for 20X6, 20X7 and 20X8 were not required
JOURNALS: for 20X9
31/12/20X9
Finance charges (E) 8 039
Finance charges incurred on the lease during 20X9
Bank (A) 30 000
Payment of lease instalment
Bank (A) 58 424
Final instalment payable on repurchase of the machine
Deferred profit (Eq) (Proceeds 150 000 – CA 100 000)/5 years 10 000
Profit on sale and leaseback (P/L) 10 000
Amortisation of deferred profit (part of the deferred profit is
recognised as income)
Depreciation (E) 150 000 leased amount/10 remaining years 15 000
Machine: accumulated depr (-A) 15 000
Current years depreciation
Solution 18B: Sale and finance leaseback: disclosure

Frown Limited
Statement of financial position (extracts) 20X5
As at 31 December 20X5 Note C
ASSETS
Non-current assets
Property, plant and equipment 4 135 000
Deferred profit 40 000
Current liabilities
Frown Limited
Notes to the financial statements (extracts) 20X5
For the year ended 31 December 20X5 C
Net carrying amount: 1 January 100 000
Gross carrying amount: 1 January 150 000
Accumulated depreciation and impairment losses: 1 January (50 000)
Sale (100 000)
Additions: Capitalised lease asset 150 000
Depreciation (15 000)
Net carrying amount: 31 December 20X5 135 000
Gross carrying amount: 31 December 20X5 150 000
Accumulated depreciation and impairment losses: 31 December (15 000)
Comment: Since risk and rewards do not pass, the sale and leaseback effect may be recorded net.
792 Chapter 16
Solution 18B: Continued …

Frown Limited
Notes to the financial statements (extracts) continued … 20X5
For the year ended 31 December 20X5 C
5. Finance lease liability
Capitalised finance lease liability 135 000
Less: current portion (16 500)
Non-current portion 118 500
Reconciliation of the future minimum lease payments to their present values
At 31 December 20X5: Minimum Lease Finance Charges Present Value
Payment (MLP - PV)
Due within 1 year 30 000 (a) 2 727 bal 27 273 (f)
Due between 1 and 5 years 148 424 (b) 40 696 bal 107 728 (f)
Total 178 424 (c) 43 423 (e) 135 000 (d)
Calculations (hint: do them in this order)
(a) Payment due on 31/12/20X6: 30 000
(b) Payment due in 20X7; 20X8 and 20X9: (30 000 x 3 years) + 58 424 = 148 424
(c) a+b
(d) Closing balance on effective interest rate table at year-end
(e) c – d (balancing). Notice that the future interest as at 31 December 20X5 (see W1) =
13 500 + 11 850 + 10 035 + 8 039 = 43 424
(f) The present values can be calculated as follows:
Due dates PVF: 10% Payments Present values
31/12/20X6 0.909091 30 000 27 273
31/12/20X7 0.826446 30 000 24 793
31/12/20X8 0.751315 30 000 22 540 107 728
31/12/20X9 0.683013 88 424 (g) 60 395 (d – 27 273)
135 000
(g) 30 000 + 58 424 = 88 424
W1: effective interest rate table Liability

Date Interest (10%) Instalment Balance
1/1/20X5 150 000
31/12/20X5 15 000 (30 000) 135 000
31/12/20X6 13 500 (30 000) 118 500
31/12/20X7 11 850 (30 000) 100 350
31/12/20X8 10 035 (30 000) 80 385
31/12/20X9 8 039 (30 000) 58 424
(58 424) 0
58 424 (208 424)
5.3 Tax implications: sale and finance leaseback

As with any finance lease, the tax authorities see only the legal From a tax
form of the lease as opposed to the lease’s substance. Therefore, perspective:
once the initial sale has occurred, the seller/lessee will no longer the lessor is the owner in
receive capital allowances on the asset, despite the subsequent a finance lease
finance lease. The accountant will continue to depreciate the asset, thus the lessor receives
thus causing a temporary difference. tax allowances
for initial sale: remember
We must also bear in mind that the other tax consequences of a sale CGT/recoupment/
will be taken into account when calculating taxable profit, for scrapping allowance!
example recoupments and capital gains.
This text assumes that the relevant tax authorities allow the deduction from taxable profits of
lease payments in respect of the finance lease.
Chapter 16 793
Example 19: Tax on a sale and finance leaseback

Assume the facts from example 18 apply and that:
The profit before tax is C400 000 (i.e. after all lease adjustments) in both years.
The tax authorities allow for capital allowances of machinery over 20 years.
There are no temporary differences and no non-deductible expenses or exempt income other than
that which is apparent from the information already provided.
Required: Prepare the tax journals for the years ended 31 December 20X5 and 31 December 20X9.
Solution 19: Tax on a sale and finance leaseback

Journals: 31/12/20X5 Debit Credit
Current tax owing to the tax authorities (see W1)
Deferred tax entries (see W2)
Journals: 20X6 – 20X8 were not required
Journals: 31/12/20X9
Income tax expense(E) 114 912
20X9 current tax entries (see W1)
Income tax expense(E) 5 088
Deferred tax 5 088
20X9 deferred tax entries (see W2)
W1: Calculation of current income tax 20X9 20X5

C C
Deferred profit amortised (10 000) (10 000)
Recoupment 150 000 – 112 500 or W2: (a) 0 37 500
Depreciation 150 000 / 10 years 15 000 15 000
Wear and tear (asset regarded as sold – i.e. lessor will get the deduction) 0 0
Finance charges 8 039 15 000
Lease payment (30 000) (30 000)
Current income tax Taxable profits at 30% 114 912 128 250
Comment: The profit before tax could have been given to you before the lease had been taken into account, in
which case the profit would have first required adjustments.
W2: Deferred tax calculations
Carrying Tax Temporary Deferred Balance or

W2.1: Asset: machine
amount Base difference taxation adjustment
O/ balance 1/1/20X5 100 000 112 500(a) 12 500 3 750 Asset
Sale (100 000) (112 500)
Acquisition 150 000 0 (147 500) (44 250) Cr DT Dr TE
Depreciation (15 000) 0
Balance 31/12/20X5 135 000 0 (135 000) (40 500) Liability
Depreciation (15 000) 0 15 000 4 500 Dr DT Cr TE
Depreciation (15 000) 0
73 424 22 027 Dr DT Cr TE
Purchase 0 58 424 (b)
C/ balance 31/12/20X9 75 000 58 424 (b) (16 576) (4 973) Liability
794 Chapter 16
Calculations relating to the DT table on the previous page:

(a) Tax base: 150 000 – [(150 000 / 20 years)] * 5 years (i.e. up to 1/1/20X5) = 112 500
(b) Frown Limited purchased the machine after the lease agreement ended on 31/12/20X9, for
58 424. At date of purchase, no capital allowances would have yet been granted.
Comment relating to the DT table on the previous page:

Please note that there was no capital gain in this example since the asset was sold and leased back at an
amount that did not exceed cost.

W2.2: Finance lease liability
amount base difference taxation adjustment
Balance 1/1/20X5 0 0 0 0
Finance lease signed (150 000)
135 000 40 500 Dr DT Cr TE
Capital repaid 15 000
Balance 31/12/20X5 (135 000) 0 135 000 40 500 Asset
Capital repaid 16 500 (16 500) (4 950) Cr DT Dr TE
Balance 31/12/20X6 (118 500) 0 118 500 35 550 Asset
Balance 31/12/20X7 (100 350) 0 100 350 30 105 Asset
Balance 31/12/20X8 (80 385) 0 80 385 24 115 Asset
Capital repaid (21 961 + 58 424) 80 385 (80 385) (24 115) Cr DT Dr TE
Closing balance 31/12/20X9 0 0 0 0

W2.3: Deferred profit
amount base difference taxation adjustment
Balance 1/1/20X5 0 0 0 0
Finance lease signed (50 000)
40 000 12 000 Dr DT Cr TE
Profit recognised 10 000
Balance 31/12/20X5 (40 000) 0 40 000 12 000 Asset
Profit recognised 10 000 (10 000) (3 000) Cr DT Dr TE
Balance 31/12/20X6 (30 000) 0 30 000 9 000 Asset
Balance 31/12/20X7 (20 000) 0 20 000 6 000 Asset
Balance 31/12/20X8 (10 000) 0 10 000 3 000 Asset
Closing balance 31/12/20X9 0 0 0 0
W2.4: Deferred tax summary Machine Lease Deferred Total Balance or

liability profit adjustment
Balance 1/1/20X5 3 750 0 0 3 750 Asset
Adjustment (44 250) 40 500 12 000 8 250 Dr DT Cr TE
Balance 31/12/20X5 (40 500) 40 500 12 000 12 000 Asset
Adjustment 4 500 (4 950) (3 000) (3 450) Cr DT Dr TE
Balance 31/12/20X6 (36 000) 35 550 9 000 8 550 Asset
Balance 31/12/20X7 (31 500) 30 105 6 000 4 605 Asset
Balance 31/12/20X8 (27 000) 24 115 3 000 115 Asset
Balance 31/12/20X9 (4 973) 0 0 (4 973) Liability
Chapter 16 795
5.4 Sale and operating leaseback (IAS 17.61 - .63)
A leaseback (i.e. where we lease an asset back after selling it) is Sale & operating
classified as an operating lease if it does not transfer substantially all leaseback
the risks and rewards associated with ownership from the lessor to involves:
the lessee. Therefore, in substance the asset has really been sold and selling an asset and
it is really being subsequently leased back by the lessee. leasing it back through
an operating lease
The lessee accounts for a sale and operating leaseback as follows: i.e. significant r+r of
ownership aren’t
the asset is derecognised, and transferred from
an operating lease expense is recognised. lessor to lessee
IAS 17 provides the following guidelines for recording a sale and operating leaseback:
If the selling price equals fair value (SP=FV)
If the selling price equals fair value, any resulting profit or loss on sale (SP – CA) is
considered to be a true and fair profit or loss and thus this profit or loss is recognised
immediately.
FV/ SP
Profit or loss
CA
This is actually quite logical and reasonable since, if the selling price and the fair value of
the asset are the same, there is a simple sale of an asset and a simple lease of an asset
under an operating lease arrangement. The transaction is not tainted by other elements.
If the selling price is less than the fair value (SP<FV)
Any profit or loss (SP – CA) is recognised immediately if the subsequent lease payments
charged are market-related lease payments. If these future lease payments are not lower
than market-related lease payments it simply suggests that the lessee had an impaired
asset or made a poor business decision, which is why the loss is recognised immediately.
However, if the loss caused by selling at below fair value is compensated for by the future
lease payments being lower than market-related lease payments, then this loss is
recognised as a deferred loss which is then amortised to profit or loss as an expense in
proportion to the lease payments over the period in which the asset is expected to be used:
The profit (or loss) on sale is still recognised and is measured as the fair value (not
selling price) less the carrying amount.
The deferred loss recognised is measured by deducting the selling price from the fair
value.
FV
Deferred loss
Profit or loss SP
CA
Where the loss is compensated for by future lease payments that are below normal
market-related lease payments, the substance of the transaction is that :
the asset has been sold at fair value, and
a discount on sale has been given to secure cheaper future rentals.
796 Chapter 16
If the selling price is greater than the fair value (SP>FV)

The true profit or loss (calculated using the fair value) is recognised immediately,
whereas the excess over the fair value is deferred and amortised over the period in which
the asset is expected to be used. This is regardless of the fact that the future lease rentals
may not have been adjusted to be greater than market-related:
The profit (or loss) on sale is still recognised and is measured as the fair value (not
selling price) less the carrying amount.
The deferred profit recognised is measured by deducting fair value from the selling
price.
SP
Deferred
profit
FV
Profit or loss
CA
In this instance, the fact that the selling price of the asset is greater than the fair value
implies that the future lease payments charged will be higher than market-related
payments (this is the assumption we apply whether or not this is the actual case).
Thus the substance of the transaction is that:
the asset has been sold at fair value, and
a premium on sale has been secured which will be paid back via higher than market-
related lease payments (income received in advance).
Summary: Sale and operating leaseback: Disposal profit
Disposal profit or loss that is Disposal profit or loss that is

recognised in profit and loss recognised as deferred profit or loss
SP = FV
SP<FV, no compensated SP less CA No deferred profit/loss
adjustment
SP<FV, with compensated Deferred loss:

FV less CA
adjustment FV less SP
SP>FV, with or without Deferred profit:

FV less CA
compensated adjustment SP less FV
This is best illustrated with an example.

Example 20: Basic sale and operating leaseback
On 2/1/20X4, Yebo Limited entered into a sale and operating leaseback with another
company for a delivery van.
The original cost of the delivery van was C1 000 000, and its carrying amount, as at 2/1/20X4, is
C500 000. The market prices in respect of a sale and leaseback arrangement are:
Fair selling price: C800 000
Fair annual lease payment: C70 000
Lease term: 5 years
The sale and (operating) leaseback agreement include the following:
Sale price Annual lease payments
Scenario 1 C900 000 C70 000
Scenario 2 C600 000 C70 000
Scenario 3 C900 000 C90 000
Scenario 4 C600 000 C10 000
Required: Prepare the journal entries of Yebo Limited for the year-ended 31/12/20X4, to account for
the different scenarios of the sale and leaseback. Ignore tax.
Chapter 16 797
Solution 20: Basic sale and operating leaseback

Scenario 1: SP>FV; non-compensating

Bank (A) 900 000
Property, plant and equipment (carrying amount) 500 000
Profit on disposal (FV less CA: 800 000 – 500 000) 300 000
Deferred profit (Eq) (SP less FV: 900 000 – 800 000) 100 000
Sale of machine
31/12/20X4
Operating lease expense (E) 70 000
Bank (A) 70 000
Payment of lease expense
Deferred profit (Eq) 20 000
Deferred profit amortised (I) 20 000
Amortisation of deferred profit:(100 000/5 lease years)
Comment:
The sale and lease back will have deferred profit regardless of whether the lease is compensated or
non-compensated.
Scenario 2: SP<FV; non-compensating

Bank (A) 600 000
Property, plant and equipment (A) 500 000
Profit on disposal (SP less CA: 600 000 – 500 000) 100 000
Sale of machine
31/12/20X4
Bank (A) 70 000
Comment: Since we are not compensated by being charged a below market rental, the profit or loss on
sale is simply C100 000, (SP: 600 000 – CA: 500 000). In other words, the profit on sale is calculated
as if it were a normal sale.
Scenario 3: SP>FV; compensating

Bank (A) 900 000
Deferred profit (Eq) (SP less FV: 900 000 – 800 000) 100 000
Sale of machine
31/12/20X4
Bank (A) 90 000
Deferred profit (Eq) 20 000
Deferred profit amortised (I) 20 000
Amortisation of deferred profit: (100 000/5 lease years)
798 Chapter 16

Scenario 4: SP<FV; compensating

Bank (A) 600 000
Deferred loss (FV less SP: 600 000 – 800 000) 200 000
Sale of machine
31/12/20X4
Bank (A) 10 000
Deferred loss amortised (E) 40 000
Deferred loss 40 000
Amortisation of deferred loss: (200 000/5 lease years)
Comment: The lower selling price is accepted due to the lower than market rentals and therefore the
loss must be deferred essentially increasing the expense each year.
5.5 Tax implications: sale and operating leaseback
Assuming that the tax authorities recognise both the sale and the lease:
taxable profit may include a profit or loss on sale (perhaps even a capital gain); and
the deductions from taxable profit would include the lease instalments.
The above treatment is similar to the accounting treatment (we recognise a sale and the lease
instalments are recognised as an expense), but temporary differences may arise on:
Deferral of any profit or loss;
Recoupments or scrapping allowances on the sale;
Differences between the lease payment allowed as a deduction and the lease expense
(e.g. instalments paid versus instalments accrued and reclaimable transaction taxes).
6. Exposure Draft – Expected Impact Thereof (ED 2013/6)
According to the World Leasing Yearbook 2013, new leasing activity in 2011 amounted to
US$ 800 billion. This is a huge number and clearly leasing activity affects most entities and
is therefore also likely to be material to the users of financial statements.
With the current version of IAS 17 there are two different categories into which leases could
be classified: finance and operating leases. This has allowed entities to structure lease
contracts in a way that would allow it to be accounted for as an operating lease or finance
lease, depending on what the entity desired for its financial statements. This ability to
manipulate the situation has caused users concern, with many arguing that the financial
statements are not transparent.
This apparent lack of transparency is because the current method of accounting for operating
leases enables entities to ‘hide’ their true liabilities: an operating lease commits the lessee to
future instalments over a period of time, but these instalments are simply expensed and the
future commitment does not appear as a liability anywhere. This is what is commonly
referred to as off-balance sheet financing (financing that can be hidden from the user). The
IASB’s project update on leases, issued in August 2014, included some fascinating figures
regarding the extent to which some companies finance their companies through off-balance
sheet financing.
Chapter 16 799
By way of example, Circuit City in the US, a company that has since gone into what is
referred to as ‘Chapter 11 liquidation’, had on average, operating lease commitments of
$4 537 million (although calculated as an undiscounted amount) over the 5 years prior to
entering ‘chapter 11’. Now, bearing in mind that operating lease commitments are not
recognised as liabilities, this company had reported debt of only $50 million. Thus this
company was essentially financing itself with operating leases rather than finance leases and
other more formal loans that would have had to be recognised and presented in the financial
statements. The operating lease commitments as a percentage of reported debt was 9 074%
(i.e. this company’s liabilities would have been 90 times higher had they been forced to
recognise the operating lease commitments as liabilities). In other words, this company was
financing itself with ‘off-balance sheet financing’. The obvious problem with this is that
users are unaware of these operating lease commitments because they are not recognised as
liabilities and thus investors, suppliers and creditors, for example, are all at risk.
Users of financial statements have thus complained that the current recognition and
disclosure of operating leases is not appropriate for their investment decisions. As a result
users have, in desperation, had to make wild estimates of what adjustments should be made
to the statement of financial position to account for ‘hidden operating leases’ so that a true
reflection of the entity’s gearing may be determined.
It is with these complaints in mind that amendments to IAS 17 have been proposed. These
proposed amendments are currently included in an exposure draft (ED 2013/6). This
replaced the previous exposure draft ED 2010/9. This section will not go into a detailed
discussion about the current exposure draft, as the detail has a habit of changing quite
dramatically during drafts. At present, public feedback on the exposure draft (ED 2013/6) has
been quite significant with the result that the new standard, which is now expected to be
released in the third quarter of 2015, is expected to differ substantially from the ED in certain
respects.
The main points of the current draft have been highlighted below:
Under the proposals in this ED 2013/6, a lessee would report assets and liabilities for all
leases of more than 12 months on its balance sheet. This would provide a more faithful
representation of the financial position of the lessee and, together with enhanced disclosures,
greater transparency about the lessee’s leverage. A lessee can choose to recognise a right-of-
use asset and a lease liability for leases of 12 months or less but is not required to do so.
In the ED 2013/6, a dual model was proposed. Under the dual model, the lease of all assets
would lead to the recognition of a right-of-use asset and a lease liability (measured at the
present value of the lease payments), but for some of these assets, the relating amortisation of
the asset and the interest on the liability would be recognised separately and other assets,
these costs would be recognised as a single lease expense which would simply be recognised
on the straight-line basis. The IASB has tentatively decided to revert to the single model that
was originally proposed in the ED 2010/9. This single model will result in all leased assets
recognising amortisation of the asset separately from the interest on the lease.
Due to the negative feedback on the proposed changes to the accounting for leases by a
lessor, the IASB has tentatively decided that all proposed changes to the current IAS 17
treatment of leases by a lessor will be dropped entirely. This is discussed in
Chapter 17: Leases: lessor accounting.
800 Chapter 16
7. Summary
Lessees
Lease classification
Does the lease transfer risks & rewards from lessor to lessee?
a) Does ownership transfer to the lessee by the end of the lease term?
b) Is there a bargain purchase option?
c) Is the lease term equal to the major part of the asset’s useful life?
d) Is the present value of the future minimum lease payments equal to
substantially all of the asset’s fair value at inception of lease?
e) Is the leased asset specialised in nature such that only the lessee can
use it without major modification?
If answer to any of the above is: Yes If answer to all of the above is: No
Finance lease Operating lease
Recognition and measurement Recognition and measurement

Initial measurement: Lease instalments are recognised as rent
- Measure the leased asset and lease expense
liability at lower of FV of asset and PV of The expense must mimic asset usage (SL:
minimum lease payments at beginning of total instalments divide by lease period in
the lease months; where total instalments excludes
- PV calculated using implicit interest rate/ contingent rent)
lessee’s incremental borrowing rate Lease expense (SL minimum rent + cont
Subsequent measurement: rent)
- Depreciate asset Accruals or prepayment adjustments will
- Minimum lease payments to be arise if the instalment amount differs
apportioned between finance charges and from amount recognised as an expense.
reduction of outstanding liability so that
there is a constant periodic rate of
interest on the O/S balance (i.e. use an
EIR table)
Taxation implications Taxation implications

A FL is treated the same as an OL Current tax: lease instalments actually
This means that: paid are deductible (excluding VAT)
Current tax: Deferred tax: prepayments/ payables will
- Deduction: lease instalments paid cause DT (tax base will be nil)
less VAT included in instalment
- VAT included in instalment = total
VAT in the lease x lease instalment/
total lease instalments
Deferred tax:
- Leased asset: No deductions on the
asset given to lessee so TB will be nil
- Lease liability: The portion of the
VAT that will still be denied as a
deduction (i.e. total VAT in the lease
x lease instalments remaining/ total
lease instalments)
Sale and leaseback
Classify the sale and leaseback using the same classification as above and treat
the resulting leaseback as above
Does the arrangement contain a lease? (IFRIC4)
2) Is the arrangement If YES to

1) Is there a right to use a If NO to any
dependent on the use of a both criteria
specified asset? criterion
specified asset? (1 & 2)
Any of the 3 criteria must be Explicitly Or implicitly IAS 17
IAS 17 applies
satisfied identified identified doesn’t apply
Chapter 16 801
SUMMARY JOURNALS AND WORKINGS
Finance lease Operating lease

Step 1: Initial Journal Step 1: Calculate rent average net of VAT
Dr Asset : Balancing a) If VAT claimable: each payment net of VAT i.e.
x 100/114
b) If VAT not claimable: each payment will remain
inclusive of VAT
Dr VAT input : 14/ 114 x cash sale value including c) Sum of all payments ÷ number of payments
(if claimable) VAT, excl finance charges = Average rent
(if per month x 12 to get an annual figure)
Cr Lease liability : Lower of FV including VAT or PV d) Ignore contingent rent in straight-lining
of MLP including VAT
Step 2: Lease Schedule (EIRTable) Step 2: Journals

Dr Rent expense : Step 1
Use the following headings: Cr Bank : Paid incl VAT
Date Interest Instalment C/balance Dr VAT input : Paid x 14/114 (if
claimable)
Dr Prepaid expenses or :Balancing figure (if
Cr Accrued expenses applicable)
Step 3: Depreciation Step 3: Current income tax calculation

a) Transfer of ownership reasonably certain: Profit before tax before adjusting for the lease
[Cost (excl VAT if claimable, incl VAT if not Less: Rent expense for the year (Step 1)
claimable) – Residual value] ÷ asset useful life
b) Transfer of ownership not reasonably certain: = Profit before tax (adjusted)
depreciate over shorter of useful life of asset or Add: Rent expense for the year (Step 1)
lease term Less: Actually paid, excluding VAT
c) If there is a guaranteed residual value: = Taxable profit
The guaranteed residual value in the lease contract x Tax rate
must be the residual value for depreciation purposes =Current income tax
Step 4: Non-current liability vs. current liability Step 4: Deferred income tax calculation
CL: next year’s payment – next year’s interest CA TB TD DT
Accrual/ Per SOFP 0 TB - CA TDx30%
NCL: closing balance on EIRT – current liability Prepaid A/ (L) A/(L)
Note: This will give you the deferred tax balance and not
the journal movement. The journal movement is
calculated by comparing the deferred tax o/balance with
the c/balance.
Step 5: Current income tax calculation

Profit before tax before adjusting for the lease
Less: Depreciation
Less: Finance costs
= Profit before tax (adjusted)
Add: Depreciation
Add: Finance costs
Less: Lease payment net of VAT
(payment – total VAT x value of instalment
total instalments
=Taxable profit
x Tax rate
=Current income tax
Step 6: Deferred income tax calculation

CA TB TD DT
XX/(XX) (XX) XX/(XX) A/L
CA = Asset carrying amount – Liability carrying amount
(c/balance per the schedule)
TB =
Total unpaid instalments ÷ Total instalments x Total VAT
802 Chapter 16
Gripping GAAP Leases: lessor accounting
Chapter 17
Leases: Lessor Accounting
Reference: IAS 17, Circular 12/ 2006 (including any amendments to 10 December 2014)
Contents: Page
1. Introduction 804
2. Finance leases 805
2.1 Overview: recognition and measurement of a finance lease 805
2.2 Disclosure of a finance lease 805
2.3 Two methods to record a lease 806
2.4 If the lessor is a manufacturer or dealer 806
2.4.1 Recognition of a finance lease: manufacturer or dealer 806
2.4.2 Measurement of a finance lease: manufacturer or dealer 806
2.4.3 Journals for a finance lease: manufacturer or dealer 807
Example 1: Finance lease: lessor is a manufacturer or dealer 808
2.5 If the lessor is neither a manufacturer nor a dealer 811
2.5.1 Recognition of a finance lease: neither manufacturer nor dealer 811
2.5.2 Measurement of a finance lease: neither manufacturer nor dealer 811
2.5.3 Journals for a finance lease: neither manufacturer nor dealer 812
Example 2: Finance lease: lessor is not a manufacturer or dealer 813
2.6 Instalments receivable in advance or in arrears 816
Example 3: Finance lease instalments receivable in advance 816
2.7 Instalments receivable during the year 818
Example 4: Finance lease instalments receivable during the period 819
2.8 Tax implications of a finance lease 821
Example 5: Deferred tax on a finance lease with no s 23A limitation 822
Example 6: Deferred tax on a finance lease with a s 23A limitation 824
Example 7: Deferred tax on a finance lease (manufacturer/ dealer) with a
s 23A limitation 826
3. Operating leases 829
3.1 Recognition of an operating lease 829
3.2 Measurement of an operating lease 829
Example 8: Operating lease – recognition and measurement 829
3.3 Tax implications of an operating lease 830
Example 9: Operating lease – tax implications 831
3.4 Disclosure of an operating lease 833
Example 10: Operating lease – disclosure 834
4. Transaction taxes 834

4.1 The effect of transaction taxes on a finance lease 834
Example 11: Finance lease with transaction taxes (VAT) 835
4.2 The effect of transaction taxes on an operating lease 837
4.2.2 Input VAT, s 23C and Interpretation Note 47 837
Example 12: Operating lease with tax and VAT 837
5. Exposure draft – expected impact thereof (ED 2013/6) 838
6. Summary 839
Chapter 17 803
1. Introduction
The principles explained in the chapter covering leases in the Classify a lease as either
books of the lessees are essentially the same as those in the a finance or operating
books of the lessor. The chief principle is substance over form. lease:
This means that where risks and rewards: if significant risks and rewards
are transferred at the end of a lease, the agreement is of ownership
really a sale agreement in which financing has been - transferred: finance lease
provided by the so-called lessor: a finance lease; or - not transferred: operating
are not transferred at the end of the lease, the agreement classification same as for a
is a true lease: an operating lease. lessee (see examples on how to
classify in the previous chapter)
See IAS 17.10
The definitions that are relevant to accounting for leases in the
books of lessees are the same as those for lessors, except for the terms minimum lease
payments and guaranteed residual value which differ slightly depending on whether you are
applying the definition to a lessee or a lessor. Thus, please revise definitions given in the
chapter on lessees. Further definitions that apply only to lessors are listed below. See IAS 17.4
The interest rate implicit in the lease is defined as:

the discount rate that, at the inception of the lease, causes the aggregate present value of:
(a) the minimum lease payments and (b) the unguaranteed residual value
to be equal to the sum of
(i) the fair value of the leased asset and (ii) any initial direct costs of the lessor.
The term minimum lease payments, from the lessor’s perspective, is defined as:
the payments over the lease term that the lessee is or can be required to make,
excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor,
together with (the following part of the definition applies only to lessors) any residual value guaranteed NOTE
to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially capable of discharging the obligations
under the guarantee.
NOTE: The part of the definition relating to the guaranteed portion differs from the perspective of the lessee.
Please see the previous chapter.
The guaranteed residual value, from the lessor’s perspective NOTE is defined as:
that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor
that is financially capable of discharging the obligations under the guarantee.
NOTE: This definition differs from the perspective of the lessee. Please see the previous chapter.
The unguaranteed residual value is defined as:

that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or
is guaranteed solely by a party related to the lessor.
Initial direct costs are defined as:

incremental costs that are directly attributable to negotiating and arranging a lease,
except for such costs incurred by manufacturer or dealer lessors.
The gross investment in the lease is defined as the aggregate of:

the minimum lease payments receivable by the lessor under a finance lease; and
any unguaranteed residual value accruing to the lessor.
The net investment in the lease is defined as

the gross investment in the lease, discounted at the interest rate implicit in the lease
Unearned finance income is defined as the difference between:

a) the gross investment in the lease; and
b) the net investment in the lease.
804 Chapter 17
2. Finance Leases (IAS 17.36 - .48)
2.1 Overview: recognition and measurement of a finance lease

Whereas a lessee pays instalments under a finance lease representing both the amount payable
for the asset acquired and interest expense, a lessor receives instalments.
For lessors who are considered to be manufacturers or Under a finance lease,
dealers, a sale is considered to have taken place when decide whether the lessor is
the lease is a finance lease. Therefore sales income and
interest income would be recognised on such a lease. Is a manufacturer/dealer:
For other lessors (i.e. lessors who are not manufacturers - recognise sales and interest income
or dealers), the income from the lease is simply Is not a manufacturer/dealer :
recognised as interest income. - recognise only interest income
Measurement of all amounts is therefore affected by whether the lessor is considered to be a

manufacturer or dealer, or considered not to be a manufacturer or dealer.
There is no depreciation of the asset under a finance Under a finance lease, a
lease in the books of lessors (whether manufacturer/ lessor does NOT depreciate
dealers or not), as significant risks and rewards would the asset
have been transferred to the lessee. Thus the asset is, in derecognise the asset!
fact, always derecognised from the lessor’s books.
The difference in measurement means that the journals in the books of the lessor will differ
slightly depending on whether the lessor is either (a) a manufacturer or dealer or (b) not a
manufacturer or dealer. The journals relevant to each of these two categories of lessor
(manufacturer/ dealer or non-manufacturer/ dealer) are covered in specific sections further on.
2.2 Disclosure of a finance lease (IAS 17.47)
Lessors involved with finance leases must disclose the following information (in addition to
the disclosure requirements laid down in IFRS 7: Financial Instruments: Disclosure):
a reconciliation between the gross investment in the lease and the present value of future
minimum lease payments receivable at the end of the reporting period;
an analysis of both the gross investment and the present value of future minimum lease
payments receivable at the end of the reporting period into:
- receivable within one year
- receivable between one and five years
- receivable later than five years;
unearned finance income;
unguaranteed residual values accruing to the benefit of the lessor;
accumulated allowance for uncollectible minimum lease payments receivable;
contingent rents recognised as income in the period;
a general description of the lessor’s material leasing arrangements.
The first three bullets listed above can be achieved by presenting a note such as the following:
Example Limited
20X3 20X2 20X1
25. Finance lease debtor C C C
Gross investment in finance lease xxx xxx xxx
Within 1 year xxx xxx xxx
After 1 year but before 5 years xxx xxx xxx
After 5 years xxx xxx xxx
Unearned finance income xxx xxx xxx
Present value of future minimum lease payments (capital): xxx xxx xxx
Within 1 year xxx xxx xxx
After 1 year but before 5 years xxx xxx xxx
After 5 years xxx xxx xxx
Chapter 17 805
2.3 Two methods to record a lease
There are two methods whereby a lessor can record a lease: the gross method or the net
method. A company can choose which method it wishes to adopt.
If the gross method is adopted, then we create the following accounts:
A ‘lease receivable account’ (“gross investment in the The gross method
lease”), which is measured at the undiscounted: recognises:
- minimum lease payments (a defined term) and the
a lease receivable:
- unguaranteed residual value (a defined term). showing the gross
This gross investment is decreased over the lease term by investment;
lease payments and the guaranteed and unguaranteed residual unearned finance
values. income
An ‘unearned finance income account’ which is amortised to
profit or loss as interest income over the term of the lease.
This balance is measured by subtracting from the lease receivable the present value of
the lease receivable.
If the net method is adopted, then we create the following account: The net method
A lease receivable account (“net investment in the lease”) recognises:
which is measured at the present value, (discounted at the a lease receivable:
interest rate implicit in the lease) of both the: showing the net
- minimum lease payments (a defined term); and the investment;
- unguaranteed residual value. NI = GI - UFI
Although interest income will be recognised, an unearned interest income account is

not recognised.
The “net investment in the lease” therefore equals: the “gross investment in the lease”
less the “unearned interest income.”
The choice of method will result in different accounts being recognised when preparing
journal entries. However, the disclosure under both methods will be the same.
For the first two examples in this chapter, we will show how these two methods differ.
Thereafter the gross method will be used as this method provides more detailed information
which is useful for preparation of financial statement disclosures.
2.4 If the lessor is a manufacturer or dealer (IAS 17.38; and .44 - .46 )
2.4.1 Recognition of a finance lease: manufacturer or dealer (IAS 17.36 - .38 and .43)
For lessors who are manufacturers or dealers offering finance leases (i.e. instead of cash
sales), the instalments received represent two types of income:
sales revenue; and
interest income.
2.4.2 Measurement of a finance lease: manufacturer or dealer (IAS 17.38 and .42 - .46)
If the lessor is a manufacturer or dealer, the measurement of the items is as follows:
sales revenue:
is measured at the lower of (a) the fair value of the asset or (b) the present value of the
minimum lease payments, computed using a market interest rate;
interest income:
should be measured at (a) the rate implicit in the agreement, (or (b) the market interest
rate if the present value of the minimum lease payments is less than the fair value of the
asset sold), multiplied by the cash sales price of the asset sold; See IAS 17.42
any costs incurred in securing or negotiating the lease (initial direct costs):
are simply expensed at the time that the sales revenue is recognised.
806 Chapter 17
2.4.3 Journals for a finance lease: manufacturer or dealer

Remember that if the lessor is a manufacturer or dealer, the finance lease is considered to be a
sale. The basic journal entries will therefore be as follows:
Using the gross method:
Jnl 1. Dr Finance lease debtors: gross investment (instalments receivable)
Cr Finance lease debtors: unearned finance income
Cr Sales revenue
Jnl 2. Dr Cost of sales
Cr Inventory
Jnl 3. Dr Bank
Cr Finance lease debtors: gross investment (instalment received)
Jnl 4. Dr Finance lease debtors: unearned finance income
Cr Finance income (interest income earned)
Alternatively, using the net method:
Jnl 1. Dr Finance lease debtors: net investment

Cr Sales revenue
Jnl 2. Dr Cost of sales
Cr Inventory
Jnl 3. Dr Bank
Cr Finance lease debtors: net investment
Cr Finance income (interest income earned)
Journal entry 1
At the commencement of the lease term, lessors shall record finance leases by recognising:
an asset (finance lease debtor); and
a corresponding income (sales revenue).
These items will be measured at amounts equal to the lower of the:
fair value of the leased property; or
the present value of the minimum lease payments.
The discount rate used to calculate the present value is the market interest rate.
At the start of the lease, the finance lease debtor (called the ‘net investment in finance lease’)
reflects the amount that the debtor would have owed had he bought the leased asset for cash.
If we use the gross method, this debtor’s balance is separated into two accounts: a positive
asset and a negative asset (much the same as an item of equipment is separated into cost and
accumulated depreciation). The information in these two accounts making up this finance
lease debtor must be disclosed in the financial statements. These two accounts represents the:
gross investment: representing the total instalments that the debtor has agreed to pay
less the unearned finance income portion: representing the interest that the debtor has not
yet incurred, but will incur over the period of the lease.
As you can see, splitting the finance lease debtor into two accounts when using the gross
method (i.e. where the debtor is split into a gross account and an unearned income account)
will be helpful for disclosure purposes.
Notice that, on this first day of the transaction, only the sales income is owed to the lessor.
This is because interest is recognised on a time basis and therefore no interest income could
yet have been earned on the first day of the transaction.
Chapter 17 807
Journal entry 2
Where the lessor is a manufacturer or dealer, inventory is sold in which case there is
obviously a cost of sale that needs to be recognised too.
Journal entry 3
The lease payments received reduce the debtors account.
Journal entry 4
The debtors account is increased by the interest earned on the debtors balance during the
period. The interest income is calculated by multiplying the balance owing by the debtor by
the market interest rate.
Costs incurred by a manufacturer or dealer lessor in arranging a lease are not included in the
definition of initial direct costs. They are therefore excluded from the debtors balance and are
simply recognised as an expense when the sales and cost of sales are recognised.
Example 1: Finance lease: lessor is a manufacturer or dealer
Lemon Tree Limited is a dealer in machines, which it sells for cash or under a finance lease.
Lemon Tree Limited sold only one machine (which it purchased on 1 January 20X1 for
C250 000), during 20X1. The machine was sold under a finance lease, but had a cash sales price of
C320 000. The terms of the lease are as follows:
inception of lease: 1 January 20X1
lease period: 5 years
lease instalments: C100 000, annually in arrears, payable on 31 December of each year.
The market interest rate applicable is 16,9911%.
Required: Prepare the journal entries for each of the years ended 31 December 20X1 to 20X5 in
Lemon Tree Limited’s books (the books of the lessor).
A. Using the gross method.
B. Using the net method.
C. Prepare Lemon Tree Limited’s disclosure for each of the years ended 31 December 20X1 to 20X5.
Ignore tax.
Solution 1: Finance lease: lessor is a manufacturer or dealer
Comment: Calculate interest on prior year’s debtor’s balance if instalments are in arrears & coincide with year-end.
W1: Analysis of total amount receivable C

Total future lease payments 100 000 x 5 years 500 000
Guaranteed residual value Not applicable in this example 0
Gross investment 500 000
Selling price (net investment) Given (also = PV of minimum lease payments) 320 000
Gross profit 320 000 – 250 000 70 000
Cost of asset Given 250 000
Finance income 500 000 – 320 000 180 000
W2: Effective interest rate method Finance income: 16.9911% Instalment Debtors balance
01 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
Notes: (a) (b) (c)
(a) Finance income: The total of this column represents the unearned finance income at the start of the lease and
shows how this income is earned in each year.
(b) Instalments (Gross investment in finance lease): The total of this column represents the gross investment in
the lease (the total amounts receivable from the lessee).
(c) Debtors balance (Net investment in finance lease): This column represents the actual balance owing by the
lessee. This balance represents the present value of the future minimum lease payments (this balance equals
the net investment in the lease, if the interest income earned is all received).
808 Chapter 17
Solution 1A: Journal Entries (gross method)

Bank (A) 250 000
Purchase of inventory
Cost of sale (E) 250 000
Cost of machine sold under finance lease
Finance lease debtors – gross investment (A) W1 500 000
Finance lease debtors – unearned finance income (-A) W1 180 000
Sale (I) W1 320 000
Finance lease entered into, cash sales price of C320 000 and 5 years of arrear
instalments of C100 000 each
31/12/20X1
Bank (A) 100 000
Finance lease debtors – gross investment (A) 100 000
Instalment received under finance lease
Finance lease debtors – unearned finance income (-A) W2: EIRT 54 372
Finance income 54 372
Interest income earned at 16.9911% , (using an effective interest rate table)
31/12/20X2
Bank (A) 100 000
31/12/20X3
Bank (A) 100 000
31/12/20X4
Bank (A) 100 000
31/12/20X5
Bank (A) 100 000
Chapter 17 809
Solution 1B: Journal Entries (net method)

Bank (A) 250 000
Cost of machine sold under finance lease
Finance lease debtors – net investment (A) W1: (500 000 – 180 000) 320 000
Sale (I) 320 000
Finance lease entered into, cash sales price of C320 000 and 5 years of arrear
instalments of C100 000 each
31/12/20X1
Bank (A) 100 000
Finance lease debtors – net investment (A) 100 000
Finance lease debtors – net investment (A) W2: EIRT 54 372
31/12/20X2
Bank (A) 100 000
31/12/20X3
Bank (A) 100 000
31/12/20X4
Bank (A) 100 000
31/12/20X5
Bank (A) 100 000
810 Chapter 17

Lemon Tree Limited
as at 31 December 20X5
20X5 20X4 20X3 20X2 20X1
Non-current assets Notes C C C C C
Lease debtors 25 0 0 85 477 158 539 220 990
Current assets
Lease debtors 25 0 85 477 73 062 62 451 53 382
Lemon Tree Limited

20X5 20X4 20X3 20X2 20X1
25. Finance lease debtor C C C C C
Gross investment in finance lease 0 100 000 200 000 300 000 400 000
Within 1 year W2: (a) 0 100 000 100 000 100 000 100 000
After 1 year but before 5 years W2: (a) 0 0 100 000 200 000 300 000
After 5 years W2: (a) 0 0 0 0 0
Unearned finance income W2: (b) (0) (14 523) (41 461) (79 010) (125 628)
(a-5) (a-4) (a-3) (a-2) (a-1)
Present value of future minimum lease payments: 0 85 477 158 539 220 990 274 372
Within 1 year (b) 0 85 477 73 062 62 451 53 382
After 1 year but before 5 years (c) 0 0 85 477 158 539 220 990
After 5 years N/A 0 0 0 0 0
Using W2:
(a) unearned interest at the start of the current year – int income in current year
(a-1) 180 000 – 54 372 (a-2) 125 628 – 46 618 (a-3) 79 010 – 37 549
(a-4) 41 461 – 26 938 (a-5) 14 523 – 14 523
(b) instalment due next year – future interest income included in this instalment
(c) instalments due in the yrs after next year – future interest income included in these instalments
2.5 If the lessor is neither a manufacturer nor a dealer (IAS 17.36 - .41A)
2.5.1 Recognition of a finance lease: neither manufacturer nor dealer (IAS 17.36 - .38)
For lessors who are neither manufacturers nor dealers, the For a lessor who is
instalments received represent: neither
the cost of the asset disposed of (i.e. finance lease); and manufacturer/dealer:
finance income. recognise only interest
income
2.5.2 Measurement of a finance lease: neither manufacturer nor dealer (IAS 17.36 - .41A)
If the lessor is neither a manufacturer nor a dealer, the measurement of the items is as follows:
interest income:
should be measured at the rate implicit in the agreement multiplied by the cost of the
asset disposed of under the finance lease;
any costs incurred in securing or negotiating the lease (initial direct costs):
are included in the calculation of the implicit interest rate (thus automatically reducing
the interest income recognised over the period of the lease).
Chapter 17 811
2.5.3 Journals for a finance lease: neither manufacturer nor dealer
If the lessor is not a manufacturer or dealer, the basic journal entries will be as follows:
Using the gross method:
Jnl 1. Dr Finance lease debtors: gross investment (instalments receivable)

Cr Finance lease debtors: unearned finance income
Cr Asset disposed of under the finance lease (cost or carrying amount)
Jnl 2. Dr Bank
Cr Finance lease debtors: gross investment (instalment received)
Jnl 3. Dr Finance lease debtors: unearned finance income

Cr Finance income (finance income earned)
Alternatively, using the net method:

Cr Asset disposed of under the finance lease (cost or carrying amount)
Jnl 2. Dr Bank
Cr Finance lease debtors: net investment

Cr Finance income (finance income earned)
Journal entry 1
At the commencement of the lease term, lessors shall record finance leases by recognising an
asset (finance lease debtor) and a corresponding asset disposal. These items will be raised at
the present value of the net investment in the lease, being defined as:
the minimum lease payments owing to the lessor; plus
any unguaranteed residual that may accrue to the lessor.
The discount rate used to calculate the present value of the minimum lease payments is the
interest rate implicit in the lease.
At the inception of the lease, the finance lease debtor (or otherwise called ‘net investment in
finance lease’) will represent the capital portion owing by the debtor.
If we use the gross method, this debtor’s balance is separated into two accounts: a positive
asset and a negative asset (much the same as an item of equipment is separated into cost and
accumulated depreciation). The information in these two accounts making up this finance
lease debtor must be disclosed in the financial statements. These two accounts represents the:
gross investment: representing the total instalments that the debtor has agreed to pay
less the unearned finance income portion: representing the interest that the debtor has not
yet incurred, but will incur over the period of the lease.
As you can see, splitting the finance lease debtor into two accounts when using the gross
method (i.e. where the debtor is split into a gross account and an unearned income account)
will be helpful for disclosure purposes.
Notice that the lessor is not owed any interest income on the first day of the transaction.
Journal entry 2
The lease payments received reduce the debtors account.
812 Chapter 17
Journal entry 3
The debtors account is increased by the interest incurred by the debtor on the balance he owed
to the lessor during the period. The lessor recognises this as interest income and measures it
by multiplying the balance owing by the debtor by the appropriate interest rate.
Costs incurred by a lessor in arranging a lease (e.g. legal costs) where the lessor is neither a
manufacturer nor a dealer are included in the definition of initial direct costs. They are
therefore included in the calculation of the implicit interest rate and thus automatically reduce
both the debtors balance and the income recognised over the period. There is therefore no
need to add these costs separately.
Summary: Finance leases (lessor perspective)
Is it a finance lease?
YES, if substantially all risks and rewards of ownership have transferred (see five examples IAS 17.10)
If a manufacturer/ dealer: If not a manufacturer/ dealer:

Remove asset Remove asset
Recognise two types of income: finance income and Recognise one type of income: finance income
sale proceeds Recognise initial direct costs as part of cost of
Recognise initial direct costs as expense up-front lease receivable (built into implicit rate thus
reduces finance income)
Example 2: Finance lease: lessor is not a manufacturer or dealer

Orange Tree Limited is neither a dealer nor a manufacturer. Orange Tree Limited entered
into an agreement under which Orange Tree Limited leased a machine to
Beanstalk Limited.
Orange Tree Limited purchased this machine on 1 January 20X1 at a cost of C210 000. The lease is a
finance lease, the terms of which are as follows:
The terms of the lease are as follows:
lease instalments: C90 000, annually in arrears, payable on 31 December of each year
guaranteed residual value: C10 000, payable on 31 December 20X3.
The interest rate implicit in the agreement is 15.5819%.
Required: Prepare the journal entries for each of the years ended 31 December 20X1 to 20X3 in
Orange Tree Limited’s books (the books of the lessor):
A. Using the gross method.
B. Using the net method.
C. Prepare the disclosure for each of the years ended 31 December 20X1 to 20X3 in Orange Tree
Limited’s books.
Ignore tax.
Solution 2: Finance lease: lessor is not a manufacturer or dealer

Comment: Interest is calculated on the debtors balance at year-end when instalments are in arrears and
coincide with the year-end.

Guaranteed residual value Given 10 000
Finance income 280 000 – 210 000 70 000
Chapter 17 813
W2: Effective interest rate table Finance income:15.5819% Instalment Debtors balance
1 January 20X1 210 000
31 December 20X1 32 722 (90 000) 152 722
31 December 20X2 23 797 (90 000) 86 519
31 December 20X3 13 481 (100 000) 0
70 000 (280 000)
(a) (b) (c)
Notes:
(a) Finance Income: the total of this column represents the unearned finance income at the start of the
lease and shows how this income is then earned each year
(b) Instalment (Gross Investment in Finance Lease): the total of this column represents the gross
investment in the lease (the total amounts receivable from the lessee)
(c) Debtors balance (Net Investment in Finance Lease): this column represents the actual balance
owing by the lessee. This balance represents the present value of the future minimum lease
payments (i.e. it equals the net investment in the lease, if the interest earned is all received).
Solution 2A: Journals: gross method

Machine: cost (A) Given 210 000

Bank (A) 210 000
Purchase of machine
Finance lease debtors – gross investment (A) W2 (a) 280 000
Finance lease debtors – unearned finance income (-A) W2 (b) 70 000
Machine: cost (A) W2(c) 210 000
Finance lease entered into over a machine costing C210 000;
Total receivable: C280 000 (90 000 x 3yrs + 10 000 residual value)
31/12/20X1
Bank (A) 90 000
Finance lease instalment received
Finance lease debtors – unearned finance income (-A) 32 722
Interest income earned, (effective interest table, W2)
31/12/20X2
Bank (A) 90 000
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Finance lease instalment received and guaranteed residual
814 Chapter 17
Solution 2B: Journals: net method

Machine (A) Given 210 000
Bank (A) 210 000
Purchase of machine
Finance lease debtors – net investment (A) W2 (a) 210 000
Machine (A) W2(c) 210 000
Finance lease entered into over a machine costing C210 000
31/12/20X1
Bank (A) 90 000
Interest income earned, (calculated using the effective interest table)
31/12/20X2
Bank (A) 90 000
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Finance lease instalment received and guaranteed residual

Comment: When doing disclosure on the face of the Statement of Financial Position it is usually easier to draw up
the note first and then do the disclosure on the face with the information from the note.
Orange Tree Limited

20X3 20X2 20X1
16. Finance lease debtor C C C
Gross investment in finance lease 0 100 000 190 000
Within 1 year W2: (a) 0 100 000 90 000
After 1 year but before 5 years W2: (a) 0 0 100 000
After 5 years W2: (a) 0 0 0
Unearned finance income W2: (b) (0) (3) (13 481) (2) (37 278) (1)
Present value of future minimum lease payments W2: (c) 0 86 519 152 722
Within 1 year W2: (a - b) 0 86 519 (5) 66 203 (4)
After 1 year but before 5 years W2: (a - b) 0 0 86 519 (5)
After 5 years W2: (a - b) 0 0 0
Notes:
(1) 70 000 – 32 722 = 37 278 (2) 37 278 – 23 797 = 13 481 (3) 13 481 – 13 481 = 0
(4) next instalment 90 000 – future interest included in instalment 23 797 = 66 203
(5) instalment: 100 000 – future interest included in instalment 13 481 = 86 519
Chapter 17 815
Solution 2C: Disclosure continued ...

Orange Tree Limited
20X3 20X2 20X1
Non-current assets Notes C C C
Finance lease debtors 16 0 0 86 519
Current assets
Finance lease debtors 16 0 86 519 66 203
2.6 Instalments receivable in advance or in arrears

All previous examples have dealt with instalments
receivable in arrears, but instalments may be receivable in Whether instalments are
in advance or arrears
advance instead. The very first instalment received in
is an important point when:
advance will reduce the capital balance owing (i.e. it will
calculating interest income using
only reduce the capital balance owing by the lessee and will
the EIR Table; and
not include a repayment of interest).
disclosing the finance lease debtor
If the instalments are payable at the end of a period (arrears), the balance owing by the debtor
at the end of that period (i.e. the net investment in finance lease) will simply be the portion of
the original capital sum that he still owes to the lessor (i.e. the balance of the cash sum that he
would have paid had he bought the asset instead of leased it under a finance lease): the
debtor’s balance will not include any interest.
If, however, the instalments are received in advance or when the lessee does not make an
instalment payment in due time, the balance owing by the debtor at the end of the period will
include not only the remaining capital sum still owing by the debtor (present value of future
minimum lease payments) but also the interest owing between the date of the last instalment
made and the end of the period.
Depending on whether the instalments are payable in advance or in arrears will also affect the
disclosure of the finance lease debtors in the notes to the financial statements, since the gross
investment in the finance lease must be reconciled to the present value of the future minimum
lease payments (capital outstanding) – which is now no longer equal to the balance on the
finance lease debtors account (net investment in the finance lease).
Example 3: Finance lease: instalments receivable in advance
Pear Tree Limited is neither a dealer nor a manufacturer. Pear Tree Limited entered into an
agreement in which Pear Tree leased a machine to Giant Limited (cost C210 000). The
lease is a finance lease, the terms of which are as follows:
lease instalments: C80 000, annually in advance, payable on 1 January of each year
guaranteed residual value: C10 000, payable on 31 December 20X3;
interest rate implicit in the agreement: 18.7927%.
Required: Prepare the journals and disclosure for each of the years ended 31 December 20X1 to 20X3
in Pear Tree Limited’s books (the books of the lessor). Ignore tax.
Solution 3: Finance lease: instalments receivable in advance
Comment: Interest is calculated on the debtors opening balance adjusted for the instalment when instalments are
in advance and coincide with the start of the financial year.

Guaranteed residual value Given 10 000
Finance income 250 000 – 210 000 40 000
816 Chapter 17
W2: Effective interest rate table Instalment Finance income: 18.7927% Debtors balance
01 January X1 210 000
01 January X1 (80 000) 0 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
(250 000) 40 000
Notes: (a) (b) (e)
(a) Instalments column: (Gross investment in finance lease): The total of this column represents the gross
(b) Finance income: The total of this column represents the unearned finance income at the start of the lease and
shows how this income is then earned each year
(c) Debtors balance (Net investment in finance lease): This column represents the total balance receivable from
the lessee. It includes both the capital owing and the interest owing for the year, which, in this example, will
be paid as part of the next instalment. The net investment is no longer equal to the present value of future
minimum payments (capital sum receivable) since the net investment includes interest income receivable.

1/1/20X1
Bank (A) 210 000
Purchase of machine
Machine: cost (A) W1 210 000
Finance lease entered into over machine costing C210 000; total
receivable: C250 000 (80 000 x 3 years + 10 000 residual value)
Bank (A) 80 000
31/12/20X1
1/1/20X2
Bank (A) 80 000
31/12/20X2
1/1/20X3
Bank (A) 80 000
31/12/20X3
Bank (A) 10 000
Chapter 17 817
Pear Tree Limited
20X3 20X2 20X1
7. Finance lease debtors C C C
Gross investment in finance lease 0 90 000 170 000
Within 1 year W2 (a) 0 90 000 (1) 80 000
After 1 year but before 5 years W2 (a) 0 0 90 000 (1)
After 5 years W2 (a) 0 0 0
Unearned finance income W2 (b) 0 (4) (1 581) (3) (15 569) (2)
Net investment in finance lease (debtors balance) 0 88 419 154 431
Represented by:
Finance income earned but receivable W2 (b) 0 13 988 24 431
Present value of future minimum payments (i.e.
capital) 0 74 431 130 000
Within 1 year W2 (a - b) 0 74 431 (6) 55 569
After 1 year but before 5 years W2 (a - b) 0 0 74 431
After 5 years W2 (a - b) 0 0 0
Calculations:
Using W2 column (a):
(1) 80 000 + 10 000 (using W2 column (a))
Using W2 column (b):
(2) 40 000 – 24 431 (3) 15 569 – 13 988 (4) 1 581 – 1 581
Using W2 column (a) and (b): next instalment/s – interest included in this instalment
(5) 80 000 – 24 431 = 55 569 (6) 80 000 + 10 000 – 13 988 – 1 581 = 74 431
Pear Tree Limited

20X3 20X2 20X1
Finance lease debtors: capital receivable 7 0 0 74 431
Current assets
Finance lease debtors: capital receivable 7 0 74 431 55 569
Finance lease debtors: interest receivable 7 13 988 24 431
2.7 Instalments receivable during the year
Instalments may be receivable during the year rather than Instalments during the
on either the first or last day of the year. The best way to year:
approach this is to, when drawing up the effective interest this occurs when the year-end
rate table, plot all the payments on the dates on which they does not coincide with the lease
fall due. The interest that belongs to the year on which you payment dates
are reporting is then simply apportioned in a separate therefore plot the instalments on
calculation. the EIR Table and apportion
interest
818 Chapter 17
Example 4: Finance lease instalments receivable during the period

Avocado Tree Limited is a dealer in machines.
It entered into an agreement to lease a machine to Giant Limited.
Avocado Tree Limited purchased the machine on 1 July 20X1 at a cost of C100 000.
The cash sales price of this machine is C210 000. The lease is a finance lease, the terms
of which are as follows:
- inception of lease: 1 July 20X1
- lease period: 5 years
- lease instalments: C60 000, annually in advance, payable on 1 July of each year
- interest rate implicit in the agreement: 21.8623%.
Required: Prepare the journal entries and disclosure for each of the years ended 31 December 20X1 to
20X5 in Avocado Tree Limited’s books (the books of the lessor). Ignore tax.
Solution 4: Finance lease instalments receivable during the period
Guaranteed residual value Not applicable in this example 0
Selling price (net investment) Given 210 000
Gross profit 210 000 – 100 000 110 000
Finance income 300 000 – 210 000 90 000
W2: Effective interest rate table Finance income: Instalment Debtors balance
21.8623%
1 July 20X1 210 000
1 July 20X1 (60 000) 150 000
31 Dec 20X1 32 793 X 6/12 16 397 166 397
1 July 20X2 32 793* X 6/12 16 396 (60 000) 122 793
31 Dec 20X2 26 845 X 6/12 13 423 136 216
1 July 20X3 26 845 X 6/12 13 422 (60 000) 89 638
31 Dec 20X3 19 598 X 6/12 9 799 99 437
1 July 20X4 19 598 X 6/12 9 799 (60 000) 49 236
31 Dec 20X4 10 764 X 6/12 5 382 54 618
1 July 20X5 10 764 X 6/12 5 382 (60 000) 0
90 000 (300 000)
(b) (a) (c)
(*) Rounded to allow the table to equal zero
(a) Instalments (Gross investment in finance lease): The total of this column represents the gross
(b) Finance income: The total of this column represents the unearned finance income at the start of the
lease and shows how this income is then earned each year
(c) Debtors balance (Net investment in finance lease): This column represents the total balance
receivable from the lessee. It includes both the capital owing and the interest owing for the year,
which in this example, will be paid as part of the next instalment.
Comment: Interest requires apportionment to the correct period if payment occurs during the period.
The table has been adapted to show this apportionment and extract closing balances. This is not
necessary though (i.e. the table could be drawn up as in previous examples and the apportionment could
be done in the journals instead).
1/7/20X1
Bank (A) 100 000
Inventory sold under finance lease
Chapter 17 819

Sale (I) W1 210 000
Sale of machine under finance lease
Bank (A) 60 000

31/12/20X1
Finance income W2: 16 397 16 397
Finance income earned, effective interest rate table
1/7/20X2
Bank (A) 60 000
31/12/20X2
Finance income W2: 16 396 + 13 423 29 819
Finance income earned, effective interest rate table:
1/7/20X3
Bank (A) 60 000
31/12/20X3
Finance income W2: 13 422 + 9 799 23 221
1/7/20X4
Bank (A) 60 000
31/12/20X4
Finance income W2: 9 799 + 5 382 15 181
1/7/20X5
Bank (A) 60 000
31/12/20X5
Finance income W2: 5 382 5 382
820 Chapter 17

Avocado Tree Limited
20X5 20X4 20X3 20X2 20X1
Non-current assets Notes C C C C C
Finance lease debtors: capital 15 0 0 49 236 89 639 122 793
Current assets
Finance lease debtors: capital 15 0 49 236 40 402 33 155 27 207
Finance lease debtors: interest 15 0 5 382 9 799 13 423 16 397
Avocado Tree Limited

20X5 20X4 20X3 20X2 20X1
15. Finance lease debtor C C C C C
Gross investment in finance lease 0 60 000 120 000 180 000 240 000
Within 1 year W2 (a) 0 60 000 60 000 60 000 60 000
After 1 year but before 5 years W2 (a) 0 0 60 000 120 000 180 000
After 5 years W2 (a) 0 0 0 0 0
Unearned finance income W2 (b) (0) (5 382) (20 563) (43 784) (73 603)
(e) (d) (c) (b) (a)
Net investment in finance lease W2 (c) 0 54 618 99 437 136 216 166 397
Represented by:
Finance income earned but receivable W2 0 5 382 9 799 13 423 16 397
Present value of future minimum lease
payments, capital repayable: 0 49 236 89 638 122 793 150 000
- Within 1 year (f) – (i) 0 49 236 40 402 33 155 27 207
- Due after 1 year but before 5 years (i) – (k) 0 0 49 236 89 639 122 793
- After 5 years N/A 0 0 0 0 0
(a) 90 000 – 16 397 (W2) (b) 73 603 – 29 819 (W2) (c) 43 784 – 23 221 (W2)
(d) 20 563 – 15 181 (W2) (e) 5 382 – 5 382 (W2)
Using W2: future instalments due – interest included in instalments:
(f) 60 000 – 16 397 x 2 = 27 207 (g) 60 000 – 13 423 x 2 = 33 155 (h) 60 000 – 9 799 x 2 = 40 402
(i) 60 000 – 5 382 x 2 = 49 236 (j) 60 000 x 3 – 13 423 x 2 – 9 799 x 2 - 5 382 x 2 = 122 793
(k) 60 000 x 2 – 9 799 x 2 – 5 382 x 2 = 89 639
2.8 Tax implications of a finance lease

Finance leases will generally have deferred tax implications since most tax authorities do not
differentiate between finance leases and operating leases. Rather, most tax authorities treat all
leases as operating leases for income tax purposes.
The tax authority, in not recognising the substance of the From a tax
finance lease (i.e. the ‘sale’), holds the view that the asset perspective:
belongs to the lessor and not the lessee. lessor is the deemed owner
- the asset has a tax base
Thus, the lessor is taxed on the lease instalments received less - the lessor is allowed tax
an annual deduction based on the leased asset’s cost (e.g. an deductions
annual capital allowance of 20% of the cost of the leased asset). DT arises as the asset’s
This creates a temporary difference because: CA = nil, but there is a TB!
the lessor immediately expenses the asset’s entire cost but
the tax authorities deduct the cost piecemeal using capital allowances based on a
percentage of the asset’s cost; and
the lessor recognises the instalments as income using an effective interest rate table (i.e.
sale incomes, if a manufacturer or dealer, and interest income) but the tax authorities tax
the instalments received on a cash basis.
Chapter 17 821
To complicate matters further, some tax authorities do Beware of the S23A

not allow the capital allowances to exceed the taxable limitation:
lease income in any one period. In South Africa, for
Tax allowances on machinery/plant
example, section 23A of the Income Tax Act limits (s11 (e) & s12) are limited to taxable
certain tax allowances to taxable lease income. lease income.
This limitation doesn’t apply to
See the section on transaction taxes (e.g. VAT) and its building allowances (s13)
impact on a lessor in a finance lease.
Summary: Finance lease tax consequences
Current tax Deferred tax

Profit before tax…
finance lease debtor
+ lease payment – (VAT x lease pmt/ total lease pmts) (see later)
- has a CA, but no TB
- tax allowance (possibly limited by S23A)
machine
- interest income (remove from profit; not taxed)
- no CA, but has a TB
…Taxable profit
Example 5: Deferred tax on a finance lease with no s 23A limitation, VAT

ignored
The facts from example 3 apply, repeated here for your convenience: Pear Tree Limited is
neither a dealer nor a manufacturer. Pear Tree Limited entered into an agreement in which Pear Tree
leased a machine to Giant Limited (cost C210 000 on 1 January 20X3). The lease is a finance lease, the
terms of which are as follows:
guaranteed residual value: C10 000, payable on 31 December 20X3;
Assume further that the tax authorities:
tax lease instalments when received;
allow the deduction of the cost of the asset over three years (capital allowance);
the income tax rate is 30%.
This is the only transaction in the years ended 31 December 20X1, 20X2 and 20X3.
Required:
Prepare the current tax and deferred tax journal entry for each of the years affected. Ignore VAT.
Solution 5: Deferred tax on a finance lease with no s 23A limitation, VAT ignored
Comment:
This example is based on the same basic facts as given in example 3.
The effective interest rate table for example 3 has been repeated here for your convenience.
Please see example 3 for any other calculation and/ or for the journals.
W1: Finance income: Instalment Debtors balance

Effective interest rate table 18.7927%
01 January X1 210 000
01 January X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 (250 000)
822 Chapter 17

W2: Carrying Tax Temporary Deferred
Deferred tax on the machine amount Base difference taxation
Opening balance 20X1 0 0 0 0
Purchase 210 000 210 000
Finance lease disposal (210 000) 0
Capital allowance 0 (70 000)
Closing balance 20X1 0 140 000 140 000 42 000 A
Closing balance 20X3 0 0 0 0
W3: Deferred tax on the Carrying Tax Temporary Deferred
finance lease debtor amount base difference taxation
New lease 210 000 0
Movement (W1) (55 569) 0
Closing balance (W1) 20X1 154 431 0 (154 431) (46 329) L
Movement (W1) (66 012) 0
Closing balance 20X2 88 419 0 (88 419) (26 526) L
Movement (W1) (88 419) 0
Closing balance (W1) 20X3 0 0 0 0
W4: Deferred tax summary Machine Finance lease Total
(W2) Debtor (W3)
Opening balance 20X1 0 0 0
Adjustment 20X1 (4 329) cr DT; dr TE
Closing balance 20X1 42 000 (46 329) (4 329) L
Adjustment 20X3 5 526 dr DT; cr TE
Closing balance 20X3 0 0 0
W5: Current tax summary 20X3 20X2 20X1 Total

C C C C
Profit before tax: finance income 1 581 13 988 24 431 40 000
Adjust for temporary differences
- less finance income (1 581) (13 988) (24 431) (40 000)
- add lease instalment received 90 000 80 000 80 000 250 000
- less capital allowance (70 000) (70 000) (70 000) (210 000)
Taxable profit 20 000 10 000 10 000 40 000
Current income tax at 30% 6 000 3 000 3 000 12 000
Journals: 31/12/20X1 Debit Credit

Current tax charge (W5)
Deferred tax adjustment (W4)
31/12/20X2
Chapter 17 823
31/12/20X3
Example 6: Deferred tax on a finance lease: s 23A limitation, VAT ignored

The facts from example 3 apply, repeated here for your convenience: Pear Tree Limited is
neither a dealer nor manufacturer. Pear Tree entered into an agreement in which Pear Tree
leased a machine to Giant Limited (cost C210 000). The lease is a finance lease, the terms being:
inception of lease: 1 January 20X1 with the lease period being 3 years
guaranteed residual value: C10 000, payable on 31 December 20X3
tax lease instalments when received;
allow a capital allowance of the cost of the asset over two years;
the tax authorities limit the capital allowance to the taxable lease income, where any excess that is
not allowed as a deduction is able to be deducted against future lease income (s 23A);
There are no temporary differences other than those evident from the information provided and there
are no non-deductible expenses and no exempt income.
Required: Prepare the current and deferred tax journals for each of the years affected. Ignore VAT.
Solution 6: Deferred tax on a finance lease with a s 23A limitation, VAT ignored
W1: Effective interest rate table Finance income: 18.7927% Instalment Debtors balance
01 January X1 210 000
01 January X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 250 000
W2: Deferred tax on the machine CA TB TD DT
Purchase 210 000 210 000
Finance lease disposal (210 000) 0
S23A limitation (W2.1) 25 000
S23A limitation (W2.1) 25 000
Capital allowance 0 0
S23A allowance (W2.1) (50 000)
824 Chapter 17
W2.1: s 23A: limitation of allowances to taxable income 20X1 20X2 20X3
Lease payment received 80 000 80 000 90 000
Less allowances
- Capital allowance (105 000) (105 000) 0
- s 23A catch-up allowance b/f: X3: 25 000 + X2: 25 000 0 (25 000) (50 000)
Taxable profit (loss) (25 000) (50 000) 40 000
- s 23A limitation c/f 25 000 50 000 0
Taxable profit after limitation 0 0 40 000
Comment: when doing a ‘lessor – finance lease’ question, it may be best to first do the s 23A check (W2.1) to
see whether or not the limitation applies.
W3: DT on the fin lease debtor CA TB TD DT

New lease (W1) 210 000 0
Movement (55 569) 0
Closing balance 20X1 154 431 0 (154 431) (46 329) Liability
Movement (66 012) 0
Closing balance (W1) 20X2 88 419 0 (88 419) (26 526) Liability
Movement (88 419) 0
Closing balance (W1) 20X3 0 0 0 0
W4: Deferred tax summary Machine (W2) Finance lease debtor (W3) Total
Closing balance 20X1 39 000 (46 329) (7 329) Liability
Closing balance 20X2 15 000 (26 526) (11 526) Liability

Profit before tax: finance income 24 431 13 988 1 581 40 000
- less finance income (24 431) (13 988) (1 581) (40 000)
- less capital allowance (105 000) (105 000) (0) (210 000)
- s 23A limitation 25 000 50 000 0
- s 23A catch-up allowance (0) (25 000) (50 000)
Taxable profit 0 0 40 000 40 000
Current income tax at 30% 0 0 12 000 12 000
There is no current tax charge and therefore no current tax journal (W4)
Income tax (E) 7 329
31/12/20X2
Chapter 17 825
Example 7: Deferred tax on a finance lease (manufacturer/dealer):

with a s 23A limitation, VAT ignored
The facts from example 1 apply, repeated here for your convenience:
Lemon Tree Limited deals in machinery, either selling for cash or under a finance lease.
Lemon Tree Limited sold only one machine (cost C250 000) during 20X1. The machine was sold
under a finance lease, but had a cash sales price of C320 000.
This is the only transaction in the years ended 31 December 20X1 to 20X5.
lease instalments: C100 000, annually in arrears, payable on 31 December of each year.
The market interest rate applicable is 16,9911%.
charge tax on the lease instalments that are received;
allow the deduction of the following capital allowances:
- 50% once-off allowance in the year of acquisition
- 20% per year on the balance of the cost after deducting the 50% once-off allowance (including
the year of acquisition)
the tax authorities limit the capital allowance to the taxable lease income: any excess that is not
allowed as a deduction may be deducted against future lease income (s 23A);
Required: Prepare the current tax and deferred tax journal entry for each year affected. Ignore VAT.
Solution 7: Def tax on a finance lease (manuf./ dealer) with a s 23A limit, VAT ignored
Comment: This example is based on the same basic facts as given in example 1. The effective interest
rate table for example 1 has been repeated here for your convenience. Please see example 1 for any
other calculation and/ or for the journals.
W1: Effective interest rate table Finance income: Instalment Debtors balance
1 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
W2: Current tax summary 20X5 20X4 20X3 20X2 20X1 Total
Sales income 320 000 320 000
Less cost of sale (250 000) (250 000)
Finance income earned 14 523 26 938 37 549 46 618 54 372 180 000
Profit before tax: 14 523 26 938 37 549 46 618 124 372 250 000
Calculation continued on the next page...
826 Chapter 17
W2: Current tax continued 20X5 20X4 20X3 20X2 20X1 Total
Carried forward from prior page:
Profit before tax: 14 523 26 938 37 549 46 618 124 372 250 000
- less profit on sale 0 0 0 0 (70 000) (70 000)
- less finance income earned (14 523) (26 938) (37 549) (46 618) (54 372) (180 000)
- add lease instalment received 100 000 100 000 100 000 100 000 100 000 500 000
- less 50% once-off allowance 0 0 0 0 (125 000) (125 000)
- less 20% annual allowance (25 000) (25 000) (25 000) (25 000) (25 000) (125 000)
- add back s 23A limitation 0 0 0 0 50 000 50 000
- less s 23A catch-up allowance (0) (0) (0) (50 000) (0) (50 000)
Taxable profit 75 000 75 000 75 000 25 000 0 250 000
Current income tax at 30% 22 500 22 500 22 500 7 500 0 75 000
W3: DT on finance lease debtor CA TB TD DT

New lease 320 000 0
Capital repaid (45 628) 0
Closing balance: 20X1 W1 274 372 0 (274 372) (82 311) L
Closing balance: 20X5 W1 0 0 0 0
W4: DT on the machine CA TB TD DT

Purchase 250 000 250 000
Finance lease sale (250 000) 0
50% tax allowance 0 (125 000)
0 125 000
s 23 limitation W2.1 0 50 000
Closing balance: 20X1 0 150 000 150 000 45 000 A
s 23A catch-up allowance W2.1 0 (50 000)
s 23 adjustment 0 0
s 23 adjustment 0 0
s 23 adjustment 0 0
W4.1: s 23A: limitation 20X5 20X4 20X3 20X2 20X1

Lease payment received 100 000 100 000 100 000 100 000 100 000
Less 50% once off allowance 0 0 0 0 (125 000)
Less Capital allowance (25 000) (25 000) (25 000) (25 000) (25 000)
Less s 23A catch-up allowance b/f (50 000) 0
Tax loss 75 000 75 000 75 000 25 000 (50 000)
- s 23A limitation c/f 0 0 0 0 50 000
Taxable profit 75 000 75 000 75 000 25 000 0
Chapter 17 827

W5: Deferred tax summary Machine (W4) Debtor (W3) Total

31/12/20X1
Check:
Tax expense in 20X1 will be C37 311 (CT: 0 + DT: 37 311 = 30% x accounting profit: 124 372)
31/12/20X2
Check:
Tax expense in 20X2 will be C13 986 (CT: 7 500 + DT: 6 486 = 30% x accounting profit: 46 618)
31/12/20X3
Check:
Tax expense in 20X3 will be C11 265 (CT: 22 500 – DT: 11 235 = 30% x accounting profit: 37 549)
31/12/20X4
Check:
Tax expense in 20X4 will be C8 081 (CT: 22 500 – DT: 14 419= 30% x accounting profit: 26 938)
828 Chapter 17


Check:
Tax expense in 20X4 will be C4 357 (CT: 22 500 – DT: 18 143= 30% x accounting profit: 14 523)
3. Operating Leases (IAS 17.49 - .57)
3.1 Recognition of an operating lease (IAS 17.49 - .51)
An operating lease is a ‘pure lease’ since ownership of the asset is not transferred at any stage
during the lease. The lessor therefore keeps his asset in his statement of financial position
(and presents his asset according to its nature, as he would normally, e.g. as property, plant
and equipment), and recognises:
costs incurred on the lease as expenses over the period (e.g. depreciation on the leased
asset where the leased asset is a depreciable asset); and
lease instalments as income over the lease period, normally on a straight line basis.
3.2 Measurement of an operating lease (IAS 17.50 - .55) Operating leases:
The total lease income receivable should be recognised as similar in principle to lessee:
income evenly over the period of the lease. Measurement of Recognise: lease income
the income should be on the straight-line basis over the Measure:
- straight line over lease term
period of the lease (irrespective of the actual instalments - unless another systematic
receivable in each period). Only if there is a systematic basis is more representative
basis that more accurately reflects the pattern in which the of the usage of asset.
asset is used, should a basis other than the straight-line basis be used.
Costs (such as depreciation and impairment losses) are measured in terms of the relevant
standard (e.g. IAS 16 and IAS 36 respectively). The depreciation policy for depreciable leased
assets will be consistent with that used by the entity for similar assets.
Costs that are considered to be initial direct costs incurred in connection with the negotiating
and arranging the operating lease should be added to the cost of the leased asset and thereby
be expensed as the leased asset is expensed (e.g. through depreciation).
Example 8: Operating lease – recognition and measurement

Banana Tree Limited entered into an operating lease with Frond Limited on 1 January
20X1.
The lease was over a plant (which Banana Tree Limited had bought on 1 January 20X1 for C300 000).
The terms of the lease is as follows:
lease instalments, payable as follows:
- 31 December 20X1: C100 000
- 31 December 20X2: C110 000
- 31 December 20X3: C150 000
Frond Limited may purchase the leased asset at its market price on 31 December 20X3
Unguaranteed residual value: C30 000.
Chapter 17 829
Frond Limited purchased the plant on 31 December 20X3 at its market price of C30 000.
Banana Tree Limited depreciates its plant over three years on the straight-line basis.
Required: Prepare the journal entries for each of the years affected. Ignore tax.
Solution 8: Operating lease – recognition and measurement
Comment: As with operating lease expense in the lessee’s records, to determine the lease income in the
lessor’s records, we average the instalments over the period of the lease.
Bank (A) 300 000
Purchase of plant for C300 000
31/12/20X1
Depreciation – plant (E) (C300 000 – 30 000) / 3 years 90 000
Lease income receivable (A) 20 000
Lease income (100 000 + 110 000 + 150 000) / 3 years 120 000
Lease income received (average rental income over three years)
31/12/20X2
Depreciation of plant:
31/12/20X3
Depreciation of plant:
Plant: accumulated depreciation (-A) 90 000 x 3 years 270 000
Sale of plant at market value (also equal to residual value)
3.3 Tax implications of an operating lease

The tax consequences of operating leases are relatively simple to understand. The tax
authorities generally:
charge tax on the lease instalments as they are received;
allow a deduction of the cost of the leased asset over a period of time (e.g. an annual
capital allowance of 20% on the cost of the asset).
The accounting treatment involves:

recognising income evenly over the lease period (generally on the straight-line basis);
recognising expenses evenly over the lease period (although the rate of depreciation
expense may differ from the rate of the capital allowance granted by the tax authorities).
830 Chapter 17
Deferred tax consequences may therefore arise if, for example:

the taxable lease instalment received differs from the lease income recognised;
the costs are allowed as a tax deduction at a faster or slower rate than they are expensed;
the initial direct costs are allowed as a tax deduction in full in the year in which they are
paid while being capitalised and recognised as expenses over the lease period from an
accounting profit perspective.
Summary: Operating leases (lessor perspective)
Recognition Measurement Taxation

still recognise asset lease income = straight line current tax = lease income
lease instalments = income basis (or systematic basis…) taxed on cash basis (when
depreciate asset (incl. initial received)
lease costs = expenses
direct costs capitalised) deferred tax =
but recognise initial direct costs
accruals or prepayment - on asset: depreciation vs
as part of the cost of the
leased asset (recognised as adjustments arise if tax allowance
depreciation over the period, if instalment amount differs - on received in advance: DT
from amount recognised as asset; or
a depreciable asset)
income - on receivable: DT liability
Example 9: Operating lease – tax implications

The facts from example 8 apply, repeated here for your convenience:
Frond Limited agreed to lease a plant from Banana Tree Limited (the plant cost Banana Tree Limited
C300 000 on 1 January 20X1: depreciation on the plant is provided over three years on the straight-line
basis to a nil residual value). The terms of the lease were as follows:
inception of lease: 1 January 20X1 where the lease period is 3 years
lease instalments, payable as follows:
- 31 December 20X1: C100 000
- 31 December 20X2: C110 000
- 31 December 20X3: C150 000
Frond Limited may purchase the leased asset at its market price on 31 December 20X3
Unguaranteed residual value: C30 000.
Frond Limited purchased the plant on 31 December 20X3 (the market price was C30 000 on this date).
Banana has no other transactions in the years ended 31 December 20X1, 20X2 and 20X3.
charge tax on the lease instalments that are received;
allow the deduction of the cost of the leased asset over three years;
Required: Prepare Banana’s journals for each of the years 20X1, 20X2 and 20X3. Ignore VAT.
Solution 9: Operating lease – tax implications
W1: DT: plant CA TB TD DT

Purchase 300 000 300 000
Depreciation/ deduction (cost/ 3yr) (90 000) (100 000)
Closing balance 20X1 210 000 200 000 (10 000) (3 000) L
Closing balance 20X2 120 000 100 000 (20 000) (6 000) L
Carrying amount of asset sold
(300 000 – 90 000 x 3yrs) (30 000)
Chapter 17 831
W2: DT: operating lease accrual CA TB TD DT
Movement 20 000 0
Movement 10 000 0
Movement (30 000) 0
W3: Deferred tax summary Plant (W1) Op lease accrual (W2) Total
Closing balance 20X1 (3 000) (6 000) (9 000) L
Closing balance 20X2 (6 000) (9 000) (15 000) L
Closing balance 20X3 0 0 0 L
Lease rental income 120 000 120 000 120 000 360 000
Less depreciation (90 000) (90 000) (90 000) (270 000)
Add profit on sale of plant 0 0 0 0
- Proceeds on sale of plant 30 000 0 0 30 000
- Less carrying amount of plant sold (30 000) 0 0 (30 000)
Adjust for temporary differences:
- less lease rental income (120 000) (120 000) (120 000) (360 000)
- add depreciation 90 000 90 000 90 000 270 000
- less capital allowance (100 000) (100 000) (100 000) (300 000)
- add recoupment on sale
(proceeds: 30 000 – tax base: 0) 30 000 0 0 30 000
Taxable profit 80 000 10 000 0 90 000
Current income tax at 30% 24 000 3 000 0 27 000

No current tax journal because there is no current tax charge (W4)
Check: tax expense in 20X1: be C9 000 (CT: 0 + DT: 9 000 = 30% x accounting profit: 30 000)
31/12/20X2
Check: tax expense in 20X2: C9 000 (CT: 3 000 + DT: 6 000 = 30% x accounting profit: 30 000)
832 Chapter 17
No current tax journal because there is no current tax charge (W4)
Check: tax expense in 20X3: C9 000 (CT: 24 000 – DT: 15 000 = 30% x accounting profit: 30 000)
3.4 Disclosure of an operating lease (IAS 17.56)

As with finance leases, operating leases require additional disclosure over and above the
requirements laid down in IFRS 7: Financial Instruments: Disclosures. The disclosure
requirements listed in IAS 17 include:
with respect to non-cancellable operating leases: the total future minimum lease payments
receivable at the end of the reporting period; and
with respect to non-cancellable operating leases: an analysis of the future minimum lease
payments receivable at the end of the reporting period into:
- receivable within one year
- receivable between one and five years
- receivable later than five years;
the total contingent rents recognised as income;
a general description of the lessor’s leasing arrangements.
The disclosure of the leased asset must be done in accordance with the standard that applies to
the nature of the asset, (e.g. leased equipment will require that the equipment be disclosed in
accordance with IAS 16: Property, plant and equipment and IAS 36: Impairment of assets).
Example 10: Operating lease – disclosure
The facts from example 9 apply.
Required: Prepare the disclosure for each of the years ended 31 December 20X1, 20X2 and 20X3.
Solution 10: Operating lease – disclosure

This is the same as example 8 and 9. Please see example 9 for the tax workings. All other workings are
in example 8.
Banana Tree Limited
20X3 20X2 20X1
14. Plant C C C
Net carrying amount – 1 January 120 000 210 000 0
Gross carrying amount – 1 January 300 000 300 000 0
Less accumulated depreciation -1 January (180 000) (90 000) 0
Purchase 0 0 300 000
Depreciation (90 000) (90 000) (90 000)
Sale (30 000) 0 0
Net carrying amount – 31 December 0 120 000 210 000
Gross carrying amount – 31 December 0 300 000 300 000
Less accumulated depreciation – 31 December 0 (180 000) (90 000)
15. Deferred tax liability

The deferred tax constitutes temporary differences from: 0 (15 000) (9 000)
Plant 0 (6 000) (3 000)
Operating lease receivable 0 (9 000) (6 000)
Chapter 17 833

Banana Tree Limited
Notes to the financial statements (extracts) continued
20X3 20X2 20X1
16. Future minimum lease payments C C C
Total future minimum lease payments due: 0 150 000 260 000
Within 1 year 0 150 000 110 000
After 1 year but before 5 years 0 0 150 000
After 5 years 0 0 0

Current income tax – current year (Example 9 W4) 24 000 3 000 0
Deferred income tax – current year (Example 9 W3) (15 000) 6 000 9 000
9 000 9 000 9 000
Banana Tree Limited

20X3 20X2 20X1
Plant 14 0 120 000 210 000
Current assets
Operating lease income receivable (20 000 + 10 000) 0 30 000 20 000
Deferred taxation: income tax 15 0 15 000 9 000
Current liabilities
Current tax payable: income tax 24 000 3 000 0
Banana Tree Limited

20X3 20X2 20X1
Notes C C C
Taxation expense 19 9 000 9 000 9 000
Profit for the year 21 000 21 000 21 000
4. Transaction Taxes (e.g. VAT)
4.1 The effect of transaction taxes on a finance lease

The existence of a transaction tax (e.g. VAT) in a
finance lease has certain accounting implications. Output VAT is charged on initial
lease capitalisation:
To understand these implications one must know
what tax legislation applies. being the earlier of date of delivery or date
of payment.
In South Africa, the VAT Act requires that VAT It is recognised as a VAT payable
immediately.
vendors calculate and charge VAT (i.e. output
VAT) on “instalment credit agreements”. A finance lease satisfies the criteria as an
“instalment credit agreement” and thus a lessor that is a VAT vendor must charge VAT (i.e.
output VAT) on a finance lease. The VAT is charged and becomes payable to the tax
authorities at the commencement date, being the earlier of delivery, or payment.
In other words, this output VAT is payable in total and upfront – it is not payable piecemeal
based on the lease payments over the lease term. Thus this full VAT is included in the debtors
balance and credited to the VAT output account (VAT payable).
834 Chapter 17
The amount is calculated by multiplying the VAT fraction by

the cash selling price (incl. VAT but excluding finance costs). Output VAT on initial
lease capitalisation:
This VAT that the lessor charges is not included in the 14/114 x cash selling price incl.
VAT (excl. fin charges)
lessor’s taxable income and thus income tax is not payable on
the VAT included in the lease instalments received. As a result, lease instalments included in
taxable profit are adjusted to exclude the proportional VAT included therein (i.e. output
VAT). This proportional VAT is called “notional” output VAT.
The tax base of the finance lease debtor initially The effects of notional output VAT:
reflects the total VAT charged on the lease, but as
and when the debtor pays his instalments, a on current tax:
add instalment less notional VAT
portion of the instalment is recognised as a
notional VAT = this instalment/ total
repayment of part of this original total VAT instalments x output VAT
payable. As mentioned above, the portion of an on deferred tax:
instalment that is assumed to be a repayment of the tax base of lease receivable = total
VAT is called a “notional” VAT payment. These output VAT x outstanding instalments/ total
notional VAT payments reduce the notional VAT instalments (or total output VAT less
balance still owed by the debtor (i.e. the tax base notional output VAT included in lease
of the debtor is gradually reduced by the notional instalments paid to date)
VAT payments until the tax base of the debtor is eventually nil).
If the lessor is not a VAT vendor, then the lessor will not have charged VAT and thus the
input and output VAT adjustments referred to above obviously do not apply. The result is that
the entire instalments are included in taxable profits and the lease receivable (lease debtor)
will be nil.
As previously discussed, the VAT Act requires that VAT is charged on the lease, payable
immediately. We recognise this entire VAT on the initial capitalisation of the lease.
Example 11: Finance lease with transaction taxes (VAT)

A Limited sold only one machine during 20X5. This machine was bought on 1 January 20X5
and had a cost price of C570 000 (including VAT).
This machine was then sold under a finance lease, on the same day.
This is the only transaction for the year ended 31 December 20X5.
A Limited is not a manufacturer/dealer in machines.
- Inception of the lease: 1 January 20X5
- Lease period: 5 years
- Lease instalments: C150 000 (incl. VAT) payable annually in arrears on 31 December each year
- Market interest rate: 9,90505% p.a.
- Apply Interpretation Note 47
- Allow the deduction of capital allowances over 5 years.
- Limit the capital allowance to the taxable lease income, where any excess that is not allowed as a
deduction is able to be deducted against future lease income (s 23A).
- Income tax rate: 30%.
A Limited is a VAT vendor.
Required: P
prepare all the journals (including tax) for the year ended 31 December 20X5.
Solution 11: Finance lease with transaction taxes (VAT)

Comment: Section 23A of the Income Tax Act does not apply as the instalments (C150 000) exceed the
wear and tear allowance (C570 000/5 = C114 000).
Chapter 17 835

Debit Credit
1/1/20X5
Current tax receivable: VAT input (A) 70 000
Bank (A) 570 000
Purchase of machine
Finance lease debtors: gross investment (with VAT) (A) 150 000 x 5 750 000
Finance lease debtors: unearned finance income (-A) 750 000 – 570 000 180 000
Current tax payable: VAT output (L) 500 000 x 14% 70 000
Machine: cost Given 500 000
Finance lease entered into
31/12/20X5
Finance lease debtors - gross investment (A) 150 000
Finance lease debtors - unearned finance income (-A) W2 56 459
Recognition of finance income
Workings:

Total future payments 750 000
Add guaranteed residual value (N/A) 0
Cost of asset 500 000
VAT output 70 000
W2: Effective interest rate table Instalment Finance income @ 9.90505% Balance
1 Jan 20X5 570 000
31 Dec 20X5 (150 000) 56 469 476 459
31 Dec 20X6 (150 000) 47 194 373 653
31 Dec 20X7 (150 000) 37 011 260 664
31 Dec 20X8 (150 000) 25 819 136 483
31 Dec 20X9 (150 000) 13 518 -
(750 000) 180 000
W3. Current tax calculation

Profit before tax Finance income is the only transaction (given) 56 459
Less finance income (56 459)
Less wear and tear 500 000 (excluding VAT)/ 5 years (100 000)
Add lease instalment received 150 000 – Notional VAT: 70 000 x (150 000/ 750 000) 136 000
W4. Deferred income tax CA TB TD DT
W4.1 Finance lease debtor
Opening balance 0 0 0 0
New lease 570 000 (a) 70 000 (d)
Movement (93 541) (b) (14 000) (e)
Closing balance 476 459 (c) 56 000 (f) (420 459) (126 138) L
836 Chapter 17

Calculations supporting 4.1
CA = Gross investment – Unearned finance income TB = output VAT x (outstanding instalments/ total
(a) = 750 000 – 180 000 (W2/ jnls) instalments)
(b) = 56 459 – 150 000 (W2/ jnls) (d) = 70 000 output VAT x (750 000/ 750 000)
(c) = 750 000 – 180 000 – (150 000 – 56 459) (W2 / jnls) (e) = 70 000 output VAT x (150 000/ 750 000)
(f) = 70 000 output VAT x (750 000 – 150 000)/ 750 000
W4.2 Machine CA TB TD DT
Purchase (excluding VAT) 500 000 500 000
Lease disposal (500 000) 0
Wear and tear 0 (100 000)
Closing balance 0 400 000 400 000 120 000 A
W4.3 Summary of deferred tax Debtor Machine Total
Opening balance of deferred tax 0 0 0
Movement (6 138)
Closing balance of deferred tax (126 138) 120 000 (6 138) L
4.2 The effect of transaction taxes on an operating lease

The existence of VAT in an operating lease is nowhere near as complex as in a finance lease.
The effect on the taxable profits calculation is what one might expect:
add the operating lease income excluding VAT;
deduct the wear and tear, calculated on the cost of the asset excluding VAT.
4.2.1 Input VAT, s 23C and Interpretation Note 47
When an input VAT deduction for the purchase of an asset is available for a lessor who is a
VAT vendor (i.e. when VAT paid on the purchase of an asset is reclaimable), the tax base will
exclude the amount of input VAT. Thus the tax deductions or allowances on this asset will be
calculated on the cost of the asset excluding the VAT that is reclaimable.
If the VAT was not reclaimable (e.g. the lessor is not a VAT vendor and thus when
purchasing an asset that included VAT, the lessor was not in a position to claim the VAT
back), then the cost of the asset for purposes of calculating an allowance includes the VAT.
Example 12: Operating lease with tax and VAT
A Limited entered into an operating lease (as a lessor) with B Limited over a machine (original
cost C1 140 000 incl. 14% VAT, purchased on 1 January 20X5). The lease terms include:
Inception of lease: 1 January 20X5 with the lease period being 3 years
Lease instalments payable as follows (incl. VAT):
- 31 December 20X5: C433 200
- 31 December 20X6: C182 400
- 31 December 20X7: C136 800
A Limited depreciates the machine over 4 years to a nil residual value.
The tax authorities allow the cost to be deducted over 5 years. Tax is levied at 30%.
A’s profit before tax for 20X5 (C400 000) has not been adjusted for the above lease transaction. There
are no temporary differences, no items of exempt income and no non-deductible expenses.
Required: Prepare the necessary journal entries for 20X5 in A Limited’s books.
Solution 12: Operating lease with tax and VAT

Comment: Notice how in W1 we average (smooth) the lease income net of VAT.

Machine: cost (A) 1 000 000
Current tax payable: VAT input (A) 140 000
Bank (A) 1 140 000
Purchase of machine
Chapter 17 837

Depreciation: machine (E) 250 000
Depreciation charge for the year: (1 000 000 – 0) / 4yrs
Bank (A) 433 200
Rent received in advance (L) Balancing 160 000
Current tax payable: VAT output (L) 433 200 x 14/114 53 200
Operating lease income (I) W1 220 000
Lease income received (W1)
Deferred tax charge (W3)
W1: Operating lease income

20X5 – actual (net of VAT) Instalment:433 200 x 100/114 380 000
660 000
Annual average lease income (net of VAT) Total instalments excl VAT: 660 000/3yrs 220 000
W2. Current tax calculation C
Profit before tax and before accounting for the lease 400 000
Add lease income W1 220 000
Less depreciation [(Cost excl VAT: 1 140 000 x 100 / 114) – 0] ÷ 4 yrs (250 000)
Less lease income See above (220 000)
Add depreciation See above 250 000
Add rental received net of VAT 433 200 x 100 / 114 (or W1) 380 000
Less wear and tear [(Cost excl VAT: 1 140 000 x 100 / 114) ÷ 5yrs (200 000)
W3. Deferred income tax
W3.1 Machine CA TB TD DT
Purchase 1 000 000 1 000 000
Depreciation / wear and tear (250 000) (200 000)
Closing balance 750 000 800 000 50 000 15 000 A
W3.2 Rent received in advance CA TB TD DT
Movement (160 000) 0 160 000 48 000
Closing balance (160 000) 0 160 000 48 000 A
W3.3 Summary of deferred tax Machine IRIA Total
Opening balance of deferred tax 0 0 0
Movement 15 000 48 000 63 000 Dr DT, Cr TE
Closing balance of deferred tax 15 000 48 000 63 000 A
5. Exposure Draft – Expected Impact Thereof (ED 2013/6)

There is a current exposure draft on leases (ED 2013/6) which proposed not only changes to the
method of accounting for leases by lessees but also by lessors. However, the backlash to the ED on
lessors was so severe (the respondents argued that the benefit of any proposed changes to the existing
IAS 17 on lessors would far outweigh the costs) that the IASB has tentatively decided to drop any
proposed changes to lessor accounting – and agreed that the mirror image of lessee/ lessor accounting
is a ‘nice to have’ but not essential!
838 Chapter 17
6. Summary
Lessors
Lease classification
Finance lease if the lease transfer risks from lessor to lessee: (if any
of the following are satisfied)
a) Does ownership transfer to the lessee by the end of the lease term?
b) Is there a bargain purchase option?
c) Is the lease term equal to the major part of the asset’s useful life?
d) Is the present value of the future minimum lease payments equal to
substantially all of the asset’s fair value at inception of lease?
e) Is the leased asset specialised in nature such that only the lessee can
use it without major modification? See IAS 17.10
Otherwise operating lease
Finance leases (lessor perspective)
If a manufacturer/ dealer: If not a manufacturer/ dealer:

Remove asset Remove asset
Recognise two types of income: finance income Recognise one type of income: finance income
and sale proceeds Recognise initial direct costs as part of cost of
Recognise initial direct costs as expense up- lease receivable (built into implicit rate thus
front reduces finance income)
Tax consequences
Current tax Deferred tax

Profit before tax…
+ lease payment – (VAT x lease pmt/ total lease pmts) (see finance lease debtor
later) - has a CA, but no TB
- tax allowance (possibly limited by S23A) leased asset
- interest income (remove from profit; not taxed) - has no CA, but has a TB
…Taxable profit
Operating leases (lessor perspective)
Recognition Measurement Taxation

still recognise asset lease income = straight line current tax = lease income
lease instalment = income basis (or systematic basis…) taxed on cash basis (when
depreciate asset (incl. initial received)
lease costs = expenses
direct costs capitalised) deferred tax =
but recognise initial direct costs
receivable or prepayment - on asset: depreciation vs
as part of the cost of the
leased asset (recognised as adjustments arise if tax allowance
depreciation over the period, if instalment amount differs - on received in advance: DT
from amount recognised as asset
a depreciable asset)
income - on receivable: DT liability
Sale and leaseback (see chapter 16)
Recognise the sale and recognise the resulting leaseback as

either a finance/operating lease
Chapter 17 839
Gripping GAAP Provisions, contingencies & events after the reporting period
Chapter 18
Provisions, Contingencies and

Events after the Reporting Period
Reference: IAS 37, IAS 10, IFRIC 1 (including any amendments to 16 December 2014)
CHAPTER SPLIT:
This chapter involves two standards IAS 37 (together with IFRIC 1, being a related interpretation) and
IAS 10. IAS 37 (and IFRIC 1) covers certain types of liabilities and assets, whereas IAS 10 deals with
events that occur after the reporting period but before the financial statements are authorised for issue.
The reason that they are combined into one chapter is that they are very much inter-related. However,
since the chapter is fairly long, it is split into these two separate parts as follows:
PARTS: Page
PART A: Provisions, Contingent Liabilities and Contingent Assets (IAS 37) 842
PART B: Events after the Reporting Period (IAS 10) 872
PART A:
Provisions, Contingent Liabilities and Contingent Assets
Contents: Page
A: 1 Introduction 842
A: 2 Scope 842
A: 3 Recognition: liabilities, provisions and contingent liabilities 842
3.1 Overview 842
3.2 Comparison: liabilities and provisions 843
3.3 Comparison: liabilities and contingent liabilities 843
3.4 Discussion of the liability definition 843
3.4.1 Present obligations 843
3.4.2 Past events 844
3.4.3 Obligating events 844
Example A1: Obligating events 845
Example A2: Obligating events 845
3.5 Discussion of the recognition criteria 845
3.5.1 Overview 845
3.5.2 Probable outflow of future economic benefits 846
3.5.3 Reliable estimate 846
Example A3: Reliable estimate 847
A: 4 Measurement: liabilities, provisions and contingent liabilities 847
4.1 Overview 847
4.2 Best estimates and expected values 848
Example A4: Best estimate using expected values 848
4.3 Risks and uncertainties 849
4.4 Future cash flows and discounting 849
Example A5:Discounting liabilities to present values and related journals 850
Example A6: Calculating present (discounted) values and related journals 850
4.5 Future events 852
Example A7: Future events 852
840 Chapter 18
Contents: Page
4.6 Gains on disposals of assets 852
Example A8: Gains on disposals of assets 853
4.7 Provisions and reimbursement assets 853
Example A9: Guarantees 854
Example A10: Reimbursements 855
4.8 Changes in provision for decommissioning etc 855
4.8.1 Change in provisions and the cost model 856
Example A11: Changes in decommissioning liability: cost model 857
4.8.2 Change in provisions and the revaluation model 859
Example A12: Changes in decommissioning liability: revaluation model 860
4.9 Changes in provisions due to payments 862
Example A13: Reducing provisions 862
A: 5 Recognition and measurement: four interesting cases 863
5.1 Future operating losses 863
5.2 Contracts 863
Example A14: Onerous contracts 864
5.3 Restructuring provisions 864
Example A15: Restructuring costs 865
5.4 Levies 865
Example A16: Levies 866
A: 6 Recognition and measurement: contingent assets 866
6.1. Recognition of contingent assets 866
6.2. Measurement of contingent assets 866
A: 7 Disclosure: provisions, contingent liabilities and contingent assets 867
7.1. Disclosure of provisions 867
7.2. Disclosure of contingent liabilities 867
Example A17: Disclosure: decommissioning provision (change in estimate) 867
7.3. Disclosure of contingent assets 869
7.4. Exemptions from disclosure requirements 869
A: 8 Summary 870
PART B:
Events after the reporting period
Contents: Page
B: 1 Introduction 872
B: 2 Adjusting events after the reporting period 872
Example B1: Event after the reporting period 873
B: 3 Non-adjusting events after the reporting period 873
Example B2: Non adjusting events after the reporting period 873
B: 4 Exceptions: no longer a going concern 874
Example B3: Events after the reporting period – various 874
B: 5 Disclosure: events after the reporting period 877
B: 6 Summary 877
Chapter 18 841
PART A:
Provisions, Contingent Liabilities and Contingent Assets
A: 1 Introduction
IAS 37 focuses on the concept of liabilities and assets. Both these terms (liabilities and assets)
are defined in the Conceptual Framework and it would be good idea for you to refresh your
memory of these two definitions before continuing.
IAS 37 introduces three new terms:
Provisions refer to liabilities that involve uncertainty in terms of either (or both) the
amount of the liability or the timing of its settlement;
Contingent liabilities are those that either do not meet the liability definition or do not
meet the recognition criteria;
Contingent assets are possible assets, the existence of which is still to be confirmed.
The discussion of the standard on provisions and contingencies (IAS 37) will be covered in
three separate stages: first we will investigate the recognition and measurement of liabilities,
then the recognition and measurement of assets and then the disclosure thereof.
A: 2 Scope (IAS 37.1 – .9)
IAS 37 shall be applied by all entities in accounting for provisions, contingent liabilities and
contingent assets, except:
those resulting from executory contracts, except where the contract is onerous Note 1; and
those covered by another standard. IAS 37.1
Note 1: Executory contracts and onerous contracts are discussed in section A: 5.2.
Some types of provisions, contingent liabilities and contingent assets are not covered by
IAS 37 but by other standards, for example:
income taxes (see IAS 12 Income taxes);
leases (see IAS 17 Leases);
employee benefits (see IAS 19 Employee Benefits);
insurance contracts (see IFRS 4 Insurance Contracts); and
revenue from contracts with customers (see IFRS 15 Revenue from contracts with
customers) unless the contract has become an onerous contract. IAS 37.5
A: 3 Recognition: Liabilities, Provisions and Contingent Liabilities (IAS 37.14 – .30)
A: 3.1 Overview
There are significant differences between a ‘pure’ liability, a provision and a contingent
liability. These differences boil down to the extent to which they meet the liability definition
and recognition criteria – if at all.
The most fundamental part of the liability definition is that there must be an obligation.
Deciding whether or not there actually is an obligation is frequently difficult, and is an
exercise that requires lots of your professional judgement. There is thus a thin line separating
‘pure’ liabilities, provisions and contingent liabilities.
In order to differentiate between a pure liability, a provision and a contingent liability, we

need to thoroughly understand every aspect of the definition and recognition criteria. These
will be explained below. Before we do this, however, let us compare the meanings of:
the term ‘provision’ and the term ‘liability’, and then
the term ‘contingent liability’ and the term ‘liability’.
842 Chapter 18
A: 3.2 Comparison: liabilities and provisions

A provision is defined as:
A provision is a type of liability. In other words, all
a liability
provisions are liabilities, but not all liabilities are of uncertain timing / amount IAS 37.10
provisions! A provision is a liability that involves
uncertainty in terms of either (or both):
the amount of the liability or
the timing of the settlement.
We must remember that before an element may be recognised (journalised), both the
definition of that element and its recognition criteria must be met. Thus ‘pure’ liabilities and
provisions are recognised if they:
meet the definition of a liability; and Provisions
meet the recognition criteria: Recognised (journalised) as a L
a reliable estimate of the liability must be Disclosed: separately to ‘pure’ Ls
the outflow of economic benefits must be probable.
Both provisions and liabilities are recognised in the statement of financial position but they
are disclosed separately from one another.
A: 3.3 Comparison: liabilities and contingent liabilities (IAS 37.27 – .30)

A contingent liability is
As already mentioned, there is a difference between a defined as either:
liability and a contingent liability.
One where the recognition criteria are
not met (type 1):
Contingent liabilities are those that either: a present obligation
do not meet the liability definition; or from past events
do not meet the recognition criteria. that is not recognised because the
recognition criteria are not met:
Thus there are two different types of contingent liabilities: - it is not probable that an outflow
of economic benefits will be
one that is a liability (i.e. meets the liability needed to settle the obligation; or
definition) that may not be recognised because one or - the amount of the obligation
both of the recognition criteria are not met (let’s call cannot be measured with
this type 1); and sufficient reliability.
the other that is not a liability because it failed the One where the liability definition is
liability definition in that there is only a possible not met (type 2):
obligation, (as opposed to a present obligation) (let’s a possible obligation
from past events;
call this type 2). In this latter type, the existence of the whose existence will be confirmed
obligation will only be confirmed by the occurrence only by the:
of some future event/s that is not wholly within the - occurrence or non-occurrence
control of the entity. - of one or more uncertain future
events
- not wholly within the control of
Since, by definition, a contingent liability either does not the entity (e.g. a possible negative
meet the definition or the recognition criteria, they may court ruling.)
not be recognised (journalised) as liabilities. These two definitions have been reworded from IAS 37.10
Although contingent liabilities are not recognised, they

Contingent liabilities
must be disclosed in the notes to the financial statements
if they are considered relevant to the user. Recognised: No, no jnl is processed
Disclosure: if considered relevant
A: 3.4 Discussion of the liability definition
A: 3.4.1 Present obligations (IAS 37.15 – .16)
For us to have a present obligation, we must have a past event that is also an obligating event.
In very rare instances, it may be difficult to determine if there is a present obligation or even
if there is a past event.
Chapter 18 843
In these instances, the entity must decide if it is:

How to decide if we
more likely that a present obligation did exist at actually have an
year-end, in which case a provision is recognised obligation?
(i.e. greater than 50% chance); or
A tip that may be helpful when deciding
more likely that a present obligation did not exist whether an obligation exists is to ask
at year-end (i.e. less than 50% chance), in which yourself the following question: if the
case a contingent liability is disclosed (unless the entity had to close down tomorrow,
possible outflow of future economic benefits is would the obligation still exist?
remote, in which case it is ignored). If the answer to that is yes, then the
entity has a present obligation as a
In making this decision, the entity uses its professional result of a past event.
judgement, other expert opinions (e.g. legal opinion)
and events after the reporting period.
For example: A typical example of where an entity may be unsure of whether or not it has a
present obligation due to a past event, is a court case in progress at year-end where there is
currently no indication as to whether the deed that the entity is being accused of actually
occurred (i.e. whether there is a past event) and even if it did occur, whether or not the entity
will be required to pay a fine or other settlement (i.e. whether there is a resulting obligation).
A: 3.4.2 Past events (IAS 37.17 – .22) Past events are those:
Events that
We need an event and it must have happened on or before Occurred on/ before RD.
the reporting date (year-end) for it to be a past event.
An obligating event is
defined as:
A: 3.4.3 Obligating events (IAS 37.17 – .22) an event that
creates an obligation (constructive
For the past event to lead to an obligation the event must or legal)
be an obligating event. that the entity has no realistic
alternative to settling.
IAS 37.10 reworded
There are two types of obligations possible:
a legal obligation, and
a constructive obligation.
A legal obligation is
An obligating event is one that leaves the entity with no defined as:
realistic alternative but to settle the liability. an obligation that derives from
a contract (through its explicit or
The event that leads to an obligation (i.e. the obligating implicit terms);
event) must: legislation; or
exist independently of the entity’s future actions: this other operation of law IAS 37.10
is known as the ‘walk-away test’, i.e. if the company
closed down its business today, would the obligation still exist? See IAS 37.19
always involve a third party (i.e. a decision must
A constructive obligation
involve a third party, not just the entity): is defined as:
this other party does not need to be known, i.e. it an obligation that derives from:
could be the public at large. IAS 37.20
an entity’s actions where
by an established pattern of past
Thus a decision made at a board meeting would not lead practice, published policies or a
to a present obligation because: sufficiently specific current
this event does not involve a third party; and statement,
is not separate from the entity’s future actions (its the entity has indicated to other
parties that it will accept certain
future actions could be changed if the board later responsibilities; AND
decides to change its mind). as a result, the entity has created
a valid expectation on the part of
IAS 37 has many great examples that those other parties that it will
explain the principles of recognition. discharge those responsibilities.
IAS 37.10
See IAS 37 Appendix C for more!
844 Chapter 18
Example A1: Obligating events

Consider the following issues that were discussed during a directors meeting on
24 December 20X3:
A: A decision was made by the directors to pay a bonus to an employee.
B: A decision was made by the directors to purchase a new machine in 3 years time.
C: Legislation recently passed means that one of the plants has to be dismantled in a year’s time.
D: Future losses are expected from a branch in Botswana.
Required: Explain whether or not any of the above result in present obligations at 31 December 20X3.
Solution A1: Obligating events

A and B: The entity is neither legally nor constructively obligated to:
pay the bonus (A); or
purchase the asset (B).
Both these future payments may still be avoided by the future actions of the entity, and therefore do not
meet the definition of an obligating event. These decisions may currently still be revoked. Only if these
decisions are communicated to the relevant third parties in such a way that there is no realistic
alternative but to make these payments, would an obligation arise.
C: The fact that we own this plant is the past event that together with the new legislation means that
we now have unavoidable future dismantling costs. We thus have an obligating event at year-end.
D: The future losses expected from the branch in Botswana is not an obligation at year-end because
they are also avoidable (the branch could be sold or shut-down before any losses are incurred). The
expected losses may, however, indicate that certain assets may need to be tested for impairment (see
the chapter on ‘impairment of assets’ for more information in this regard). Provisions shall not be
recognised for future operating losses. IAS 37.63
Example A2: Obligating events

Damij Ltd owned a road tanker that overturned in December 20X3 during a bad rain storm.
The tanker spilled its contents, thus contaminating a local river. Damij Ltd has never before
contaminated a river. Damij Ltd has no legal obligation to clean the river, has no published policies as
to its views on the rehabilitation of the environment and has not made any public statement that it will
clean the river. It intends to clean-up the river and has been able to calculate a reliable estimate of the
cost thereof.
Required: Explain whether Damij should recognise a liability or a provision at 31 December 20X3.
Solution A2: Obligating events

The event is the accident, and since it happened before year-end, it is a past event. There is, however,
no present obligation since:
there is no law that requires the company to rehabilitate the river, and
there is no constructive obligation to rehabilitate the river since neither:
- a public statement has been made and nor
- is there an established pattern of past practice since this was its first such accident.
Although Damij Ltd intends to clean-up the river and even has a reliable estimate of the costs thereof,
no liability or provision should be recognised because an obligating event is one that results in the
entity having no realistic alternative but to settle the obligation: Damij Ltd can still change its intention.
A: 3.5 Discussion of the recognition criteria
A: 3.5.1 Overview (IAS 37.14)
Before a liability may be recognised, it needs to meet the definition (discussion above) and
meet the recognition criteria. The recognition criteria to be met are the following:
The outflow of economic benefits must be probable; and
The amount of the obligation can be reliably estimated.
Chapter 18 845
A: 3.5.2 Probable outflow of future economic benefits (IAS 37.23 – 24)

In deciding whether an outflow of future economic benefits is probable, one must be sure that
the outflow is more likely to occur than not to occur, in which case a provision should be
recognised. If it is more likely that the outflow will not occur, then a contingent liability
should be disclosed (unless the possible outflow is remote).
A: 3.5.3 Reliable estimate (IAS 37.25 - .26)

It should be remembered that uncertainty and estimates are a normal part of the recognition
and measurement process. This means that, although a provision is a liability of uncertain
timing or amount, it does not mean that this liability cannot be reliably measured.
If the estimated amount of an obligation involves a normal degree of uncertainty, and it is
possible to make a reliable estimate thereof, it is recognised as a ‘pure’ liability.
Examples of a pure liability can be categorised into those that:

do not involve uncertainty: a telephone payable recognised at year-end where the invoice
has been received; and
do involve uncertainty: a financial liability that is measured at the present value of future
outflows: the present value is obviously based on an estimated discount rate where the
discount rate chosen is subject to measurement uncertainty.
A typical example of a provision is the estimated amount of damages payable pursuant to a

court case where the court case has already ruled against the entity but has yet to establish an
amount. The level of uncertainty here could be extreme and the measurement of the amount
will need to consider the probabilities for each possible outcome.
If the estimated amount of an obligation involves a larger degree of uncertainty than normal,
but yet a reliable estimate is still possible, the liability is still recognised but is termed a
provision. Provisions should be disclosed separately from ‘pure’ liabilities and therefore it is
important to be able to differentiate a provision from a pure liability.
If an amount is so uncertain that the estimate is not reliable, then it is a contingent liability.
Contingent liabilities are not recognised at all since, by definition, either:

one of the recognition criteria is not met (i.e. can’t reliably measure the amount); or
the definition is not met, as a possible obligation rather than a present obligation exists.
A typical example of a contingent liability would be where the entity is being sued but:
it is either not yet possible to estimate whether the courts will probably rule against the
entity (i.e. the outflow of future economic benefits is not yet probable) or
it is not yet possible to estimate the amount that the courts will force the entity to pay (i.e.
a reliable estimate is not yet possible).
Recognition of provisions and contingent liabilities flowchart
846 Chapter 18
Example A3: Reliable estimate

A company sells goods with a refund policy – if the customer is not satisfied, the goods may
be returned for a full refund. Sales for the year came to C100 000.
Required: For each of the following scenarios, explain if there is a pure liability, provision or
contingent liability at year-end, or if the refund policy should be ignored:
a) At year-end, it is reliably estimated (based on past experience) that only 5% of sales will be
returned for a full refund.
b) At year-end, it is not possible to estimate the possible returns and related refunds.
Solution A3(a): Reliable estimate

Please note that in order to prove that the definition of a liability has been met, one needs to first
identify the event, assess whether this event is on or before year-end and then decide whether the event
leads to an obligation (either legal or constructive)|: if the event leads to an obligation but occurred
after year-end, it would not be a present obligation, which is a critical part of the definition.
Definition: Is there an obligation?
The company has a refund policy attached to the sales whereby the company is obliged to refund
customers who are unhappy with their purchases. This obligation may either be:
- a legal obligation (i.e. written into the contract of sale) or
- a constructive obligation (i.e. through an established pattern of past practice of refunds).
Definition: Does the obligation come from a past event?
The sale of goods is the event and since these occurred before year-end, the event is a past event.
Definition: Is there therefore a present obligation?
Since there is a past event to which there is an obligation attached, we have a present obligation.
Definition: Is there an outflow of future economic benefits expected?
The refund policy means that if a customer is unhappy with his purchase, he may return it for a
cash refund, this cash refund representing an outflow of future economic benefits.
Recognition criteria: Is the expected outflow of future economic benefits probable?
The refund policy represents a probable outflow of future economic benefits. There are numerous
sales transactions to which this refunds policy applies and, in the event that there are numerous
sales transactions to which a warranty is attached, it matters not that management may estimate
that only a very few customers will return to demand refunds – the question is simply whether it is
probable that some outflow may be required in order to settle potential refunds – management’s
assessment of the extent of the refunds will be considered when measuring the liability.
Recognition criteria: Is the probable outflow of future economic benefits reliably estimated?
Past experience is available that suggests that it is probable that 5% of the sales will be refunded
and therefore the extent of the obligation can be reliably measured: C5 000 (5% x C100 000).
This is not a pure liability, however, since there is still more uncertainty than normal in predicting the
amount and timing of this outflow. Therefore, this liability is recognised and presented as a provision.
Comment: Note that it is the sale of goods that is the obligating event.
Solution A3(b): Reliable estimate

The answer to A3(b) is identical to that of A3(a) as far as the first 5 bullets above. The probable
outflow of future economic benefits is, however, not able to be reliably measured. Although the
definition of a liability is met, this recognition criteria (reliable measurement) is not met and therefore:
no liability may be recognised in the financial statements, although
a contingent liability must be disclosed in the notes to the financial statements.
A: 4 Measurement: Liabilities, Provisions and Contingent Liabilities (IAS 37.36 – .52)
A: 4.1 Overview
The same measurement principles are used whether we are measuring liabilities, provisions or
contingent liabilities. However, since provisions and contingent liabilities involve uncertainty,
the measurement thereof will involve the use of professional judgement.
Chapter 18 847
Provisions should be measured at the ‘best estimate of the expenditure required to settle the
present obligation’ at the end of the reporting period. IAS 37.36 (reworded)
In other words, it is measured at the amount that the entity would ‘rationally pay’ to settle the
obligation or transfer it to a third party at the end of the reporting period. See IAS 37.37
Measurement:
Although a contingent liability is not recognised, it must
be disclosed unless the possibility of an outflow is The measurement of a
provision (or contingent
remote. If we are to disclose it, we must try to estimate
liability) involves:
the amount of the contingent liability. This is done in the
same way that we measure a provision. deciding what the best estimate is of
the expected settlement amount
after considering all related risks &
Provisions and contingent liabilities are measured at the
uncertainties
best estimate of the expected amount of the settlement
calculating it as a present value if
(where the best estimate takes into account all the related
the effects of discounting are
risks and uncertainties). The measurement would be material.
calculated as the present value of the future cash flows if
the effects of discounting to present value are considered The following are ignored in the
material. The measurement should ignore: measurement:
future events unless there is ‘sufficient objective Future events for which there is
insufficient evidence.
evidence that they will occur’; and
Gains on disposals of assets.
gains made on the disposal of assets.
The measurement of the balance presented at year-end can also be affected by:
changes to estimated provisions; and
reductions in provisions.
Certain of these aspects involved in measurement will now be explained in more detail.
A: 4.2 Best estimates and expected values (IAS 37.36 - .41)
The best estimate of the amount of an obligation is the amount that an entity would rationally
pay to settle the liability at year-end. It is often difficult for management to estimate the
amount of the obligation where management may have to base its estimate upon a
combination of:
management’s professional judgement;
previous experience with similar transactions;
possibly expert advice; and
events after the reporting period. IAS 37.38 (reworded)
Previous experience may indicate a range of possible outcomes, for which it may be possible
to estimate a probability. The method of weighting the outcomes based on their individual
probabilities is referred to as calculating the expected value. The application of this method
when calculating the best estimate is best explained by way of example.
Example A4: Best estimate using expected values

A company offers goods for sale with a 6-month warranty, where goods sold that are found
to be faulty within 6 months after purchase may be returned for a full refund. Not all goods
will be faulty and similarly, not all customers bother to return faulty goods. The company’s past
experience suggests that the following are the possible outcomes and the probability thereof:
Outcomes Probability Estimated cost
Goods will not be returned 70% 0
Goods will be returned 30% 100 000
100%
Required:
Calculate the expected cost of the provision and journalise it.
848 Chapter 18
Solution A4: Best estimate using expected values

The provision, measured at the best estimate, using the expected value of the future cost of fulfilling
the warranty obligation: Expected value = 70% x C0 + 30% x C100 000 = C30 000
Debit Credit
Warranty costs (E) 30 000
Provision for warranty costs (L) 30 000
Provision for warranty costs
A: 4.3 Risks and uncertainties (IAS 37.42 - .44)
When determining the best estimate of a provision, the risks and uncertainties surrounding the
events and circumstances must be taken into account. This may be done by using judgement,
or by use of risk adjustments to either:
the amounts of the provision; or
the discount rate used (if the provision is present valued).
Care must be taken not to duplicate a risk adjustment thus overstating liabilities or
understating assets.
A: 4.4 Future cash flows and discounting (IAS 37.45 - .47)
The possibility that the settlement of an obligation may occur far into the future has an effect
on the value of the obligation in current day terms. The effect that the passage of time has on
the value of money is often referred to as the ‘time value of money’.
Discount rate
Imagine being asked whether you would prefer to
receive C100 today or C100 in 10 year’s time. For many The rate to be used is :
reasons, (including the fact that you could utilise the A pre tax discount rate
C100 immediately), you would choose to receive it based on the current market
immediately. This is because you can buy more with assessment of:
C100 today than you can with C100 in the future. In - the time value of money and
other words, today’s value (the present value) of a future - the risks specific to the
cash flow is less than the actual (absolute/ future) provision IAS 37.47
amount of the cash flow. This is essentially the present The WACC (Weighted average cost of
value effect or the effect of the time value of money. capital) is not an appropriate discount
rate as the WACC takes into account
If the difference between the actual amount of the future the risk of the entity as a whole and not
cash flow and its present value is material, then the just the risk related to the provision.
liability should be measured at its present value (the
smaller amount).
The present value is calculated using a pre-tax discount rate based on the current market
assessment of the time value of money and the risks specific to the liability. See IAS 37.47
As the period between now (the present) and the date of the payment (the future) gets shorter,
so the difference between the present value and the future value (actual amount) of the cash
flow gets smaller.
When you finally get to the day that the payment is due, the present value will equal the
actual amount due.
Thus, each year between the date that the provision is recognised and the date that the
provision is settled (paid), the present value of the future outflow must be recalculated.
Each year, as we get closer to the future payment date, the present value will increase until the
actual payment date is reached, when the provision (calculated as the present value) will
finally equal the actual liability.
Chapter 18 849
The increase in the liability each year will be debited to Unwinding the discount
finance charges and credited to the provision such that at
each reporting date, the provision is measured at its The following journal is
present value. These finance charges are often referred to processed each year to
as ‘notional finance charges’ (meaning ‘make-believe unwind the discount:
finance charges’) and is really just the ‘unwinding of the DR Finance charges
discounting’ process. CR Provision/Liability
Example A5: Discounting liabilities to present values and the related journals
On 1 January 20X1, an event occurs that results in an obligation to pay C100 000 at
31 December 20X3. This is duly paid on 31 December 20X3. The present values of this
obligation have been calculated as follows:
1 January 20X1: C60 000
31 December 20X1: C70 000
31 December 20X2: C90 000
31 December 20X3: C100 000
Required:
Show the related journal entries for each of the three years.
Solution A5: Discounting liabilities to present values and the related journals
Expense/ Asset Given: PV of future amount 60 000
Liability 60 000
Initial recognition of the obligation: beginning of year 1
31/12/20X1
Finance charges (E) PV 31/12/X1: 70 000 – PV 1/1/X1: 60 000 10 000
Liability 10 000
Increase in liability as a result of time value of money
31/12/20X2
Liability 20 000
31/12/20X3
Liability 10 000
Liability Future cash flow now paid 100 000
Bank (A) 100 000
Payment of liability at the end of year 3
Example A6: Calculating present (discounted) values and related journals

A factory plant is bought on 1 January 20X1:
Cost: C450 000 cash, including costs of installation.
The entity is obliged to decommission the plant after a period of 3 years.
Future decommissioning costs are expected to be C399 300.
The appropriate discount rate is expected to be 10%.
The effect of discounting is considered to be material.
Depreciation is estimated on the plant using the straight-line method to a nil residual value
Required:
Prepare a present value table (amortisation table) showing the present value of the future costs on
1 January 20X1 and at the end of each related year, together with the annual movements and journal
entries to record the movements.
850 Chapter 18
Solution A6: Calculating present (discounted) values and related journals

W1 Present value table:
Date Opening balance: Calculation of Finance Charge Closing balance:
Liability finance Liability
charges:
1 Jan X1 300 000 (W2) 300 000 x 0.1 30 000 330 000
31 Dec X1 330 000 330 000 x 0.1 33 000 363 000
31 Dec X2 363 000 363 000 x 0.1 36 300 399 300
31 Dec X3 399 300
Total 99 300
W2 Calculating discount factors manually *
* Present values can be calculated using a financial calculator instead
Number of years until the cash Calculation of discount Discount factor (rounded): 10%
settlement factor
0 years (i.e. it’s due) Actual = 1 1
1 year 1/(1+10%) 0.909
2 years 0.909/(1+10%) 0.826
3 years 0.826/(1+10%) 0.751
399 300 x 0.751 = 300 000 or 399 300 x (1/(1+0.1)3) = 300 000
Comments:
As it gets closer to the date on which the C399 300 is to be paid, the discount factor increases.
The gradual increase in the discount factor over the passage of time is referred to as the ‘unwinding
of discount’.
The increase in the discount factor causes the liability to gradually increase from its original present
value of C300 000 to C399 300 on 31 December 20X3.
The increase in the liability results in the recognition of finance charges each year.
The present value of the liability of 300 000 (on date of initial recognition) less the actual future
amount payable of C399 300 equals C99 300, being the total finance charges expensed over 3
years.
The finance charges are sometimes referred to as ‘notional’ finance charges.
Remember the discount rate to be used must be a pre tax discount rate.
Journals
Debit Credit
1 January 20X1
Bank (A) 450 000
Plant (decomm.): cost (A) PV of future amount (W1) 300 000
Decommissioning liability 300 000
Initial recognition of the decommissioning obligation
31 December 20X1
Finance charges (E) PV 31/12/X1: 330 000 – PV 1/1/X1: 30 000
Decommissioning liability 300 000; OR 300 000 x 10% 30 000
Increase in liability as a result of unwinding of the discount
Depreciation (E) (450 000 + 300 000 - 0) / 3 years 250 000
Plant: accum. depreciation 250 000
31 December 20X2
Finance charges (E) PV 31/12/X2: 363 000 – PV 31/12/X1: 33 000
Depreciation (E) (450 000 + 300 000 - 0) / 3 years 250 000
Chapter 18 851
Solution A6: Continued...

Finance charges (E) PV 31/12/X3: 399 300 – PV 31/12/X2 36 300
Depreciation (E) 250 000
Decommissioning liability Given 399 300
Bank (A) 399 300
Payment in respect of decommissioning
Comment:
Please notice that a total of 849 300 is expensed over the 3 years:
849 300 = depreciation of 750 000 (250 000 for 3 years) + finance charges of 99 300
This is the total cost of both using and decommissioning the asset:
849 300 = 450 000 (cost of asset excluding cost of decommissioning) + 399 300 (cost of decommissioning)
Also note how the cost (PV) of decommissioning the plant is debited to the plant’s cost account IAS 16.16
A: 4.5 Future events (IAS 37.48 – .50)
When calculating the amount of the liability or provision, expected future events should be
taken into account when there is ‘sufficient objective evidence’ available suggesting that the
future event will occur. An example would be possible new legislation that is virtually certain
to be enacted that may lead to a provision for environmental restoration (clean-up).
Example A7: Future events

A company owns a number of nuclear plants.
The company is presently obliged to dismantle one of these plants in 3 years time.
The last nuclear plant dismantled by the company cost C1 000 000 to dismantle, but
the company expects to dismantle this nuclear plant, if using the same technology, at a
slightly reduced cost of C800 000 due to the increased experience.
There is also a chance that completely new technology may be available at the time of
dismantling, which could lead to a further C200 000 cost saving
Required: Discuss the measurement of the provision.
Solution A7: Future events

A provision should reflect expected future events where there is sufficient objective evidence that these
will occur.
Since the company has had experience in dismantling plants, it is argued that the expected cost
savings due to this experience can be reasonably expected to occur.
The cost savings expected as a result of the possible introduction of completely new technology,
being outside of the control of the company, should not be taken into account, unless of course the
company has sufficient objective evidence that this technology will be available.
Therefore, the provision should be measured at C800 000 (and not at C600 000).
A: 4.6 Gains on disposals of assets (IAS 37.51 - .52)
When an obligation involves the sale of assets (e.g. when one has committed to restructure a
business, obligations exist for retrenchment packages etc but there are assets that would
probably also need to be sold), the expected asset disposals must be seen as separate
economic events. For this reason, gains on the expected disposal of assets are not taken into
account in measuring a provision, even if the expected disposal is closely linked to the event
giving rise to the provision. Instead, an entity recognises gains on expected disposals of assets
at the time specified by the standard dealing with the assets concerned. IAS 37.52
852 Chapter 18
Example A8: Gains on disposals of assets

New legislation means that Undoo Ltd must dismantle its nuclear plant in a year’s time:
The dismantling is estimated to cost C300 000.
Undoo Ltd also expects to earn income from the sale of scrap metal of C100 000.
The effects of discounting are expected to be immaterial.
Required: Process the required journal entry to raise the provision
Solution A8: Gains on disposals of assets

Debit Credit
Nuclear plant (A) 300 000
Provision for dismantling costs (L) 300 000
Expected costs of dismantling
Comment: The measurement of the provision is not reduced by the C100 000 expected income.
A: 4.7 Provisions and reimbursement assets (IAS 37.53 – .58)
An entity may have an obligation to one party and may be expecting to be reimbursed by
another party for all or part of the costs incurred in settling this obligation. The entity’s
obligation represents a liability and the entity’s expected reimbursement represents an asset.
Whilst the recognition of the liability (obligation) is based on all the normal principles already
discussed in this chapter, any asset relating to an expected reimbursement (e.g. from a
manufacturer or other third party) should:
be disclosed as a separate asset (i.e. the asset should not be set-off against the liability);
only be recognised if it is virtually certain that the reimbursement will be received;
be measured at not more than the amount of the related provision. IAS 37.53(reworded)
Please note that although the liability (obligation) and the asset (reimbursement) may not be
set-off against each other, the related expenses and income may be set-off against each other.
The fact that the asset and liability may not be set-off against each other is because the actual
sequence of events (the entity has offered a guarantee, being a liability and the entity has
received a counter-guarantee, being an asset) would otherwise be obscured to the user of the
financial statements and would thus not result in fair presentation.
If reimbursement by the manufacturer is not virtually Reimbursement assets and

their treatment
certain, an asset may not be recognised, but a contingent
asset may be disclosed in the notes to the financials. A reimbursement asset is only
recognised if it is virtually certain
A typical example involves guarantees (or warranties). that the reimbursement will be
Let us look at a few examples. received See IAS 37.53
If it is not virtually certain that the
In recognising a liability regarding a guarantee, we must reimbursement will be received, a
contingent asset may be disclosed.
look carefully at the detail of the agreement to assess its
substance. We look at these agreements to be sure we know who really has the obligation:
Where the entity provides a guarantee (or warranty) to a customer, the entity has created an
obligation for itself and must recognise a liability. This guarantee could be a written
guarantee (i.e. a legal obligation) or could simply be due to past actions that created an
expectation that the entity will provide a guarantee (i.e. a constructive obligation).
If, however, the manufacturer (the supplier) of a product provides the guarantee to the
entity’s customer and the entity (the retailer) simply communicates this guarantee (or
warranty) to the customer, then it is the manufacturer, and not the entity (the retailer) that
has the obligation. The entity (the retailer) will therefore not recognise a liability since the
entity is simply acting as the conduit for a manufacturer.
If the manufacturer provides the guarantee to the customer, but the entity (retailer) is
somehow obligated to the customer if the manufacturer defaults on his obligation, then the
entity must disclose a contingent liability in its records to reflect the extent to which the
entity is exposed in the event that the manufacturer defaults on his obligation.
Chapter 18 853
Where a provision is recognised reflecting a guarantee offered by the entity to its customer,
we must consider whether there is a possible reimbursement available to the entity. If the
entity has received a counter-guarantee (i.e. a reimbursement) from the supplier and it is
virtually certain to be received, we must assess to what extent the provision may be
recovered:
If an entity expects to incur costs of C100 to settle a guarantee and expects proceeds from
a counter-guarantee of only C70, the entity has a provision of C100 and an asset of C70.
If an entity expects to incur costs of C100 to settle a guarantee and expects proceeds from
a counter-guarantee C110, the entity has a provision of C100 and an asset of C100 (the
measurement of the asset must be limited to the amount of the provision).
The guarantee and counter-guarantee are presented in the following diagram:
Diagram: Flow of guarantees
A guarantee is provided by the entity (e.g. retailer) to its customer and where the manufacturer offers
a counter-guarantee to the entity in case of any return:
The customer returns goods to entity (retailer) under the guarantee (this is a L to the entity);
The entity returns goods to manufacturer under the guarantee (this is an A to the entity)
Retailer (the entity):

Goods sold to: Goods sold to:
Guarantee offered
to customer = L
Manufacturer Customer
Guarantee Guarantee received Guarantee
offered to: from manufacturer = A offered to:
Example A9: Guarantees

A retailer company sells goods to its customers that are guaranteed.
Required:
State whether the retailer must raise a provision for the cost of meeting future guarantee obligations:
A. The retailer company provides the guarantee.
B. The manufacturer provides the guarantee. The retailer is not liable in any way.
C. The manufacturer provides the guarantee but the retailer company provides a guarantee irrespective
of whether the manufacturer honours his guarantee.
D. The manufacturer and retailer company provide a joint guarantee, whereby they share the costs of
providing the guarantee: they jointly and severally accept responsibility for the guarantee.
E. The manufacturer and retailer company provide a joint guarantee, whereby they share the costs of
fulfilling the guarantee: the retailer is not liable for amounts that the manufacturer may fail to pay.
Solution A9: Guarantees

A. The retailer has the obligation and must therefore raise the provision.
B. The manufacturer has the obligation. The retailer has no obligation. No provision (i.e. no liability)
should be raised in the retailer’s books.
C. The retailer must raise a provision for the full cost of the provision and must recognise a separate
reimbursement asset to the extent that it is virtually certain to receive the reimbursement.
D. The portion of the costs that the retailer is expected to pay is recognised as a provision, whereas
the portion of the costs that the manufacturer is expected to pay is disclosed as a contingent
liability in case the manufacturer does not honour his obligations. IAS 37.29
E. The portion of the costs that the retailer is expected to pay is recognised as a provision. A
contingent liability is not recognised for the portion of the costs that the manufacturer is expected
to pay since the retailer has no obligation to pay this amount in the event that the manufacturer
does not honour his obligations.
854 Chapter 18
Example A10: Reimbursements

A retailer company offers guarantees to its customers:
It estimates that it will cost C100 000 to fulfil its obligation in respect of the
guarantees.
The supplier, however, offers a guarantee to the retailer company.
Required: Show all related journals and disclosure in the statement of financial position assuming that:
a) the entire C100 000 is virtually certain of being received from the supplier.
b) an amount of C120 000 is virtually certain of being received from the supplier.
Solution A10(a): reimbursements

Debit Credit
Guarantee expense (E) 100 000
Provision for guarantees (L) 100 000
Provision for the cost of fulfilling guarantees
Guarantee reimbursement (A) 100 000
Guarantee reimbursement income (I) 100 000
Provision for guarantee reimbursements
Company name
20X2
ASSETS C
Current assets
Guarantee reimbursements 100 000
LIABILITIES AND EQUITY
Current liabilities
Provision for guarantees 100 000
Comment:
The asset and liability should be separately disclosed and may not be set-off against each other
(therefore both asset and liability will appear in the statement of financial position); whereas
The income and expense may be set-off against each other (as they both affect profit and loss) and,
in this case, would cancel each other out (will not appear in the statement of comprehensive
income at all).
Solution A10(b): Reimbursements

The journals will be the same because the reimbursement asset is not allowed to be measured at more
than the provision.
A: 4.8 Changes in provisions for decommissioning etc (IAS 37.59 - .60 & IFRIC 1)
The measurement of a provision is estimated based on circumstances in existence at the time

of making the provision. As circumstances change, the amount of the provision must be
reassessed and increased or decreased as considered necessary.
There are thus three distinct types of changes that can occur to a provision for future costs:
the unwinding of the discount as one gets closer to the date of the future cost (e.g. getting
closer to the date on which the asset has to be decommissioned);
a change in the estimated future cash outflow (or future economic benefits); and
a change in the estimated current market discount rate.
The unwinding of the discount is really just the natural increase in the measurement of the
liability as one gets closer to D-Day (the day on which the future cost is to be incurred).
Chapter 18 855
If you recall, the provision is originally measured at the discounted amount (i.e. present value)
and the unwinding of the discount thus reverses the original discounting (see example 6):
The balance on the provision must be gradually increased as the present value increases
so that it finally equals the actual amount to be paid (the future amount).
This increase in the liability is recognised directly in profit or loss as a finance cost. These
finance costs may never be capitalised to the asset.
Whereas the unwinding of the discount is expensed, the following changes are adjusted for by
adjusting the asset’s carrying amount:
a change in the estimated future cash outflow; or
a change in the estimated discount rate.
The journals we process when adjusting the provision and the asset’s carrying amount (i.e.
due to changes in estimated future cash flows or estimated discount rate) depend on the model
adopted for that class of property, plant and equipment. There are two models possible:
the cost model, and
the revaluation model.
A: 4.8.1 Change in provisions and the cost model (IFRIC 1.5)
The cost model measures the carrying amount of the asset at:
cost
less accumulated depreciation (decrease in carrying amount due to normal usage), and
less accumulated impairment losses (the decrease in carrying amount due to damage).
If the cost model is used and an adjustment to the provision is needed, IFRIC 1 requires that
the adjustment be processed as follows:
An increase (credit) in the liability:
- is added (debited) to the cost of the related asset in the current period; but
- the entity shall consider whether this is an indication that the new carrying amount of
the asset may not be fully recoverable:
if it is such an indication, the entity must:
- test the asset for impairment (damage) by estimating its recoverable amount, and
- account for any impairment loss in accordance with IAS 36.
A decrease (debit) in the liability:
- is deducted (credited) from the cost of the related asset in the current period; but
- the amount deducted from the cost of the asset cannot exceed its carrying amount:
if a decrease in the liability does exceed the carrying amount of the asset, the excess:
- shall be recognised immediately in profit or loss. IFRIC 1.5
The essence of IFRIC 1.5 and the cost model is as follows:

For an increase in the provision:
Dr Asset cost
Cr Provision
However, because the cost of the asset is increasing purely due to the increase in the
provision, an impairment test (involving a calculation of the recoverable amount) must be
done to ensure that the new “inflated” carrying amount is fully recoverable.
If the recoverable amount is lower than the carrying amount, the carrying amount must be
decreased as an impairment loss in accordance with IAS 36.
856 Chapter 18
The essence of IFRIC 1.5 and the cost model continued ....
For a decrease in the provision:
Dr Provision
Cr Asset cost (limited to historical carrying amount*)
Cr Profit/Loss (excess over historical carrying amount*)
* The historical carrying amount is the carrying amount that the asset would have had
based purely on ‘cost less accumulated depreciation’
Example A11: Changes in decommissioning liability: cost model

Susan Limited acquired a plant for C1 000 000 on 1 January 20X5.
Depreciation is calculated using the straight-line method and a nil residual value.
Susan Limited has a legal obligation to dismantle the plant at the end of its 4-year useful life.
The estimated future cost of dismantling is C40 000.
The present value of the future dismantling costs is C27 321 (using a discount rate of 10%).
The company uses the cost model to account for property, plant and equipment.
Required: Ignoring tax, prepare the journal entries for 20X5 and 20X6 assuming
a) The dismantling costs increased to C60 000 on 1 January 20X6.
b) The dismantling cost decreased to C30 000 on 1 January 20X6.
Solution A11(a): Increase in decommissioning liability: cost model

Workings:
W1: Effective interest rate table: estimate increases on 1 January 20X6
Date Discount Calculation of Finance Liability Calculation of finance charges: can

factor liability balance charges balance be calculated either way
(rounded): (present value) Liability Movement in
10% balance x 10% liability balance
1 Jan X5 0.683013 40 000 x 0.683013 27 321
31 Dec X5 0.751315 40 000 x 0.751315 2 732 30 053 27 321 x 10% 30 053 – 27 321
01 Jan X6 45 079 – 30 053 15 026
01 Jan X6 0.751315 60 000 x 0.751315 45 079
31 Dec X6 0.826446 60 000 x 0.826446 4 508 49 587 45 079 x 10% 49 587 – 45 079
31 Dec X7 0.909091 60 000 x 0.909091 4 959 54 545 49 587 x 10% 54 545 – 49 587
31 Dec X8 1 60 000 x 1 5 455 60 000 54 545 x 10% 60 000 – 54 545
Total 17 653
Journals:
Plant: cost (A) 1 000 000 + 27 321 1 027 321
Provision: decommissioning costs (L) Given 27 321
Purchase of plant and provision is capitalised to the cost.
31 December 20X5
Depreciation (E) (1 027 321 – 0) / 4yrs x 1yr 256 830
Plant: Accumulated depreciation (A) 256 830
Depreciation for 20X5 year
Finance charge (E) W1 2 732
Provision: decommissioning costs (L) 2 732
Finance charge for 20X5
Chapter 18 857
Solution A11(a): Continued...

Plant: cost (A) * W1 15 026
Increase in decommissioning liability
31 December 20X6
Depreciation (E) (1 027 321 – 256 830 +15 026 - 261 839
Plant: Accumulated depreciation (A) 0) /3 remaining years x 1 yr 261 839
Depreciation for 20X6 year: (CA – RV) / remaining useful life
Finance charge for 20X6 based on the new estimate
* Comment:
Because we are increasing the cost of the asset, we would also have to conduct an impairment test to
ensure this full amount is recoverable. See chapter 11.
Solution A11(b): Decrease in decommissioning liability: cost model

Workings:
W1: Effective interest rate table: estimate decreases on 1 January 20X6
Date Discount factor Calculation of Finance Liability Calculation of finance charges: can
(rounded): liability balance charges balance be calculated either way
10% (present value) Liability Movement in
balance x 10% liability balance
1 Jan X5 0.683013 40 000 x 0.683013 27 321

31 Dec X5 0.751315 40 000 x 0.751315 2 732 30 053 27 321 x 10% 30 053 – 27 321
01 Jan X6 22 539 – 30 053 (7 514)
01 Jan X6 0.751315 30 000 x 0.751315 22 539
31 Dec X6 0.826446 30 000 x 0.826446 2 254 24 793 22 539 x 10% 24 793 – 22 539
31 Dec X7 0.909091 30 000 x 0.909091 2 479 27 273 24 793 x 10% 27 273 – 24 793
31 Dec X8 1 30 000 x 1 2 727 30 000 27 273 x 10% 30 000 – 27 273
Total 10 193
Journals:
Plant: cost (A) 1 000 000 + 27 321 1 027 321
Purchase of plant
31 December 20X5
Depreciation (E) (1 027 321 – 0) / 4yrs x 1yr 256 830
Plant: accumulated depreciation (A) 256 830
1 January 20X6
Provision: decommissioning costs (L) W1 7 514
Plant: cost (A) * 7 514
Decrease in decommissioning liability
858 Chapter 18
Solution A11(b): Continued...

Depreciation (E) (1 027 321 – 256 830 – 7 514 – 0) 254 326
Plant: accumulated depreciation (A) / 3 remaining years x 1 year 254 326
Depreciation for 20X6 year: (CA – RV) / remaining useful life
* Comment: If our plant’s carrying amount had, for whatever reason, been lower than the decrease
that needed to be credited to the asset, the excess would be recognised immediately in profit or
loss. For example, had the plant’s carrying amount dropped to C7 000 on 1 January 20X6 (e.g.
through an impairment in the prior year), then only C7 000 of the decrease could be credited to
the plant and C514 would have had to be recognised in profit or loss.
A: 4.8.2 Change in provisions and the revaluation model (IFRIC 1.6)
The revaluation model measures the carrying amount of the asset at:
fair value
less subsequent accumulated depreciation (the decrease from normal usage), and
less accumulated impairment losses (the decrease from damage).
Important
If the revaluation model is used and an adjustment to the
provision is needed, IFRIC 1 requires that the adjustment A change (increase or
be processed as follows: decrease) in the liability may be an
indication that the asset may have to be
An increase (credit) in the liability:
revalued in order to ensure that its CA
- first debit the revaluation surplus account (i.e. does not differ materially from its fair
other comprehensive income), if there is one for value. Any such revaluation shall be
this asset, until this balance is exhausted; taken into account in determining the
- then debit any excess to an expense (i.e. in profit amounts to be recognised in P/L or OCI
or loss) under IFRIC 1.IFRIC 1.6(c) slightly reworded
A decrease (debit) in the liability: So before processing the adjustments

- first credit an income account (i.e. in profit or in accordance with IFRIC 1, revalue the
loss) if the decrease reverses a revaluation asset if necessary and then use the
expense on the asset(i.e. previously expensed in updated balances in revaluation surplus
account to do the relevant adjustments.
profit or loss)
- then credit the revaluation surplus (i.e. other comprehensive income), but in the event
that a decrease in the liability exceeds the carrying amount that would have been
recognised had the asset been carried under the cost model, the excess shall be
recognised immediately in profit or loss.
The essence of IFRIC 1.6 and the revaluation model is as follows:
First revalue the asset to its latest fair value. The fair value must include the present value of the
provision. Thus, if you are given a fair value net of the present value of the provision, add back the
present value of the provision.
For an increase in the provision:

Dr Revaluation Surplus
Dr Profit/Loss (excess over RS or if RS does not exist)
Cr Provision
For a decrease in the provision:
Dr Provision
Cr Revaluation Surplus (limited to historical carrying amount)
Cr Profit/Loss (excess over historical carrying amount)
Chapter 18 859
Example A12: Changes in decommissioning liability: revaluation model

Nabilah Limited acquired a plant for C1 000 000 on 1 January 20X5.
Depreciation is calculated using the straight-line method and a nil residual value.
Nabilah Limited has a legal obligation to dismantle the plant at the end of its 4-year useful life.
The estimated future cost of dismantling is C750 000.
The present value of the future dismantling costs is C512 260 (using a discount rate of 10%).
The company uses the revaluation model to account for property, plant and equipment.
The plant was revalued on 31 December 20X5 when its ‘net’ fair value (i.e. after deducting the cost of
the decommissioning) was C1 200 000.
The company transfers revaluation surplus to retained earnings when the asset is disposed of.
Required: Ignoring tax, prepare the journal entries for 20X5 and 20X6 assuming :
a) The future dismantling costs increased to C900 000 on 1 January 20X6;
b) The future dismantling cost decreased to C300 000 on 1 January 20X6.
Solution A12(a): Increase in decommissioning liability: revaluation model

W1: Effective interest rate table: estimate increases on 1 January 20X6
Date Discount Calculation of Finance Liability Calculation of finance charges: can be
factor liability balance charges balance calculated either way
(rounded): (present value)
10% Liability Movement in
1 Jan X5 0.683013 750 000 x 0.683013 512 260
31 Dec X5 0.751315 750 000 x 0.751315 51 226 563 486 512 260 x 10% 563 486 – 512 260
01 Jan X6 676 183 – 563 486 112 697
01 Jan X6 0.751315 900 000 x 0.751315 676 183
31 Dec X6 0.826446 900 000 x 0.826446 67 618 743 802 676 183 x 10% 743 802 – 676 183
31 Dec X7 0.909091 900000 x 0.909091 74 380 818 182 743 802 x 10% 818 182 – 743 802
31 Dec X8 1 900000 x 1 81 818 900 000 818 182 x 10% 900 000 – 818 182
Total 275 043
Journals
Plant: cost (A) 1 000 000 + 512 260 1 512 260
Purchase of plant and provision is
capitalised to the cost
31 December 20X5
Depreciation (E) (1 512 260 – 0) / 4 yrs x 1 yr 378 065
Plant: accumulated depreciation (A) 378 065
Plant: cost (A) FV (1 200 000 + 563 486 (W1)) 629 291
Revaluation surplus (Eq: OCI) – CA: (1 512 260 – 378 065) 629 291
Revaluation to fair value
1 January 20X6
Revaluation surplus (Eq: OCI) Incr in prov: 112 697 limited 112 697
Provision: decommissioning costs (L) to RS balance: 629 291 Note 1 112 697
Increase in decommissioning liability
860 Chapter 18
Solution A12(a): Continued...

Depreciation (E) FV: (1 200 000 + 563 846 – 0) / 587 829
Plant: accumulated depreciation (A) 3 years remaining x 1 year 587 829
Note 1:
The balance in the revaluation surplus was C629 291 and was thus not a limiting factor.
If we had previously revalued upwards by only C100 000 (instead of C629 291), then C100 000 of
the increase in the provision would have been debited to the revaluation surplus and C12 697
would have been debited to an expense.
Solution A12(b): Decrease in decommissioning liability: revaluation model

Workings:
W1: Effective interest rate table: estimate decreases on 1 January 20X6
Date Discount Calculation of Finance Liability Calculation of finance charges: can
factor liability balance charges balance be calculated either way
10% Liability Movement in
01 Jan X5 0.683013 750 000 x 0.683013 512 260
31 Dec X5 0.751315 750 000 x 0.751315 51 226 563 486 512 260 x 10% 563 486 – 512 260
01 Jan X6 225 394– 563 486 (338 092)
01 Jan X6 0.751315 300 000 x 0.751315 225 394
31 Dec X6 0.826446 300 000 x 0.826446 22 539 247 934 225 394 x 10% 247 934 – 225 394
31 Dec X7 0.909091 300 000 x 247 934 x 10% 272 727 – 247 934
0.909091 24 793 272 727
31 Dec X8 1 300 000 x 1 27 273 300 000 272 727 x 10% 300 000 – 272 727
Total 125 832
W2: Historical carrying amount C
Cost 1 January 20X5 1 000 000 + 512 260 1 512 260
Less accumulated depreciation 31 December 20X5 (1 512 260 – 0) / 4 yrs x 1 yr 378 065
Historical carrying amount 31 December 20X5 1 134 195
Journals:
Plant: cost (A) 1 512 260
Bank 1 000 000
Purchase of plant
31 December 20X5
Depreciation (E) (1 512 260 – 0) / 4 yrs x 1 yr 378 065
Plant: accum. depreciation (A) 378 065
Plant: cost (A) FV (1 200 000 + 563 486 (W1)) 629 291
Revaluation surplus (Eq: OCI) – CA: (1 512 260 – 378 065) 629 291
Revaluation of plant to fair value
Chapter 18 861
Solution A12(b): Continued...

Provision: decommissioning costs (L) Decr in prov: 338 092 338 092
Revaluation surplus (Eq: OCI) limited to 1 134 195 (W2)* 338 092
Decrease in decommissioning liability
31 December 20X6
Depreciation (E) (1 200 000 + 563 486 – 0) / 3 587 829
Plant: Accum. depreciation (A) years remaining x 1 year 587 829
Depreciation for 20X6 year:
* Any excess over C1 134 195, being the historical carrying amount of the asset, would be
recognised immediately in profit or loss as the decrease in the liability would then have exceeded
the historical carrying amount of the asset. The decrease in the liability of C338 092 was not
limited by the historical carrying amount, which was much larger, C1 134 195.
If the HCA had been C300 000, then of the C338 092 reduction in the provision, only C300 000
would have been credited to RS and the remaining C38 092 would be credited to income (P/L).
A: 4.9 Changes in provisions due to payments (IAS 37.61 - .62)

A provision is made for future costs. When these costs are eventually paid for, the provision
is reduced. Care must be taken to reduce the provision by only those costs, now paid for, that
were originally provided for. A provision may only be reduced by the expenditures that were
originally recognised, i.e. a provision may only be used for the purpose for which it was
originally created. IAS 37.61 If expenditures that were provided for in a provision are no longer
expected to happen, that provision must be derecognised.
Example A13: Reducing provisions

A company recognised a provision of C350 000 in respect of a court case, which was
estimated at 31 December 20X5 as follows:
Amount to be paid to lawyer A: C250 000
Amount to be paid to lawyer B: C100 000.
During 20X6, the company attended a number of court hearings and on a few occasions received
parking fines whilst inside the court house.
The following are all the court-related payments made (all payments were made on 31 August 20X6):
Lawyer A: C270 000
Lawyer B: C70 000
Parking fines: C20 000
The case was thrown out of court on 30 November and no further payments were required.
Required: Show the journal entries in both 20X5 and 20X6.
Solution A13: Reducing provisions

Legal expenses (E) 350 000
Provision for legal expenses (L) 350 000
Provision for expected lawyers’ fees
31 August 20X6
Legal expenses (E) 20 000
Bank (A) 270 000
Payment to Lawyer A: only C250 000 had been raised as a provision
and thus the C20 000 must be expensed (not debited to the provision)
862 Chapter 18

31 August 20X6 Debit Credit
Bank (A) 70 000
Payment to Lawyer B
Parking fines (E) 20 000
Bank (A) 20 000
Payment of parking fines
30 November 20X6
Provision for legal expenses (L) (350 000 – 250 000 – 70 000) 30 000
Legal expenses (I) 30 000
Derecognition of the balance on the provision for legal fees
Comment:
Payment of parking fines – although the fines occurred at the time of the court case, these fines had
not been provided for and may not be debited to the provision
When we know that payments that have been provided for will not occur, the balance in the
provision must be derecognised. When the case was thrown out of court, it becomes clear that no
further legal fees will be incurred. This therefore means that the extra fee of C30 000 provided for
in respect of lawyer B will not be incurred and this balance must therefore be derecognised
(C100 000 – C70 000).
A: 5 Recognition and Measurement: Four Interesting Cases
A: 5.1 Future operating losses (IAS 37.63 - .65)

Future operating losses
A future operating loss does not meet the definition of a
A provision may never be
liability since there is no obligation to incur the future recognised for future operating losses
loss (remember that a liability exists independently of the as it is avoidable. No present obligation
entity’s future actions and therefore, if there is any future exists to incur the loss.
action that may avoid the obligation, there is no liability).
Thus, an expected future operating loss may not be recognised as a provision. An expected
future loss may, however, be considered an indication that some or all of the entity assets are
impaired (see chapter 11).
A: 5.2 Contracts (IAS 37.66 - .69)
There are two kinds of contracts referred to in IAS 37:

An onerous contract is
Executory contracts
defined as:
Onerous contracts.
a contract where:
Executory contracts are simply contracts still being - the unavoidable costs of
executed – in other words, either: meeting the obligations (terms)
neither party has performed any of its obligations or of the contract
both parties have partially performed their obligations - exceed the economic
to an equal extent. IAS 37.3 benefits expected to be
received from the contract
IAS37.10 reworded
Costs that have been contractually committed to by an
entity but not yet incurred should not be recognised as a liability since these are considered to
be future costs (there is not past event and thus no present obligation exists).
The only time that costs in respect of a contract should be provided is when the executory
contract is an onerous contract. Therefore a provision may only be raised if the contract is an
onerous contract as defined in IAS 37.
Chapter 18 863
An onerous contract is one where the unavoidable costs Measuring onerous

to fulfil the terms of the contract are greater than the contract provision.
benefits that will be derived from it (i.e. the contract will The provision must be
make a loss). In this case, a provision must be recognised measured at the lower of the:
for the unavoidable costs, these being the lower of: costs of fulfilling the contract and;
the cost of fulfilling the contract; and any compensation, penalties or fines
the compensation or penalties that would be incurred arising from failure to fulfil the
if the contract were to be cancelled. contract See IAS 37.68
Example A14: Onerous contract

Silliun Ltd entered into a contract to perform certain services.
The total contract price is C80 000.
The estimated costs of fulfilling these contractual obligations have been recently re-
assessed to be C140 000. No work has yet been done.
A penalty of C30 000 is payable if the contract is to be cancelled.
Required: Process the required journal entry.
Solution A14: Onerous contract

Debit Credit
Contract cost 30 000
Provision for onerous contract (L) 30 000
Minimum cost related to an onerous contract:
Comment: The onerous contract is measured at the lower of: C30 000 (cost to exit before completing) or C60 000
(being the cost to complete: C140 000 – C80 000).
A: 5.3 Restructuring provisions (IAS 37.70 - .83)

Restructuring is defined as:
a programme that is planned and controlled by management; and
materially changes either:
the scope of a business undertaken by an entity; or
the manner in which that business is conducted. IAS 37.10
Restructuring occurs when, for example, a line of Restructuring is defined as:

business is sold (e.g. a company producing shoes and
clothes sells its shoe-manufacturing factory) or there is a A programme that is planned and
controlled by management, and
change in the management structure. In both cases, there materially changes either:
will be a variety of costs involved: for example, - the scope of a business
retrenchment packages will probably need to be paid out undertaken by an entity; or
and in the case of the sale of the factory, there may be - the manner in which that
costs incurred in the removal of certain machinery. business is conducted IAS 37.10
The same definition and recognition criteria must be met before recognising a provision for
the costs of restructuring, although IAS 37 provides further criteria to assist in determining
whether the definition and recognition criteria have been met.
These extra criteria for recognising a constructive obligation to restructure are as follows:
there must be a detailed formal plan that identifies at least all the following:
the business or part of a business concerned;
the principal locations affected;
the location, function and approximate number of employees who will be
compensated for terminating their services;
the expenditure that will be undertaken; and
when the plan will be implemented.
the entity must have raised valid expectations in those affected before the end of the
reporting period that it will carry out restructuring, by either having:
started to implement the plan; or
announced its main features to those affected by it. IAS 37.72
864 Chapter 18
Costs of restructuring a business entity should be provided for (i.e. should be recognised as a
provision) on condition that the costs provided for are only those costs that are directly
associated with the restructuring, being:
those that are necessary; AND
not associated with the ongoing activities of the entity (i.e. future operating costs are not
part of the provision, for example: retraining and relocation costs for continuing staff,
investment in new systems, marketing, etcetera). IAS 37.80
Where the restructuring involves a sale of an operation, no obligation arises until there is a
binding sale agreement. IAS 37.78
Example A15: Restructuring costs

A few days before year-end, Dropout Ltd decided to close its shoe factory within 6 months
of year-end:
A few days before year-end, Dropout Ltd announced its intention
There is a detailed formal plan that lists, amongst other things, the expected costs of
closure:
retrenchment packages: C1 000 000
retraining the staff members who will be relocated to other factories: C500 000
loss on sale of factory assets: C100 000.
Required:
Process the required journal entry.
Solution A15: Restructuring costs

Debit Credit
Restructuring costs (E) 1 000 000
Provision for restructuring costs (L) 1 000 000
Provision for restructuring costs
Note: The cost of retraining staff is a future operating cost and must therefore not be provided for. As it
is avoidable. The loss on sale of assets simply indicate a possible need to impair the assets at year-end.
A: 5.4 Levies (IFRIC 21)
A levy is defined as ‘an outflow of resources embodying economic benefits that is imposed by
government on entities in accordance with legislation, other than:
those outflow of resources that are within the scope of other standards (such as income
taxes, which are covered by IAS 12); and
fines or other penalties that are imposed for breaches of the legislation’. IFRIC 21.4
Over and above the items excluded from this definition, IFRIC 21 goes on to explain that
IFRIC 21 also does not apply to liabilities arising from emission trading schemes. See IFRIC 21.6
IFRIC 21 gives guidance on the accounting treatment and Levies does not apply to:
recognition principles for the liability to pay a levy if that
levy is within the scope of IAS 37. Outflows within the scope of other
standards Fines or penalties,
The obligating event that gives rise to the recognition Liabilities arising from emission
of a liability to pay a levy is the activity that triggers trading schemes,
the payment of the levy, as identified by legislation. (e.g. income taxes) IFRIC 21.4 & .6
IFRIC 21.8
The liability to pay a levy is recognised progressively, if the obligating event occurs over
a period of time. IFRIC 21.11
If an obligation to pay a levy is triggered by reaching a minimum activity threshold, the
corresponding liability will be recognised when that threshold is reached. See IFRIC 21.12
Chapter 18 865
Example A16: Levies

Dash Limited is required to pay a levy to the government for operating in its sector.
The levy is determined with reference to the amount of revenue generated.
The financial year end of the company is 31 December 20X1;
Dash Ltd starts generating revenue in 20X1 from 2 January 20X1.
Required: Discuss when the liability to pay the levy should be recognised if:
A. The levy is triggered as Dash Limited generates revenue in 20X1.
B. The levy is triggered once Dash Limited reaches revenue of C30 million.
C. The levy is triggered as soon as Dash Limited generates revenue in 20X1; however, the levy is
calculated based on 2% of the 20X0 revenue.
Solution A16: Levies

A. The liability is recognised progressively as the entity generates revenue in 20X1. If Dash Limited
prepares interim financial statements during 20X1 the liability will be recognised in these interim
financial statements based on the revenue to date for 20X1.
B. The liability will be recognised on the date that Dash Limited’s revenue reaches C30million.
C. The liability will only be recognised in 20X1 as soon as revenue is generated in 20X1. The
generation of revenue in 20X0 is necessary but not sufficient to create a present obligation. The
activity that triggers the payment of the levy is the generation of revenue in 20X1. Therefore, the
liability will be recognised on 2 January 20X1, and measured at 2% of the 20X0 revenue.
A: 6 Recognition and Measurement: Contingent Assets (IAS 37.31 - .35)
A: 6.1 Recognition of contingent assets

For an asset to be recognised, both the definition and the recognition criteria need to be met.
Contingent assets, which are only possible assets depending on future events, will, however,
never be recognised since the definition and recognition criteria will not be met.
A contingent asset is
Where the inflow of economic benefits from a ‘contingent defined as:
asset’ is:
A possible asset that arises from past
virtually certain, the asset is no longer considered to events and whose existence will be
be a ‘contingent’ asset but a normal asset and is confirmed only by the:
recognised (unless a reliable estimate is not possible);
probable, a contingent asset would be disclosed (if occurrence or non-occurrence of
material); and one or more uncertain future events
possible or remote, the contingent asset is ignored not wholly within the control of the
(based on the concept of prudence). entity IAS 37.10 (e.g. a possible positive
court ruling).
A: 6.2 Measurement of contingent assets
Although contingent assets are not recognised, the asset Treatment of contingent
may need to be disclosed, in which case its value will still assets in the financial
need to be measured. statements
The measurement principles for a contingent asset are the Inflow virtually certain:
Recognise(i.e. journalise) pure asset
same as those for a contingent liability. In other words, if
Inflow probable:
the inflow is expected far into the future, the present Disclose in the notes to the financial
value thereof should be calculated and if this present statements
value is materially different from the absolute value of the Inflow possible or remote:
inflow, then the present value should be used instead (i.e. Ignore
use the present value if the difference between the present value and future value is
considered to be material.
866 Chapter 18
A: 7 Disclosure: Provisions, Contingent Liabilities and Contingent Assets

(IAS 37.84 - .92)
A: 7.1 Disclosure of provisions

Provisions should be disclosed as a separate line item in the statement of financial position.
For each class of provision, disclose the following in the notes to the financial statements:
a brief description of the nature of the obligation;
the expected timing of the outflows;
the uncertainties relating to either or both the amount and timing of the outflows;
major assumptions made concerning future events (e.g. future interest rates; the
assumption that a future law will be enacted with the result that a related provision was
raised; future changes in prices and other costs);
the expected amount of any reimbursements including the amount of the reimbursement
asset recognised (if recognised at all);
a reconciliation between the opening carrying amount and the closing carrying amount of
the provision (for the current period only) indicating each movement separately:
additional provisions made, including increases to existing provisions;
increases in a provision based on increasing present values caused by the normal
passage of time and from any changes to the estimated discount rate;
amounts used during the year (debited against the provision); and
unused amounts reversed during the year.
comparative information is not required in the notes.
Since provisions are estimates, a change in a provision must be accounted for as a change
estimate in terms of IAS 8 Accounting policies, changes in accounting estimates and errors.
The disclosure requirements for a change in accounting estimate (per IAS 8) are as follows:
the nature and amount of the change in estimate, where the amounts to be disclosed are:
- the effect on the current period; and
- the effect on future periods.
A: 7.2 Disclosure of contingent liabilities (IAS 37.86)
Where a contingent liability is to be disclosed, the following information should be provided

(per class of contingent liability):
a brief description of the nature of the contingent liability;
an estimate of its financial effect;
the uncertainties relating to the amount or timing of the outflows; and
the possibility of any reimbursement.
Example A17: Disclosure: decommissioning provision (change in estimate)

The following information has been given:
Cash purchase price (1 January 20X1) : C450 000
Future decommissioning (the outflow expected on 31 December 20X3, : C399 300
as assessed on 1 January 20X1)
Discount rate : 10%
Depreciation straight-line to nil residual values : 3 years
During 20X2, it was established that, due to unforeseen prices increases, the expected future cost of
decommissioning will be C665 500.
Note: These amounts have not been discounted.
Required: Disclose the above in the financial statements for the year ended 31 December 20X2.
Chapter 18 867
Solution A17: Disclosure: decommissioning provision (change in estimate)

Workings:
W 1. Effective interest rate table
Date Discount Calculation of Finance Liability Calculation of finance charges: can be
factor liability balance charges balance calculated either way
10% Liability balance Movement in
x 10% liability balance
1 Jan X1 0.751315 399 300 x 0.751315 300 000
31 Dec X1 0.826446 399 300 x 0.826446 30 000 330 000 300 000 x 10% 330 000 – 300 000
550 000 – 330 000 220 000
31 Dec X1 0.826446 665 500 x 0.826446 550 000
31 Dec X2 0.909091 665 500 x 0.909091 55 000 605 000 550 000 x 10% 605 000 – 550 000
31 Dec X3 1 665 500 x 1 60 500 665 500 605 000 x 10% 665 500 – 605 000
Total 145 500 30 000 + 55 000 + 60 500
W 2. Change in estimated finance Was Is Difference Adjustments

costs (a) (b) (b) – (a)
Initial liability (300 000)
Finance costs: 31/12/20X1 (30 000)
Carrying amount: 31/12/20X1 (330 000) (330 000)
Adjustment (see ex. 10 for workings) (220 000) (220 000) Extra liability
(550 000)
Finance costs: 20X2 (33 000) (55 000) (22 000) Extra expense
Carrying amount: 31/12/20X2 (363 000) (605 000) (242 000)
Finance costs: future (36 300) (60 500) (24 200) Extra expense
Carrying amount: future (399 300) (665 500) (266 200) Total change
W 3. Change in estimated Was Is Difference adjustments

depreciation (a) (b) (b) – (a)
Cost (450 000 + 750 000
300 000)
Depreciation 20X1 750 000 / 3 yrs (250 000)
Adjustment (see ex. 10 for workings) 220 000 220 000 Extra asset
Remaining useful life (years) 2 years 2 years
Depreciation: 20X2 (250 000) (360 000) (110 000) Extra expense
Depreciation: future (250 000) (360 000) (110 000) Extra expense
Carrying amount: final 0 0 0 Total change
Company name
Note 20X2 20X1
ASSETS C C
Non-current assets
Provision for decommissioning 6 605 000 330 000
868 Chapter 18

Company name
20X2 20X1
6. Provision for decommissioning C C
Opening carrying amount 330 000 0
Provision for decommissioning raised 0 300 000
Increase in provision – increased future cost 220 000
Increase in present value – unwinding of discount: 55 000 30 000
finance charges (per note 8)
Closing carrying amount 605 000 330 000
Decommissioning of the plant is expected to occur on 31 December 20X3 and is expected to result
in cash outflows of C665 500 (20X1 estimate: C399 300). The amount of the outflows is uncertain
due to changing prices. The timing of the outflow is uncertain due to the changing asset usage,
which may result in a longer or shorter useful life. Major assumptions include that the interest rates
will remain at 10% and that the asset has a useful life of 3 years.
Net carrying amount: 1 January 500 000 0
Gross carrying amount: 1 January 750 000 0
Accumulated depreciation: 1 January (250 000) 0
Acquisition (450 000 + 300 000) 0 750 000
Depreciation (per profit before tax note) (360 000) (250 000)
Increase in present value of future decommissioning costs W1 220 000 0
Net carrying amount: 31 December 360 000 500 000
Gross carrying amount: 31 December 970 000 750 000
Accumulated depreciation: 31 December (610 000) (250 000)

Profit before tax is stated after accounting for the following disclosable (income)/ expense items:
Finance charges W1 55 000 30 000
Depreciation W3 360 000 250 000
9. Change in estimate
The expected cash outflow on 31 December 20X3 in respect of the decommissioning of plant was
changed. The effect of the change is as follows: increase/(decrease)
Current year profits (before tax) (W2: 22 000 + W3: 110 000) (132 000)
Future profits (before tax) (W2: 24 200 + W3: 110 000) (134 200)
A: 7.3 Disclosure of contingent assets (IAS 37.89)
Where the contingent asset is to be disclosed, the following information should be provided:
a brief description of the nature of the contingent asset; and
an estimate of its financial effect.
A: 7.4 Exemptions from disclosure requirements (IAS 37.91 – 92)
There are two instances where disclosure of provisions, contingent liabilities and contingent
assets are not required:
where disclosure thereof is not practicable, in which case this fact should be stated; and
where the information required would be seriously prejudicial to the entity in a dispute
with a third party. If this is the case, then simply disclose the general nature of the dispute
together with the fact that full disclosure has not been made and the reason for this.
Chapter 18 869
Part A: Summary
Liabilities
Accruals and other Provisions Contingent Liability Contingent Liability

pure liabilities – type 1 – type 2
Present obligation Present obligation of Present obligation Possible obligation
of the entity the entity as a result of past as a result of past
as a result of past as a result of past events events
events events the settlement of which the existence of which
the settlement of the settlement of is expected to result in is to be confirmed
which is expected which is expected to the outflow of economic by the occurrence or
to result in the result in the outflow benefits non-occurrence of
outflow of economic of economic benefits but where the liability uncertain future
benefits where the amount or may not be recognised event/s
timing of payments is since the recognition that are not wholly
uncertain criteria are not met: within the control of
- the amount is not the entity
reliably measured or
- the outflow of future
ec. benefits is not
probable
Recognition flowchart: provisions and contingent liabilities
Liability
Present Possible Future obligation:

No No
obligation? obligation? Ignore
Yes Yes
Probable Possible
No No Remote: Ignore
outflow? outflow?
Yes Yes
Disclose as a
Reliable
No contingent
estimate?
liability
Yes but
high degree of
Yes uncertainty
Recognise a Recognise a provision

liability (liability)
Note: IAS 37 defines an outcome being probable if it is ‘more likely than not’ to occur. This
applies only to this standard and is not always appropriate for other standards. The term ‘possible’
referred to in the flowchart above refers to both ‘as likely to occur as not to occur’ (i.e. an equal
possibility) and ‘less likely to occur than not to occur’.
870 Chapter 18
Assets under different levels of uncertainty may be summarised as follows:
Assets
A resource
controlled by the entity
as a result of past events
from which future economic benefits are
expected to flow into the entity
Pure asset Pure asset Contingent asset Contingent asset

where this flow of where this flow of where this flow of where this flow of
economic benefits is economic benefits is economic benefits is economic benefits
considered certain: considered virtually considered to be is considered to be
certain: probable: possible or
remote:
- recognise - ignore
- recognise - disclose
The following flowchart is a useful summary of when to recognise and when to disclose a
particular type of asset.
Recognition flowchart: assets
Asset
inflow
certain or Inflow Inflow possible /
No No
virtually probable? remote
certain?
Y es Y es Yes
Reliable Disclose as a
No Ignore
estimate? contingent asset?
Y es
Recognise
(Pure asset, not
contingent)
Chapter 18 871
PART B:
Events After the Reporting Period
B: 1 Introduction
Although one might assume that events that occur after the current year-end should not be
taken into account in the current year’s financial statements, this is not always the case!
There is generally a fairly significant time delay between our financial year-end and the date
on which our financial statements are ready to be authorised for issue. During this time,
certain things (events) may happen which we need to consider carefully in terms of our users’
needs. Some of the events that happen during this period could influence our users’ decisions
and thus we need to consider whether this information should somehow be included in our
financial statements or not. The events need not be unfavourable to be included – they could
be favourable as well!
There are two types of events after the reporting period: Events after the reporting
adjusting; and period are defined as events
non-adjusting. that:
are favourable or unfavourable
The period between the end of the reporting period (the occur between the:
year-end) and the date on which the financial statements - end of the reporting period and
are authorised for issue is often called the post-reporting - date when the f/statements are
date period. authorised for issue. IAS 10.3
Assume that an entity has a December year-end and that the financial statements for 20X1
were completed and ready for authorisation on 25 March 20X2. In this case, the period
1 January 20X2 to 25 March 20X2, is the ‘post-reporting date period’, and events taking place
during this period need to be carefully analysed in terms of this standard into one of two
categories of adjusting events and non-adjusting events.
B: 2 Adjusting Events after the Reporting Period (IAS 10.8 - 9)
When considering whether or not to make adjustments for Adjusting events after the
an event that occurred after our reporting date but before reporting period are
the financial statements are authorised for issue, (i.e. defined as events that:
referred to as an ‘event after the reporting date’ or ‘post- provide evidence of
reporting period event’) we simply need to ask ourselves conditions that existed as the end of
if the event is one that gives more information about a the reporting period IAS 10.3
condition that existed at year-end.
If the event does give us information about a condition that existed at year-end, then we must
adjust the financial statements that we are about to issue. In other words, we will actually
need to post journal entries to account for the event in the current year financial statements.
The essence here is that the condition must already have been in existence at year-end. For
example, many estimates are made at year-end (e.g. impairment losses, legal and settlement
costs) where these estimates are made based on the circumstances prevailing at the time that
the estimate is made. If new information is discovered during the post-reporting date period
that gives a better indication of the true circumstances at year-end, then these estimates would
need to be changed accordingly.
Please remember that the event need not be unfavourable to be an adjusting event; for
example, a debtor that was put into provisional liquidation at year-end may reverse the
liquidation procedure during the post-reporting date period, in which case it may be
considered appropriate to exclude the value of his account from the estimated allowance for
credit losses and thus increase the value of the receivables balance at year-end.
872 Chapter 18
Example B1: Event after the reporting period

A debtor owed Newyear Limited C100 000 at 31 December 20X2, had their factory
destroyed in a fire and as a result, filed for insolvency. The following info is relevant:
A letter from the debtor’s lawyers was received in February 20X3, in which it was
stated that they will probably pay 30% of the balance,
The financial statements are not yet authorised for issue.
The fire occurred during December 20X2.
Required: Explain whether the above event should be adjusted for or not in the financial statements of
Newyear Limited as at 31 December 20X2. If the event is adjusting provide the journal entries.
Solution B1: Event after the reporting period

The event that caused the debtor to go insolvent was the fire, which happened in December 20X2,
being before year-end. This is therefore an adjusting event.
The adjustment would be as follows:
20X2 Debit Credit
Receivable: allowance for credit loss (-A) 70 000
Impairing the receivable balance due to credit risk: 100 000 x 70%
Comment: Disclosure of this may also be necessary if the amount is considered to be material.
B: 3 Non-Adjusting Events after the Reporting Period (IAS 10.10 – 13)
As already mentioned, when we decide whether or not to Non-adjusting events

adjust for an event that occurred after the reporting date after the reporting period
but before the financial statements are authorised for are defined as events that
indicate:
issue, (i.e. referred to as an ‘event after the reporting date’
or ‘post-reporting period event’) we simply need to ask are indicative of
ourselves if the event gives more information about a: conditions that arose after the
reporting period. IAS 10.3
condition that existed at reporting date; or about a
condition that arose after reporting date.
If the event gives us information about a condition that only developed after year-end, then
this event has obviously no connection with the current financial statements that are being
finalised, and thus no adjustments should be made to these current financial statements.
However, if the event is material (i.e. useful to our users) we should include information
about this event in the notes.
Example B2: Non adjusting events after the reporting period

A debtor that owed Newyear Limited C100 000 at 31 December 20X2 (year-end) had their
factory destroyed in a fire.
As a result, this debtor filed for insolvency and will probably pay 30% of the balance
owing. A letter from the debtor’s lawyers to this effect was received by Newyear
Limited in February 20X3.
The financial statements are not yet authorised for issue.
The fire occurred during January 20X3.
Required: Explain whether the above event should be adjusted for or not in the financial statements of
Newyear Limited as at 31 December 20X2. If the event is adjusting provide the journal entries.
Solution B2: Non adjusting events after the reporting period

The event that caused the debtor to go insolvent was the fire, which happened in January 20X3, being
after year-end. Thus this is a non-adjusting event.
Disclosure of this may be necessary if the amount is material. You will need to use professional
judgement to decide if disclosure is necessary.
Chapter 18 873
A typical example of an event after the reporting period is a dividend distribution that is
declared after the reporting date but before the financial statements are authorised for issue.
If a dividend distribution relating to the period under review is declared during this post-
reporting period, this dividend would not be recognised (adjusted for) as a dividend
distribution in the statement of changes in equity in the current period under review.
This is because the obligation only arises on the date that the dividend is declared (being
the obligating event).
Since the dividend was declared after the reporting date, the obligating event cannot be
considered to be a past event.
Since the obligating event was not a past event, it means that the obligation could not
have existed on reporting date. In other words, there isn’t a present obligation at
reporting date.
Thus, the dividend declaration represents a condition that arose after reporting date. These
dividends declared must be disclosed in the notes to the financial statements instead (in
accordance with IAS 1 Presentation of financial statements).
B: 4 Exceptions: No Longer a Going Concern (IAS 10.14 - .16)
IAS 1, which deals with the presentation of financial Going concern

statements, requires that management make an annual
formal assessment of the ability of the entity to continue If the going concern
as a going concern. When assessing the going concern of assumption is no longer appropriate, the
entire financial statements will need to
the entity, management need to consider events that have
be revised even if the conditions were
occurred right up until the date the financial statements not in existence at year end.
have been authorised for issue! Thus, if it is believed that
the going concern assumption is no longer appropriate, then the financial statements will need
to be completely revised, whether or not the condition was in existence at year-end!
Example B3: Events after the reporting period – various

Finito Limited is currently in the process of finalising their financial statements for the year
ended 31 December 20X2.
The following events occurred / information became available between 1 January 20X3 and
28 February 20X3 (the date the financial statements were authorised for issue):
A. A debtor that owed Finito C110 000 at year-end was in financial difficulties at year-end and, as a
result, Finito processed an impairment loss adjustment of C30 000 against this account. In January
20X3, the debtor’s lawyers announced that it would be paying 40% of all debts.
B. A debtor that owed Finito C150 000 at year-end had their factory destroyed in a labour strike in
December 20X2. As a result, this debtor has filed for insolvency and will probably pay 60% of the
balance owing. Finito was unaware of this debtor’s financial difficulties at 31 December 20X2.
C. Inventory carried at C100 000 at year-end was sold for C80 000 in January 20X3. It had been
damaged in a flood during June 20X2.
D. Current tax expense of C30 000 had been incorrectly debited to revenue in 20X2.
E. Finito had decided in a directors meeting held on 28 December 20X2 to close down a branch in the
Canary Islands. This decision was announced to the affected suppliers and employees via a
newspaper article published on 15 January 20X3.
F. A court case was in progress at 31 December 20X2 in which Finito was the defendant against
claims of radiation from cell phones purchased by a group of customers during 20X2. No
provision was recognised at year-end because Finito disputed the claims made.
The court ruled against Finito on 20 February 20X3 but has not yet indicated the amount to be paid
to the claimant in damages although Finito’s lawyers have now estimated that an amount of
C200 000 will be payable.
There was no inventory of the radioactive cell phones on hand at year-end.
874 Chapter 18
G. A customer lodged a claim against Finito in February 20X3 for food poisoning experienced in
January 20X3. After investigation, Finito found that all cans of berries produced in December 20X2
were poisoned. The claim is for C100 000. The carrying amount of canned berries at
31 December 20X2 is C80 000. Legal opinion is that Finito may be sued for anything up to
C1 000 000 in damages from other customers although a reliable estimate is not possible.
H. Finito declared a dividend on 20 February 20X3 of C30 000.
Required: None of the above events has yet been considered. Explain whether the above events should
be adjusted for or not when finalising the financial statements for the year ended 31 December 20X2. If
the event is an adjusting event, provide the relevant journal entries.
Solution B3: Events after the reporting period – various

A. An adjusting event: the event that caused the debtor to go insolvent occurred before year-end: the
lawyer’s announcement simply provided information regarding conditions in existence at year-end.
20X2 Debit Credit
Receivables: allowance for credit losses (-A) 36 000
Further impairment of receivables: 110 000 x 60% – 30 000
B. An adjusting event: the event that caused the debtor to go insolvent was the strike, which happened
before year-end.
20X2 Debit Credit
Receivables: allowance for credit losses (-A) 60 000
Impairment of receivables: 150 000 x (100% - 60%)
C. An adjusting event: the event that caused the inventory to be sold at a loss occurred before year-
end (the post-reporting period event simply gives more information about the net realisable value
at year-end).
20X2 Debit Credit
Inventory write-down (E) 20 000
Write-down of inventory to net realisable value: 100 000 – 80 000
D. The discovery of this error during the post-reporting date period is an adjusting event since it gives
us more information about a condition that existed at year-end.
20X2 Debit Credit
Revenue (I) 30 000
Correction of error
E. Non-adjusting event: A liability is based on either a legal obligation or present obligation. There is
no legal obligation at year-end to close the factory and there is no constructive obligation at year-
end since the announcement was only made after year-end. The announcement is therefore a non-
adjusting event. If the decision-making ability of the users may be affected by this information,
details of the decision should be disclosed.
F. A liability (present obligation) is based on either a legal obligation or constructive obligation.
There is no evidence to suggest that a constructive obligation existed at year-end and therefore the
situation appears to be based purely on whether a legal obligation existed at year-end.
At year-end, alleged radiation had already taken place (the past event) but Finito was disputing the
related legal claims, and therefore it was not clear whether a present obligation existed. Therefore:
no provision would have been recognised at year-end since it was considered more likely that
no obligation existed at year-end IAS 37.16(b)
a contingent liability would have been disclosed instead, unless the outflow of economic
benefits was considered to be remote IAS 37.16(b).
Chapter 18 875
Solution B3: Continued...

Since the sales of the allegedly radioactive cell phones were made before year-end, we have a past
event that leads to a possible legal obligation at year-end. Where it is not clear that an obligation
exists at year-end, events that occur during the post reporting period must be considered and may
result in us having to deem that an obligation existed at year-end IAS 37.15.
The court ruling during the post-reporting date period is therefore an adjusting event.
Since the court ruled against Finito Ltd, a legal obligation is deemed to exist at year-end. A
liability should therefore be recognised.
The exact amount owed is not available but an estimate is available: the liability should therefore
be classified as a provision
Since the estimate was made by a team of experts, the estimate is assumed to be reliable: the
definition and recognition criteria are met and therefore the following journal should be processed:
20X2 Debit Credit

Legal costs and damages (E) 200 000
Provision for legal costs and damages (L) 200 000
Provision for legal costs and damages
If the estimate is not considered to be reliable, then a contingent liability would need to be
disclosed in the notes instead.
Please note: Had the court ruling not occurred during the post-reporting period, there would have
been no journal entry to recognise a liability (remember that contingent liabilities are not
recognised) although Finito Limited would have disclosed a contingent liability note instead.
G. The inventory:
Information arising in the post-reporting period that brought to the attention the fact that inventory
at 31 December 20X2 was poisoned, requires an adjustment to the carrying amount thereof (i.e. an
adjusting event) since it is representative of conditions in existence at year-end.
The inventory of poisoned cans on hand at year-end must be written-off:
20X2 Debit Credit
Inventory write-down (E) 80 000
Write-down of inventory to net realisable value:
The claim:
The event that caused the claim was poisoning that occurred in January 20X3, being after year-
end. No provision is raised for this claim since the event that lead to it was poisoning that
occurred after year-end. Any information relating to this claim is therefore a non-adjusting event.
Claims in the post-reporting period due to poisoning that occurred after year-end would therefore
normally be non-adjusting events, but if they are so significant that they could result in Finito
having a going concern problem, then the entire financial statements would need to be adjusted to
reflect this fact (i.e. use liquidation values).
The possible future claims:
Since it is clear, however, that all inventory on hand at year-end was also poisoned, it is evidence
to suggest that there were other instances of poisoning that took place before year-end.
Poisoning that occurred before year-end would lead to an obligation at year-end. The fact that
claims had not yet been received does not alter the fact that an obligation exists (Finito will either
have a constructive obligation through past practice to reimburse customers for poisoning or legal
claims will be lodged against the company which the company will not be able to defend).
876 Chapter 18
Solution B3: Continued...

Whether or not Finito expects claims to be made in connection with poisoning that occurred
before year-end is simply taken into account in the measurement of the liability (using the
theory of probability and expected values): the liability exists.
Although Finito’s lawyers have estimated that Finito may expect claims of up to C1 000 000, this
was not considered to be a reliable estimate.
Since no reliable estimate is possible, the recognition criteria are not met and therefore a provision
may not be recognised. A contingent liability note would be included instead.
H. Non-adjusting event: Since the declaration was announced after year-end, there is no past event
and no obligation at year-end and the declaration is therefore a non-adjusting event. Details of the
dividend declaration must, however, be disclosed (IAS 1) IAS 10.13.
B: 5 Disclosure: Events after the Reporting Period (IAS 10.17 - .22)
The following information should be disclosed:

the date that the financial statements were authorised for issue;
the person or persons who authorised the issue of the financial statements;
the fact that the financial statements may be amended after issue, if this is the case;
each material category of non-adjusting event after the end of the reporting period:
the nature of the event; and
the estimated financial effect or a statement that such an estimate is not possible.
Part B: Summary
Events after the reporting period
Events that occur after year-end,

but before the financial statements are
authorised for issue
Adjusting events Non-adjusting events Exceptions

Events that give more Events that give more Where the going concern
information about conditions information about ability of the entity becomes
that were already in conditions that only arose no longer feasible, the
existence at year-end after year-end financial statements need to
be completely revised,
Disclosure may be whether or not this condition
necessary was in existence at year-end
Make adjustments No adjustments Make adjustments

No extra disclosure Disclosure may be Disclosure is necessary
necessary
Chapter 18 877
Gripping GAAP Employee benefits
Chapter19
Employee Benefits
Reference: IAS 19; IFRIC 14 (updated for any amendments to 10 December 2014)
Contents: Page
1. Introduction 880
2. Short-term employee benefits 881

2.1 Overview of short-term benefits 881
2.2 Short-term paid absences 882
2.2.1 Absence taken in year granted 883
2.2.2 Unused leave 883
2.2.2.1 Non-accumulating leave 883
Example 1: Short-term paid leave: non-accumulating leave:
single employee 883
Example 2: Short-term paid leave: non-accumulating: group of
employees 884
2.2.2.2 Accumulating leave 884
Example 3: Short-term paid leave: accumulating: vesting versus
non-vesting 885
Example 4: Short-term paid leave: accumulating, vesting and
non-vesting 886
2.3 Profit sharing and bonus plans 888
Example 5: Bonuses – raising the bonus provision 888
Example 6: Bonuses – paying the bonus 889
Example 7: Profit sharing as a bonus 889
3. Post-employment benefits 890

3.1 Overview of post-employment benefits 890
3.2 Defined contribution plans 891
Example 8: Defined contribution plans 891
3.3 Defined benefit plans 892
3.3.1 Overview of a defined benefit plan 892
3.3.1.1 The plan asset account 893
3.3.1.2 The plan obligation account 894
3.3.1.3 The asset ceiling adjustment account 894
3.3.1.4 The DBP employee benefit expense accounts 895
3.3.1.5 The DBP remeasurement accounts 895
3.3.2 Measurement of a defined benefit plan 896
3.3.2.1 Deficit or surplus 896
3.3.2.2 Net defined benefit plan liability or asset 896
3.3.2.3 Measurement of the plan obligation 897
3.3.2.3.1 Present value and interest cost 897
Example 9: DBP: effect of the unwinding of the
discount 898
3.3.2.3.2 Current service costs 899
Example 10: DBP: current service costs 899
878 Chapter 19

3.3.2.3.3 Past service costs 900
Example 11: DBP: past service costs 900
3.3.2.3.4 Benefits paid 902
Example 12: DBP: benefits paid 902
3.3.2.3.5 Curtailments and settlements 903
3.3.2.4 Measurement of the plan assets 903
Example 13: DBP: plan assets 904
3.3.2.5 Actuarial assumptions 904
3.3.2.6 Changes to actuarial assumptions 905
Worked example: Actuarial gains and losses 905
3.3.2.7 Asset balances: the asset ceiling 906
Example 14: DBP: asset ceiling 906
Example 15: Asset ceiling 907
3.3.2.8 Minimum Funding requirements 909
4. Other long-term benefits 909
5. Termination benefits 909

6. Disclosure 911
6.1 Short-term employee benefits 911
6.2 Post-employment benefits 911
6.2.1 Defined contribution plans 911
6.2.2 Defined benefit plans 911
Example 16: DBP: disclosure 914
Example 17: DBP disclosure: asset ceiling 917
6.3 Other long-term employee benefits 918
6.4 Termination benefits 918
7. Summary 919
Chapter 19 879
1 Introduction
Why do we work? Apart from philosophical reasons (that are unfortunately beyond the scope
of this book), we generally work for rewards.
In the mid 1890’s a Russian scientist, by the name of Ivan Pavlov, began investigating the
gastric function of dogs. He very importantly noticed that dogs tend to salivate before food
was delivered to their mouths. He called this a ‘psychic secretion’. He became so interested in
this phenomena that his research, which began as a scientific study of the chemistry of their
saliva, mutated into a psychological study and led to the establishment of what is commonly
referred to as ‘conditional reflexes’ or ‘Pavlovian response’.
The answer to ‘why do we work’ lies in this Pavlovian theory of conditional reflexes: we
work since we expect to receive a benefit – a bit like the dog salivating in expectation of food!
The term ‘employee’ includes all categories: full-time, part-time, permanent, casual,
temporary, management, directors and even their spouses or dependants where the benefits
are paid to them.
The benefit we, as employees, expect to receive may be summarised into four categories:
benefits in the short-term (benefits payable to us while employed and shortly after we
provide the service, e.g. a salary payable within 12 months);
benefits in the long-term (benefits payable to us while employed but where the benefits
may become payable long after we provide the service, e.g. a long-service award);
benefits post employment (i.e. after we have retired from employment e.g. a pension); and
termination benefits (those that would be receivable if our employment were to be
terminated before normal retirement age (e.g. a retrenchment package).
The definitions of these four categories of employee benefits are as follows:

Employee benefits:
The different types
Short-term Other long-term Post-employment Termination benefits

benefits benefits benefits
Defined in IAS 19 Defined in IAS 19 as: Defined in IAS 19 as: Defined in IAS 19 as:
as: All employee benefits Those that are payable Those that are payable
Those that are due other than: after the completion of as a result of either
to be settled wholly employment. the:
short-term,
within 12 months a) entity’s decision to
after the end of the post-employment or terminate the
period in which the employment before
termination
employee renders normal retirement
benefits
the related service. date; or
b) employee’s decision
Short-term benefits Post-employment to accept an offer
do not include benefits do not include of benefits in
termination termination benefits exchange for
benefits. and short-term termination
employee benefits.
Employee benefits include settlements made to employees, both past and present. Benefits
given to an employee’s spouse, children or others in exchange for services provided by that
employee would be considered to be a benefit given to that employee.
880 Chapter 19
Employee benefits apply to any type of settlement,

Employee benefits are defined as:
with the exception of IFRS 2: Share based payments.
Thus employee benefits only include settlements that All forms of consideration
an entity makes in the form of: Given by an entity
cash (e.g. cash salary); in exchange for service rendered by
goods (e.g. free products); or employees or for the termination of
employment. IAS 19.8 (reworded)
services (e.g. free medical check-ups).
Post-employment benefits are usually provided under
either:
defined contribution plans or
defined benefit plans.
IAS 19 requires a lot of disclosure for defined benefit plans whereas little or no disclosure is
required for other types of employee benefits. There are, however, disclosure requirements
that emanate from other standards such as:
IAS 1 Presentation of Financial Statements:
- requiring disclosure of the employee benefit expense;
IAS 24 Related Party Disclosures:
- requiring disclosure of each type of benefit provided to key management personnel;
IAS 37 Provisions, Contingent Liabilities and Contingent Assets:
- which may require that a contingent liability be disclosed upon termination of
employee services.
In addition to the other standards that require disclosure relating to employee benefit/s, other
related disclosure may also be required due to the requirements of the Companies Act, the
JSE Listing Requirements and King III (see chapter 1 regarding directors remuneration).
2 Short-Term Employee Benefits (IAS 19.9 – 19.25)
2.1 Overview of short-term benefits

Short-term employee benefits are benefits that are due to be settled within twelve months after
the end of the reporting period during which the employee provided the service. The
following is an overview of the 4 categories of short-term benefits:
Short-term benefits
Wages, salaries and Paid leave Profit sharing and/ or Non-monetary benefits
Note 1
social security (e.g. annual/ sick bonuses
contributions leave) (e.g. a car, medical care,
(e.g. medical aid) housing & free/subsidised
goods/ services)
Note 1: For current employees only (e.g. excluding non-monetary benefit given to a past employee)
Short-term benefits are recognised when the employee renders the service (this is the accrual
concept). This means that:
an expense is recognised (debit); and
bank is reduced (credit) to the extent that it is paid, or a liability is recognised (credit) to
the extent that any amount due has not been paid.
Measurement of the short-term employee benefit is relatively simple because:
no actuarial assumptions are required to measure either the obligation or the cost; and
no discounting is applied to short-term employee benefit obligations (simply because, by
definition, the time between receiving the service and the payment of the benefit is short).
IAS 19 does not require any disclosure of a short-term benefit although other standards may
require certain limited disclosure. This is covered in the section on disclosure (section 6).
Chapter 19 881
The accrual approach is evident in the following journals shown below:

Step 1: The employee benefit is raised as a liability when incurred: Debit Credit
Employee benefit expense XXX

Account payable (e.g. wages payable) (L) XXX
Recognising short-term employee benefits incurred (e.g. wages)
Step 2: When the benefit is paid, the journal entry is:

Bank XXX
Payment of short-term employee benefit (e.g. wages)
Step 3: If the expense has been underpaid, there will be a credit balance on the account
payable. But if the expense has been overpaid, there will be a debit balance on the account
payable. If an overpayment cannot be recovered from the employee (e.g. the employee is not
obligated to return the cash, or a future payment to the employee may not be reduced by the
overpayment) then the overpayment (which will be reflected as a debit balance in, for
example, the wages payable account) is expensed:
Debit Credit
Over-payment of short-term employee benefit (e.g. wages)
expensed
It is also possible that another standard allows or requires that the employee cost be
capitalised instead of expensed. This may happen if, for example, an employee is used on the
construction of another asset such as inventory. In this case, the benefits payable to this
employee (or group of employees) will be capitalised to inventory (IAS 2) instead of
expensed (see Step 1 above).
Debit Credit
Inventory (or other asset) XXX
A portion of the short-term employee benefit expense that
related to the manufacture of inventories is capitalised to the
cost of inventories
Whereas we are all probably capable of processing the journals for wages (or salaries
etcetera), the following other types of short-term benefits warrant a bit more attention:
short-term compensated absences;
profit sharing and bonuses.
2.2 Short-term paid absences (IAS 19.13 – 19.18)

Short-term paid absences refer to paid leave. In other words, these absences are those when
employers continue to pay employees during the periods that they are absent from work.
Short-term paid absences are categorised as either:
accumulating paid absences, which can be carried forward and used in a future period; or
non-accumulating paid absences, which are forfeited if unused at period end.
Accumulating paid absences can be either:

Short-term paid absences
vesting, which means it may be converted into cash can either be: See IAS 19.14
if unused; or
non-vesting, which means it may not be converted accumulating; or
into cash if unused. non-accumulating
882 Chapter 19
The possibility that an employee may, for example, resign before taking all of his
accumulative leave will not reduce the amount of the liability that should be recognised if the
leave is vesting leave. This is because all untaken leave will then be paid to the employee in
cash. If the leave is non-vesting, however, any leave that is not yet taken at the time the
employee resigns will then be forfeited. This possibility must be considered when measuring
the provision to be recognised for the unpaid absence.
A provision for unused leave may need to be recognised depending on whether the leave is
non-accumulating or accumulating and whether it the leave is vesting or non-vesting.
2.2.1 Absence taken in year granted
When an employee takes leave from work, the cost of this employee’s short-term absence is
recognised as part of his salary expense (no separate adjustment is required). For example, if
you were to take paid annual leave, your salary would be paid to you while you were on
holiday: there would be no extra amount owing to you and thus the leave that you have taken
is simply absorbed into the usual salary expense journal (i.e. there is no extra journal entry).
2.2.2 Unused absences
If, for example, there was any leave that was owed to an employee during the year that was
not taken by the employee, a distinction will need to be made between whether the leave was:
non-accumulating: where unused leave cannot be carried forward (i.e. falls away if not
used in the current period); or
accumulating: where unused leave can be carried forward to another period.
2.2.2.1 Non-accumulating leave
If an employee fails to take all the leave that was owing to him and this leave is non-
accumulating leave, the unused leave will be simply forfeited. Since the leave is forfeited, the
entity has no obligation to allow the employee to take this unused leave in future years. Since
there is no obligation, the definition of a liability is not met and thus a provision for unused
leave may not be recognised.
Example 1: Short-term paid leave: non-accumulating leave: single employee
Mitch Limited has one employee. His name is Guy.
Guy is owed 22 days leave per year.
Guy is paid C90 000 per year.
The year is 365 days and Guy is expected to work 5 days a week.
Guy took 8 days leave in 20X1. Guy’s leave is non-accumulating.
Required: Show all journals and calculate any leave pay provision at the 31 December 20X1 year-end.
Solution 1: Short-term paid leave: non-accumulating leave: single employee

No leave pay provision is recognised at 31 December 20X1 for the 14 days that Guy did not take (of the
22 days leave that was offered to Guy, 8 days were used and thus 14 days remained unused). This is
because the leave is non-accumulating, which means that Mitch Limited is not obliged to give him this
leave (i.e. Guy simply forfeits/loses whatever leave that he does not take in a year).
The following journal relating to Guy’s salary would be processed as 12 individual journals over the
year (90 000 / 12 = 7 500 per month).
Debit Credit
Employee benefit expense (E) Total salary processed over the year 90 000
Salaries payable (L) 90 000
Salary owed to Guy for 20X1 (includes leave taken)
Comment: when leave is non-accumulating, it means that any leave that is not taken at year-end simply
falls away and thus the entity has no obligation to provide the employee with this leave. Since there is
no obligation, there can be no liability (since the definition of a liability is not met) and therefore a
provision may not be recognised.
Chapter 19 883
Example 2: Short-term paid leave: non-accumulating: group of employees

Lee Limited operates a five-day working week. At Lee Limited’s financial year ended 31
December 20X4 (a year with 365 days):
there were 50 similarly paid employees
each earning an average annual salary of C50 000
and earning 20 days annual leave per year of service.
The leave entitlement of 20 days is non-accumulating and has remained the same for years
and will remain the same for years to come. Similarly, the salary of C50 000 has remained
unchanged for years and no significant changes are expected in the next few years.
The following are the actual average leave statistics to date:
end of prior year 20X3: an average of 10 days was used, all earned in 20X3
end of current year 20X4: an average of 12 days was used, all earned in 20X4
The estimated future leave statistics for the year ended 31 December 20X5:
an average of 14 days will be taken, all earned in 20X5
Ignore public holidays.
Required: Calculate the leave pay provision for Lee Limited’s financial year ended 31 December
20X4 assuming that the annual leave does not accumulate.
Solution 2: Short-term paid leave: non-accumulating: group of employees

Comment: this example is similar to example 1, with the difference being that the provision calculated
in this example is for a group of employees whereas the provision in example 1 is calculated for an
individual employee.
Leave that is taken is simply recognised as part of the salary of C50 000 (which would have been
debited to salaries and credited to bank over the year).
The employees lost an average of 10 days each in 20X3 (20 – 10 days) and 8 days in 20X4 (20 – 12
days taken). Non-accumulating means that the entity is not obliged to allow the employee to take any
of the unused leave in the future and thus the leave that was not taken at the end of the period is
forfeited. Since the entity has no obligation, and without an obligation there can be no liability, no
provision is made at 31 December 20X4 for the leave that was not taken.
2.2.2.2 Accumulating leave (IAS 19.15)
If an employee fails to take all the leave that was owing to him and this leave is accumulating
leave, the unused leave will continue to be owed to the employee. Since the entity has an
obligation to allow the employee to take the unused leave in future years, a liability for
unused leave must be recognised. This liability is recognised when the employee has rendered
the service that entitles him to that leave.
The measurement of this provision for leave liability depends on how many days are owing
multiplied by what his average salary per day is expected to be when he takes this leave. The
reason for using the future salary per day is because the entity will effectively be losing this
value on the days that the employee eventually stays away from work.
The measurement of the provision is further affected by whether the leave is:
vesting: unused leave can be taken in the future or can be exchanged for cash; or
non-vesting: unused leave can be taken in the future but cannot be exchanged for cash.
If the leave is accumulating but non-vesting and the employee leaves (e.g. resigns or retires)
before taking all of his accumulative leave, the entity would not need to pay the employee out
for the unused leave. This possibility needs to be considered when measuring this provision
for leave (i.e. a provision for unused accumulating leave that is non-vesting would possibly be
measured at a lower amount than if the leave was vesting).
884 Chapter 19
Example 3: Short-term paid leave: accumulating: vesting versus non-vesting

Mark Limited has one employee. His name is Scott.
Scott is paid C365 000 per year, but this is expected to increase by 10% in 20X2.
The year is 365 days and Scott is expected to work 5 days a week.
Scott is owed 30 days leave per year.
Scott took 20 days leave in 20X1. Scott’s leave is accumulating.
Mark Limited’s financial year-end is 31 December 20X1.
Required: Calculate any leave pay provision at 31 December 20X1 and show all journals assuming:
A. the leave is accumulating and vesting (i.e. Scott is entitled to convert his unused leave into cash):
past experience suggests that Scott will only take 90% of his unused leave balance before he
finally either resigns or retires from Mark Limited;
B. the leave is accumulating and non-vesting (i.e. Scott may not convert unused leave into cash): past
experience suggests that Scott will only take 90% of his unused leave balance before he finally
either resigns or retires from Mark Limited;
A. the leave is accumulating for a limited period and non-vesting: it accumulates for one year only
after which unused leave will be forfeited: past experience suggests that Scott will take 3 days
leave in 20X2 from his 20X1 leave entitlement carried forward.
Solution 3: Short-term paid leave: accumulating: vesting versus non-vesting

The provision is based on the expected daily cost of employing Scott. The cost per day is calculated as:
Average salary per day: (C365 000 x 110%) / 365 days = C1 100
Effective cost per day: C1 100 x 7/ 5 = C1 540 (since he not required to work every day but rather
5 days out of every 7 days, the effective cost per day is a little higher)
Or: (C365 000 x 110%) / (365 / 7 x 5) = C1 540
Ex 3A Ex 3B Ex 3C
Debit/ Debit/ Debit/
(Credit) (Credit) (Credit)
Employee benefit expense (E) Total salary for the year 365 000 365 000 365 000
Salaries payable (L) (365 000) (365 000) (365 000)
Salary owed to Scott for 20X1 (includes leave taken) NOTE 1
Employee benefit expense (E) A: W1; B: W2; C: W3 15 400 13 860 4 620
Provision for leave pay (L) (15 400) (13 860) (4 620)
Leave still owing to Scott at 31 December 20X1
Note 1: The salary journal would actually be processed as 12 individual journals over the year
(365 000 / 12 = 30 416)
W1: (30 – 20 days) x C1 540 per day = 15 400
The average cost per day is multiplied by the total number of outstanding days (since Scott
will either take this leave or will be paid out for it, regardless of the fact that he will
probably only use 90% he gets paid for the remaining 10% thus recognise 100%).
W2: (30 – 20 days) x 90% x C1 540 per day = 13 860
The average cost per day is multiplied by the total number of outstanding days that Scott will
probably take as leave (since the leave is non-vesting, the 10% leave that will probably
remain unused when he either retires or resigns will not be paid out and will thus be lost).
W3: 3 days x C1 540 per day = 4 620
The average cost per day is multiplied by the total number of outstanding days that Scott will
probably take as leave (since the leave is non-vesting leave, the leave that will probably not
have been taken by the end of 20X2 will not be paid out in cash and will thus be lost).
Comment:
The measurement of the provision is based on the expected cost when the leave is expected to be
taken – since the leave is expected to be taken in 20X2, the expected salary in 20X2 is used.
The principle applied in A deals with vesting leave: since the leave is vesting, the provision is
measured based on the total unused leave, irrespective of how many days the company is expecting
Scott to be able to take – this is because the company is obliged to pay Scott for any unused leave.
The principle applied in B and C is the same: since the leave is non-vesting, the provision
recognised is measured only on the leave that the company is expecting Scott to be able to take.
Chapter 19 885
In practice, there are many more employees than just one employee. It is normally impractical
to estimate the leave pay provision (liability) for each employee and this is therefore
estimated on an average basis. When calculating the leave pay provision on an average basis,
we will need to:
identify the number of employees within a certain salary/ leave bracket;
calculate the average salary per employee within this salary bracket;
calculate the average employee salary per day; and then
estimate the average days leave that the entity owes each employee at year-end (either in
days or in cash).
The provision will therefore be:

the estimated average days leave owing per employee,
multiplied by the average employee salary cost per day.
Example 4: Short-term paid leave: accumulating, vesting and non-vesting
Lee Limited operates a five-day working week. At Lee Limited’s financial year ended
31 December 20X4 (a year with 365 days):
there were 50 similarly paid employees
each earning an average annual salary of C50 000
and earning 20 days annual leave per year of service.
The leave entitlement of 20 days has remained the same for years and will remain the same
for years to come. Similarly, the salary of C50 000 has remained unchanged for years and
no significant changes are expected in the next few years.
The following are the actual average leave statistics per employee:
end of prior year 20X3: an average of 10 days of the 20X3 leave were unused
end of current year 20X4: an average of 12 days was used, and on average this came
from:
- the 20X3 leave entitlement: 4 days
- the 20X4 leave entitlement: 8 days.
The estimated future leave statistics per employee for the year ended 31 December 20X5:
an average of 14 days will be taken and on average this is expected to come from:
- 20X3: 0 days (No 20X3 leave days can be taken in 20X5 as they expired at the
end of 20X4)
- 20X4: 5 days
- 20X5: 9 days
Ignore public holidays.
Required:
Calculate the leave provision for Lee Limited’s financial year ended 31 December 20X4 if:
A. annual leave is carried forward and available for use in the next financial year (i.e. accumulating)
and is paid out in cash at the end of the next financial year if not used (i.e. vested).
B. annual leave is carried forward to the next financial year (i.e. accumulates) but simply expires if
not used by the end of the next financial year end (i.e. non-vesting).
Solution 4A and B: short-term paid leave

Comment:
This example involves a calculation for a group of employees rather than for just one employee.
No leave relates to the 20X3 year as all this leave was either paid out or expired at the end of the
20X4 year
The average rate per actual day is:
C50 000 / 365 = C136.99 per actual day
But, only 5 out of 7 days are worked, therefore, the effective rate per working day is actually higher:
C136.99 x 7 / 5 days = C191.78 per working day
Or: C50 000 / (365 / 7 x 5) = C191.78 per working day
886 Chapter 19
Solution 4A: Short-term paid leave – accumulating and vesting

Total provision to be recognised at 31 December 20X4:
= 20X3 leave: C0 + 20X4 leave: C115 068 + 20X5 leave: C0 = C115 068
Explanation and calculations:
20X3 unused leave: No provision to be recognised:
There were 10 days still due to the employee at 31 December 20X3 (given) for which a provision
would have been recognised at 31 December 20X3:
4 of these days were then taken in 20X4 and
the remaining 6 days from 20X3 would then have been paid out on 31 December 20X4.
No provision is thus recognised at 31 December 20X4 in respect of 20X3 leave since unused
leave will have been used or paid out in full by 31 December 20X4 and thus there is no further
obligation regarding this leave.
20X4 unused leave: Provision to be recognised for 12 days leave:
There were 12 days still due to the employee at 31 December 20X4 (20 days – 8 days used from
the 20X4 entitlement): the entity is obliged to either allow the employees to take this leave in
20X5 or to pay the employees out for any unused leave on 31 December 20X5.
The provision to be recognised = C191.78 x (20 days – 8 days taken) x 50 employees = C115 068
20X5 expected unused leave: No provision to be recognised:
Since the 20X5 leave has not yet been earned by the employees (the services in 20X5 have not yet
been provided by the employees), there is no past event that obligates the entity to provide any of
the 20X5 leave). If there is no past event, there can be no obligation at 31 December 20X4.
Solution 4B: Short-term paid leave – accumulated and non-vesting

Total provision to be recognised at 31 December 20X4:
20X3 leave: C0 + 20X4 leave: C47 945 + 20X5 leave: C0 = C47 945
Explanation and calculations:
20X3 unused leave: No provision to be recognised:
There were 10 days still due to the employee at end of 20X3:
4 of these days were taken in 20X4 and
the remaining 6 days from 20X3 would have been forfeited at the end of 20X4.
No provision is thus recognised at 31 December 20X4 in respect of 20X3 leave since unused leave
will have been used or forfeited by 31 December 20X4 and thus there is no further obligation
regarding this leave.
20X4 unused leave: Provision to be recognised for 5 days leave:
The employee is owed 20 days leave per year. Of the 20 days owed to the employee in 20X4, 8 days
were taken as leave in 20X4 (note: another 4 days were also taken, but these came out of the 20X3
leave entitlement). This means that at 31 December 20X4, the entity owes the employee another 12
days. Since the employee has already rendered the service that entitles him to this leave, a past event
has occurred and there is therefore an obligation at 31 December 20X4. A liability must therefore be
recognised at 31 December 20X4 for unused leave.
Because the leave is non-vesting, however, any leave that is not used will not be paid out in cash. As
a result, the provision must be measured based on the number of 20X4 days that the employee will
probably take in 20X5: only 5 days – not the full 12 days (we are therefore expecting that the
employees will forfeit an average of 7 days of their 20X4 leave: 20 – 8 – 5 days = 7 days). Compare
this to part A where the liability was based on the full 12 days since the terms of part A’s leave
entitlement was that the employee would be paid out for every day that he does not take.
Although the entity will not be paying the employee out in cash, the cost to the entity is still C191.78
per day since the entity will effectively lose this value on the days that the employee stays at home.
The provision to be recognised = C191.78 x 5 days (20X4 unused leave expected to be used in
20X5) x 50 employees = C47 945.
Chapter 19 887

20X5 expected unused leave: No provision to be recognised:
The 20X5 leave entitlement of 20 days of which 9 days will probably be taken in 20X5 is ignored
since the employee has not yet provided the 20X5 services that would entitle him to the 20X5 leave.
Since there is no past event (services rendered) there is no present obligation. No liability is therefore
recognised for any of the 20X5 leave entitlement.
2.3 Profit sharing and bonus plans (IAS 19.19 – 19.25)

Profit sharing or bonuses given to employees as a reward for services rendered are also
considered to be employee benefits. If these are payable within 12 months of the year-end in
which the employee provided the services, these would be considered to be short-term
employee benefits (otherwise they would be other long-term employee benefits).
Recognition of these benefits should only occur when:
there is a present obligation at year end (i.e. settlement cannot realistically be avoided);
resulting from a past event (the provision of the agreed upon services); and
the obligation can be reliably estimated.
The obligation can be either be a legal obligation or constructive obligation. For instance:
a legal obligation would arise if the employment contract detailed the profit-sharing or
bonus arrangement, and if all conditions of service were met;
a constructive obligation could arise if the entity created an obligation for itself through,
for instance, a past practice of paying bonuses (or sharing in profits). Therefore, even
though the employment contract may be silent on such profit-sharing or bonuses (in
which case there would be no legal obligation), it is possible for the entity to create a
constructive obligation through its past practices, policies, actions or public
announcements etc.
In accordance with IAS19.22, a reliable estimate can Bonus schemes that are
either:
only be made if the:
terms of the formal plan contain a formula for Settled in the entity’s own shares; or
determining the amount of the benefit; based on, or determined in relation to
entity calculates these payments before authorising the entity’s share price
the financial statements for issue; or are not within the scope of IAS 19,
past practice gives clear evidence of the amount of but IFRS 2.
the entity’s constructive obligation.
A characteristic of profit sharing and bonuses are that they often accrue over a period of time,
and may end up being only partially earned or even forfeited if an employee leaves before the
payment date. This characteristic will impact on the measurement of the provision: the
probability that the employee/s may leave before they become entitled to the benefit must be
factored into the calculation.
Example 5: Bonuses – recognising the bonus provision

During 20X2, Luke Limited created an obligation to pay a bonus of C120 000 to each
employee:
There were 6 employees at 1 January 20X2, and
2 more employees were hired on 1 April 20X2 (i.e. 8 employees at
31 December 20X2).
It was expected that 3 employees would resign during 20X3.
Required: Calculate the provision to be recognised in the financial statements of Luke Limited for the
year ended 31 December 20X2 and show the journal if the terms of the agreement are such that:
A. the bonus accrues to those employees still employed at year-end (31 December 20X2)
B. the bonus accrues proportionately based on the number of months worked during 20X2;
C. the 20X2 bonus accrues only if the employee is still employed at 31 December 20X3, the next
year-end
888 Chapter 19
Solution 5 A, B and C: Bonuses – raising the provision

Comment: this example highlights the importance of understanding the exact terms of the obligation. A
slight alteration of the terms can have a significant outcome on the amount of the provision.
Liability balance at year-end: Calculation C

Part A: 120 000 x 8 employees 960 000
Part B: 120 000 x 6 employees x 12 / 12 + 120 000 x 2 employees x 9 / 12 900 000
Part C: 120 000 x (8 – 3 employees) 600 000
Ex 5A Ex 5B Ex 5C
31 December 20X2 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Employee benefit expense (E) 960 000 900 000 600 000
Provision for bonuses (L) (960 000) (900 000) (600 000)
Bonuses provided for
Example 6: Bonuses – paying the bonus

Assume the same information as that in the previous example and that the C120 000 bonus
accrued to each of those employees still employed on 31 December 20X3 (i.e. example
5C). Assume that no employees resigned during 20X3 and that the bonus was paid on 31
December 20X3.
Required: Show the journals to be processed by Luke Limited for the year ended 31 December 20X3.
Solution 6: Bonuses – paying the bonus

Comment: this example emphasises that the recognition and measurement of the initial obligation to
pay the bonus and the payment itself, are separate economic events.

Employee benefit expense (E) 8 x 120 000 – 600 000 360 000
Provision for bonuses (L) 360 000
Increase in 20X2 bonus provision
Provision for bonuses (L) 8 x 120 000; OR 960 000
Bank (A) 600 000 + 360 000 960 000
Payment of 20X2 bonuses at 31 December 20X3
Example 7: Profit sharing as a bonus

John Limited has 5 directors at 31 December 20X2 with whom it has employment contracts
that provide for a 20% share each of the 10% of the profits that exceed a pre-determined
target – which is set at the end of each year for the next year’s profit sharing calculation.
At 31 December 20X1 it was decided that the target profit for 20X2 was C1 000 000.
The actual profit achieved in 20X2 was C1 200 000.
The targeted profit for 20X3, set on 31 December 20X2, is C1 400 000. Before the
20X2 financial statements were authorised for issue it looked probable that this profit
target will also be achieved.
Each of the directors still employed on 31 March of the year after the target is achieved is
entitled to their 20% of the total 10% profit share.
Required: Journalise the provision in the financial statements at 31 December 20X2 assuming:
A. John expects that no directors will resign before 31 March 20X3.
B. John expects that one director will resign before 31 March 20X3.
C. John pays the bonus to all of its employees, (i.e. not just 20% of the 10% excess to each of its
directors), who are still employed by the end of the next year. It is estimated that 10% of the
employees will leave during the next 12 months.
Chapter 19 889
Solution 7: Profit sharing as a bonus

Ex 7A Ex 7B Ex 7C
31 December 20X2 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Employee benefit expense (E) 20 000 16 000 18 000
Provision for profit sharing (L) (20 000) (16 000) (18 000)
Provision for profit share recognised
W1 (A): 10% x (1 200 000 – 1 000 000) x 5/5 = 20 000
The entire 10% profit share is expected to be paid since no directors are expected to resign
before 31/3/20X3
W2 (B): 10% x (1 200 000 – 1 000 000) x 4/5
Only 4/5 (80%) of the 10% profit share is expected to be paid since 1 director is expected to
resign before 31/3/20X3, leaving only 4 out of the original 5 directors employed.
W3 10% x (1 200 000 – 1 000 000) x 90%
(C): Only 90% of the 10% profit share is expected to be paid since only 90% of current employees
are still expected to be employed on 31/3/20X3. The bonus that relates to the 10% of
employees that left is not redistributed to the remaining employees as it was earned by the
10% that had left, and not the remaining 90%.
Comment:
Did you notice that no provision is made for the expected profit share related to the 20X3 targeted
profit (in part A, B or C)? This is because, even though it seems probable that the target will be met,
the profit share depends on the actual and final achievement of the profit – this has not yet happened
and therefore there is no past event and therefore there is no present obligation at 31 December 20X2.
3 Post-Employment Benefits (IAS 19.26 – 19.152)
3.1 Overview of post-employment benefits
If the employee remains employed by the entity until normal retirement age (i.e. does not
terminate his employment before this date) he may be entitled to further benefits. Since these
benefits would accrue while he was no longer employed, they would be referred to as ‘post-
employment’ benefits. Examples of these benefits: pensions, medical and life insurance.
It really is important to note that it is the services that he provided whilst employed that entitle
him to these benefits after employment. Therefore, the services that he provided whilst
employed are considered to be the past event for which the entity has an obligation.
Since the obligation arises during the employee’s work-life, the journal recognising the
obligation and related cost must be processed as and when the services are provided:
Debit Credit
Employee benefit expense (E) XXX
Post-employment benefits (L) XXX
Post-employment benefit provided for
As mentioned in the introduction, post-employment benefits are either:

defined contribution plans; or
defined benefit plans.
The classification of a defined plan depends on whether the entity has obligation (legal or
constructive) to fund any possible short-fall that the plan might experience (i.e. in the case of
a defined benefit plan, it is the entity who bares the risk for any possible shortfall).
Defined contribution plans are easier to recognise, measure and require almost no disclosure
whereas defined benefit plans are more complex to measure and require lots of disclosure.
890 Chapter 19
The post-employment plan may be a simple single employer plan or may be a:

multi-employer plan: explained in IAS 19.32-37;
group administration plan: explained in IAS 19.38;
common control shared-risk plan: explained in IAS 19.40-42;
state plan: explained in IAS 19.43-45; or an
insured benefit plan: explained in IAS 19.46-49.
The classification of such plans as defined contribution plans or defined benefit plans,
although not complicated, is not covered further in this chapter. This chapter focuses on
single-employer plans only.
3.2 Defined contribution plans (DCP) (IAS 19.50 – 19.54)
Defined contribution plans are post-employment benefit
Defined contribution
plans in which the entity and the employee agree to make plans:
contributions to a fund. On resignation or retirement, the
contributions together with any gains (or less any losses)
Involve payments to a separate
are paid to the employee. entity (usually an independently
What is important here is that defined contribution plans administered fund);
limit the entity’s obligation: the entity is only obliged to Limit the entity’s obligation to
pay the contributions in terms of the agreed plan (these contributions payable
are generally paid to a separate insurance company that the risks belong to the employee.
runs the plan). The entity is not responsible for any
possible short fall and has no claim to any gain in the plan.
The economic substance of a defined contribution plan is therefore that:
the obligation is limited to the agreed upon contributions; and
the risks belong to the employee (the employee runs the risk that the benefits will be less
than expected).
The amount recognised as an expense in the statement of comprehensive income is the
contribution payable by the employer to the defined contribution fund.
Debit Credit
Employee benefit expense (E) XXX
Contributions payable (L) XXX
Post-employment benefit: defined contributions provided for
As already explained (see section 3.1), the post-employment benefit expense is recognised as
and when the employee provides the services.
The measurement of the liability (provision) to be recognised is really easy:
no actuarial assumptions are needed; and
it is normally undiscounted (but will need to be discounted if the contributions become
payable after 12 months from the end of the period in which the employee provides the
service, where it would be discounted using a rate determined by reference to market
yields at the end of the reporting period on high quality corporate bonds).
Example 8: Defined contribution plans
Matthew Limited’s annual salary expense for 20X4 is as follows:
gross salary of C4 000 000:
C1 200 000 of this was the employees’ tax, which was withheld (payable to the tax
authorities);
7% of this was withheld (payable, on behalf of the employees, to a defined
contribution plan);
the balance thereof was payable to the employees;
company contributions to the defined contribution plan: 10% of gross salaries.
Required: Provide the following for Matthew Limited’s financial year ended 31 December 20X4:
A. the relevant journals (on an annual basis despite, in reality, being journalised on a monthly basis);
B. the profit before tax note.
Chapter 19 891
Solution 8: Defined contribution plans

Debit Credit
Employee benefit expense (E) Given 4 000 000
Current tax payable: employees tax (L) Given 1 200 000
Defined contributions payable (L) 4 000 000 x 7% 280 000
Employees payable (L): net salary Balance (paid to the employee) 2 520 000
Gross salaries for the year: payable to tax authorities, DCP &
employees
Employee benefit expense (E) 4 000 000 x 10% 400 000
Defined contributions payable (L) 400 000
Matthew’s (the employer’s) contribution to the defined contribution plan
Matthew Limited
20X4 20X3
Profit before tax is stated after taking into account the following disclosable expenses/ (income):
Employee benefit expenses 4 000 000 + 400 000 4 400 000 xxx
Included in employee benefit expenses are the following:
Defined contribution plan costs Employer contribution only 400 000 xxx
Comment:
Both the employer and the employees contributed to the plan: the employees contributed C280 000
over the year whereas the employer contributed C400 000.
Both the employees’ and the employer’s contributions (280 000 + 400 000, respectively) are
included in the total employee benefit expense (this expense is disclosable in terms of IAS 1).
The entity’s cost relating to the defined contribution plan (DCP) must be disclosed (IAS 19.53),
being the 400 000. The 280 000 contribution is a cost relating to the DCP that was incurred
directly by the employees (who effectively paid 280 000 out of their salaries of 4 000 000) and not
directly by Matthew Ltd.
3.3 Defined benefit plans (DBP) (IAS 19.26 and IAS 19.55 - 19.152)
3.3.1 Overview of a defined benefit plan
Where an entity guarantees (promises) that certain benefits will be payable to its employees
after employment, we have a defined benefit plan. The entity opens itself up to both:
an obligation that is potentially much bigger than simply the payment of future
contributions to a post-employment plan (e.g. pension payments are often based on the
employee’s last salary which may be far greater than originally expected); and
the risk that there will not be sufficient assets set aside to settle the obligation (i.e. to pay
the benefit owing to the employee).
Due to the risks involved in a defined benefit plan, there is also far more disclosure required
than is required of a defined contribution plan.
When recognising a defined benefit plan we must
recognise both: Defined benefit plans:
the plan obligation (i.e. the benefits that it owes to
its employees); and The entity has the obligation to
the plan assets (i.e. those set aside in order to settle provide the benefits
the obligation). the risks belong to the entity.
The plan obligation and the plan asset will be set-off against each other and presented in the
statement of financial position as either a net defined benefit plan asset or net defined benefit
plan liability. If the plan asset exceeds the plan obligation, the surplus recognised is limited to
what is referred to as the ‘asset ceiling’. This asset ceiling is discussed in section 3.3.2.7.
892 Chapter 19
There are many ledger accounts that are necessary when accounting for a defined benefit
plan, which are:
plan asset account
plan obligation account
asset ceiling account (also called plan asset ceiling adjustment account)
employee benefit expense accounts (there are a various of sub-accounts)
remeasurements of defined benefit plan accounts (there are various sub-accounts).
These accounts are explained in the following sections 3.3.1.1 to 3.3.1.5.

Please note the different terms which will be used throughout the chapter:
obligations: this is measured at the present value of the obligations arising from the plan,
deficits: a deficit occurs if the plan obligation is greater than the plan asset, and
net defined benefit plan liability: this will be equal to a deficit,
plan asset : this is measured at the fair value of the assets belonging to the plan,
surplus: a surplus occurs if the plan asset is greater than the plan obligation,
net defined benefit plan asset: a surplus after making any adjustments that may be
necessary as a result of the asset ceiling.
3.3.1.1 The plan asset account
The initial journal entry to create the plan asset is as follows:
Defined benefit plan: asset Bank
Bank yyy DBPA yyy
As can be seen in these ledger accounts, any contributions made to a defined benefit plan
(whether by the employer on behalf of the employer or by the employer on behalf of the
employee) will be recognised as a plan asset (i.e. an investment) instead of as an expense (i.e.
as in the case of a defined contribution plan).
The plan asset is measured at its fair value at year-end.
The fair value is generally its market value at year-end The plan asset balance is
and thus simple to measure although, if there is no measured as:
market price, the fair value will need to be estimated The FV at year-end.
using discounted future cash flows. IAS 19.113
Interest income on the plan asset is debited to the plan asset and the credit is recognised in
profit or loss as part of the employee benefit expense (EBE: interest expense). This interest is
based on a discount rate relevant to high quality
corporate bonds at the beginning of the year. Plan assets must: See IAS 19.8
The actual returns on these assets may be vastly different be held by a separate legal entity;
to the interest income debited to the plan asset and thus only be available to pay or fund
an adjustment will be required when re-measuring the employee benefits; or
asset to fair value at year-end. This re-measurement be qualifying insurance policies.
adjustment is recognised in other comprehensive income
and may never be reclassified to profit or loss.
A summary of the basic movements in the plan asset account is as follows:
Plan asset account Contra C

Opening balance Fair value of plan assets at the end of the prior year XXX
Interest income O/ bal x discount rate determined at the end of the prior year EBE XXX
Contributions by employer Investments made into the plan assets during the year Bank XXX
Contributions by employee Investments made into the plan assets during the year Bank XXX
Less benefits paid Actual amounts paid to employees Oblig. (XXX)
Subtotal XXX
Return on plan assets Balancing figure (XXX)
Closing balance Fair value of plan assets at the end of year XXX
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3.3.1.2 The plan obligation account
The initial entry processed to create the plan obligation is as follows:

Employee benefit expense Defined benefit plan: obligation
DBPO xxx EB expense Xxx
These accounts show the obligation being created as the employee provides services to the
entity. The entity’s obligation to an employee increases as the employee provides further
services to the entity. This increase in the obligation is credited to the plan obligation as a
service cost and the debit is recognised in profit or loss as part of the employee benefit
expense (EBE: service cost).
The plan obligation is measured at the present value of the future obligations based on
actuarial assumptions that are relevant at year-end.
Actuarial assumptions involve issues such as expected
The plan obligation balance
salary increases, mortality and what discount rate to use. is measured as the:
Since the obligation is measured at its present value, the present value of the
effects of the discounting must be ‘unwound’ over time. future obligations based on
The opening balance will be multiplied by the interest
rate that was used at the end of the prior year to discount actuarial assumptions at year-end.
the future obligation to a present value (the rate relevant to high quality corporate bonds at the
end of the prior year). This interest (the unwinding of discount) is credited to the plan
obligation and the debit is recognised in profit or loss as part of the employee benefit expense
(EBE: interest expense).
The opening balance of the obligation is the present value based on the actuarial assumptions
relevant at the beginning of the year (i.e. the end of the prior year) whereas the closing
balance is the present value based on actuarial assumptions relevant at the end of the year.
Actuarial assumptions are very changeable by nature, and thus when re-measuring the
obligation to its present value at year-end using the current, latest actuarial assumptions, an
adjustment may be required, referred to as an actuarial gain or loss.
This re-measurement adjustment must be recognised in other comprehensive income and may
never be reclassified to profit or loss.
Other movements to the plan obligation could include the payment of a benefit to the
employee. This payment would be debited to the obligation and credited to the plan assets
(i.e. the benefit is paid using the plan assets and thus the plan assets are reduced).
A summary of the basic movements in the plan obligation account is as follows:
Plan obligation account C

Opening balance PV of future obligation, based on actuarial assumptions at the end of the prior year XXX
Interest expense O/ balance (PV) x discount rate determined at the end of the prior year XXX
Service cost Increase in obligation due to services provided by the employee (PV) XXX
Less benefits paid Actual payments made (XXX)
Subtotal XXX
Actuarial (gain)/ loss Balancing figure (XXX)
Closing balance PV of future obligation, based on actuarial assumptions at the end of the current year XXX
3.3.1.3 The plan asset ceiling adjustment account (IAS 19.64-.65 and IAS 19.83)
If your plan assets are greater than your plan obligations, you have what is referred to as a
surplus. Whenever you have a surplus, you need to be sure your surplus does not exceed the
asset ceiling (the calculation of the asset ceiling is explained below).
In other words, the net defined benefit plan asset balance must be measured at the lower of:
The surplus in the defined benefit plan, and
The asset ceiling. IAS 19.64
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If your surplus exceeds the asset ceiling, you need to reduce your plan asset account. This
reduction is processed by crediting the plan asset ceiling adjustment account. This account
effectively operates as a negative asset (much like accumulated depreciation, which reduces
the cost of an item of plant).
The asset ceiling is essentially a calculation of the amounts that the entity expects to recover
from the plan. The asset ceiling is calculated 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. IAS 19.65 (c)
In other words, the net defined benefit plan asset is limited to the present value of the amount
actually receivable by the entity (i.e. the asset ceiling prevents us from measuring our net
asset at an amount that exceeds the amount that the entity is likely to recover from the plan)
When calculating the asset ceiling, the present value must be measured using a discount rate
equal to the rate of high quality corporate bonds determined at year-end. IAS 19.83
A summary of the basic movements in the plan asset ceiling account is as follows:
Plan asset ceiling adjustment account C

Opening balance PV of the adjustments at the end of the prior year XXX
Interest expense O/ balance (PV) x discount rate determined at the end of the prior year XXX
Remeasurement adj to current The current year’s adjustment XXX
year asset ceiling at year-end
Closing balance PV of the adjustments at the end of the current year XXX
3.3.1.4 The DBP employee benefit expense accounts

As can be seen from above, when increasing or decreasing the plan obligation, plan asset and
plan asset ceiling adjustment accounts, the contra entries will be processed either to:
Profit or loss (employee benefit expense accounts); or
Other comprehensive income (remeasurement of Employee benefit expense
includes only:
defined benefit plan accounts).
Interest (on plan obligation, plan
The employee benefit expense is comprised purely of asset and asset ceiling)
interest and service costs. There are, however, a number
Service costs (current and past)
of employee benefit expense accounts, each of which
must be kept separately so that the relevant disclosure requirements can be met at year-end.
The various employee benefit expense accounts could include the following:
Employee benefit expense: interest expense on plan obligation
Employee benefit expense: interest income on plan asset (a credit balance!)
Employee benefit expense: interest expense on asset ceiling
Employee benefit expense: current service costs
Employee benefit expense: past service costs.
3.3.1.5 The DBP remeasurement accounts
As mentioned above, when increasing or decreasing the
plan obligation, plan asset and plan asset ceiling Remeasurements:
adjustment accounts, the contra entries are processed
either to: are recognised in OCI
profit or loss (employee benefit expense accounts) or may never be reclassified to P/L
other comprehensive income (remeasurement of
defined benefit plan accounts).
Remeasurements of defined benefit plans are always recognised in other comprehensive
income. There are a number of remeasurements possible, each of which must be accounted
for in separate accounts in order that the disclosure requirements at year-end may be met.
Chapter 19 895
The various remeasurement accounts could include the following:

Remeasurement of DBP: return on plan assets;
Remeasurement of DBP: actuarial gain/ loss from changes in demographic assumptions;
Remeasurement of DBP: actuarial gain/ loss from changes in financial assumptions; and
Remeasurement of DBP: asset ceiling. IAS 19.141 (c)
Remeasurements are always recognised in other comprehensive income and may not be
reclassified to profit or loss. IAS 19.122
3.3.2 Measurement of a defined benefit plan (IAS 19.55 - 19.60)
3.3.2.1 Deficit or surplus

Essentially we have two accounts:
the plan obligation account; and
the plan assets account.
These two accounts are set-off against each other:
if the obligation is bigger than the asset, it is a deficit (we owe more than we own and are
thus ‘in trouble’, having a net liability position); and
if the assets are bigger than the obligation, we have a surplus (we own more than we owe
and are thus ‘not in trouble’, having a net asset position).
Thus, the deficit or surplus is calculated as follows:
C
Plan obligation Present value of future obligation XXX
Less plan assets Fair value (XXX)
Deficit/ (surplus) XXX
When processing journals to the plan obligation and plan asset accounts for service costs and
interest, the contra entry is always to the employee benefit expense account. However, there
are other journals that one processes to the plan obligation and plan asset accounts where the
contra entry is not to employee benefit expense account. Journals that may affect the plan
obligation or plan asset accounts but would not affect the employee benefit expense include:
investing in fund assets: debit the plan asset and credit bank;
paying out benefits: debit the plan obligation and credit the plan asset;
actuarial gains or losses on the plan obligation: debit or credit the plan obligation and
credit/ debit OCI: remeasurements.
3.3.2.2 Net defined benefit plan liability or asset (IAS 19.57)

The defined benefit plan can be either:
a net defined benefit plan liability or
a net defined benefit plan asset.
If the plan obligation exceeds the plan assets, then we have a deficit, which is presented in the
statement of financial position as the net defined benefit liability.
If the plan assets exceed the plan obligations, then we have a resulting surplus. This surplus
may need to be reduced to the ‘asset ceiling’. The asset ceiling is discussed in section 3.3.2.7.
The surplus, after any adjustment that may be necessary as a result of the asset ceiling, is
presented in the statement of financial position as a net defined benefit asset.
The liability or asset (presented in the statement of financial position) is calculated as:
C
Less plan assets Fair value (XXX)
Deficit/ (surplus) (XXX)
Adjustment to limit a surplus to the asset ceiling IAS 19.64 XXX
Net defined benefit liability/ (asset) (XXX)
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3.3.2.3 Measurement of the plan obligation (IAS 19.66 – 19.98)
The obligation is measured at its present value. The movement in the plan obligation account
was briefly introduced to you in section 3.3.1. This introduction showed you just some of the
adjustments that are possible. Other movements are also possible. A more detailed summary
of the movements possible, and the various sections in which each of these movements is
discussed in this textbook, is shown below:
Plan obligation Paragraph C
Opening balance 3.3.2.3.1 PV of future obligation: actuarial assumptions at beginning of year XXX
Interest costs 3.3.2.3.1 Opening balance (PV) x discount rate determined from high quality XXX
corporate bonds at the beginning of the year
Current service cost 3.3.2.3.2 Increase in obligation due to services provided in the current year (PV) XXX
Past service cost 3.3.2.3.3 Increase in obligation due to services provided in prior years (PV) XXX
Less benefits paid 3.3.2.3.4 Actual payments made (XXX)
Less settlements 3.3.2.3.5 Actual payments made (XXX)
Curtailment (gain)/ loss 3.3.2.3.5 Present value using latest actuarial assumptions XXX
Settlement (gain)/ loss 3.3.2.3.5 Present value using latest actuarial assumptions (XXX)
Subtotal XXX
Actuarial (gain)/ loss 3.3.2.5/6 Balancing figure (XXX)
Closing balance PV of future obligation: actuarial assumptions at end of year XXX
The above calculation uses the projected unit credit method to value the obligation (and the
related current service cost and past service cost expenses). The workings of the projected
unit credit method are explained together with an example in IAS 19.67-68.
This method essentially means that for each period of service provided by an employee, an
extra unit of benefit is added. In other words, the obligation grows as services are provided.
The present value of the obligation is measured using a discount rate determined at the end of
the year based on high quality corporate bonds.
The interest costs are calculated as part of the ‘net interest’ calculation. The interest rate used
is the rate determined at the beginning of the year based on high quality corporate bonds (in
other words, it is the rate used to discount the obligation at the end of the prior year and thus
this interest represents the unwinding of the discount).
3.3.2.3.1 Present value (opening balance) and interest cost (IAS 19.67 & .83 and .123)
A present value is a future amount that has been discounted using a discount rate that reflects
the passage of time. The discount rate to be used shall be determined with reference to market
yields at the end of the reporting period on high quality corporate bonds.
It should be noted that the interest costs on the net defined liability/(asset) is measured using
the interest rate mentioned above (i.e. the rate determined with reference to market yields on
high quality corporate bonds), but the rate as determined at the beginning of the period. It is
only when discounting to present value that the discount rate at the end of the period is used.
Net interest is comprised of:
The present value increases as we get closer to the
future date on which the future amount is expected to interest income on plan
be paid, until it ultimately equals the future amount. assets;
interest expense on the defined
The gradual increase of the present value (until it benefit liability;
equals the future amount) is called the unwinding of interest effect of the asset ceiling.
discount.
The following example explains the workings of a present value calculation and how one
records the unwinding of the discount.
Chapter 19 897
Example 9: Defined benefit plan: effect of the unwinding of the discount

On 1 January 20X1 we owe C100 000, payable on 31 December 20X5. For simplicity,
assume that:
this future obligation arose due to services provided by the employee in the first few
days of 20X1 and that services thereafter did not result in an increase in the obligation
(i.e. the obligation remained static at C100 000); and
the discount rate remained unchanged at 10% each year
Required: Prepare the effective interest rate table and then post the necessary journals.
Solution 9: Defined benefit plan: effect of the unwinding of the discount
Step 1: PV factor at 10% after five years (5 years between 1 January 20X1 and 31 December 20X5):
1/(1.1) 5 = 1 / 1.1 /1.1 /1.1 /1.1 /1.1 OR = 1 / (1.1 x 1.1 x 1.1 x 1.1 x 1.1) = 0.620921323
100 000 x 0.620921323 = 62 092
Or using a financial calculator:
n=5 FV = 100 000 I = 10 Comp PV = 62 092
Step 2: Effective interest rate table
Opening balance Interest Closing balance
5 years to payment date 62 092 6 209 68 301
1 year to payment date 90 908 9 092 * 100 000
*Adjusted for the effects of rounding 37 908
Step 3: The ledger accounts:
Defined benefit plan: Obligation
20X1 Jnl 1 EB Exp*: current cost 62 092
20X1 Jnl 2 EB Exp: interest cost 6 209
20X1 Closing balance 68 301
20X5 Jnl 7 Bank 100 000 20X5 Jnl 6 EB Exp: interest cost 9 092
100 000 100 000
20X5 Closing balance 0
* Employee Benefit
Bank
20X5 Jnl 7 DBP: Obligation 100 000
Employee benefit expense: Current cost

Employee benefit expense: Interest cost

Comment: Note the difference in the treatment of the initial amount (current service cost) and the
unwinding of the discount (interest cost).
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3.3.2.3.2 Current service costs (IAS 19.70 & .71)
The defined benefit obligation increases over time: each day that the employee works
increases this obligation. This is what is referred to as the projected unit credit method.
This increase in the obligation is called a current service cost and is recognised in profit or
loss as an employee benefit expense (EBE).
For disclosure purposes, we need to separate all the different types of employee benefit
expense accounts, so the specific account we would use for current service costs would be
called ‘employee benefit expense: current service costs’.
This increase in the obligation is measured at the present value of the obligation arising from
services provided by the employee in the current year.
Example 10: Defined benefit plan: current service cost
On 1 January 20X2, a plan obligation has a balance of C68 301 (the present value of an
amount of C100 000, payable to an employee on 31 December 20X5).
Further services provided in 20X2 increase the future obligation by C20 000 (PV of C15 026).
these further services were provided at 31 December 20X2;
the discount rate remained unchanged at 10% each year.
Required: Show the journal entries posted in the ledger accounts in 20X1 and 20X2.
Solution 10: Defined benefit plan: current service cost

Step 1: PV of current service costs:
1/(1.1) 3 = 1 / 1.1 /1.1 /1.1 OR = 1 / (1.1 x 1.1 x 1.1) = 0.751314801 (factor at 10% after 3 years:
between 31 Dec 20X2 and 31 Dec 20X5)
20 000 x 0.751314801= 15 026 (this amount was given)
Or using a financial calculator:
n=3 FV = 20 000 I = 10 Comp PV = 15 026
This calculation was not required because the present value was given – the calculation is given for
interest sake only.
Step 2: Effective interest rate table (revised for added current costs)
Opening balance Interest Current cost Closing balance
A x 10% (provided end of year) (A + B + C)
Year A B C D
20X1 62 092 6 209 68 301
20X2 68 301 6 830 15 026 90 157
20X3 90 157 9 016 99 173
20X4 99 173 9 917 109 090
20X5 109 090 10 910 120 000
42 882
The above table assumes that no further services are provided by the employee subsequent to the
services provided at 31 December 20X2. Notice how the final closing balance on 31 December 20X5
reaches C120 000 (C100 000 + C20 000).
Step 3: The ledger accounts:
Defined benefit plan: Obligation (L)
20X1 Jnl 1 EB Exp: current cost 62 092
Employee benefit expense: Current cost (E)

Chapter 19 899

Employee benefit expense: Interest cost (E)
3.3.2.3.3 Past service costs (IAS 19.70 and IAS 19.102-.108)
The employer may introduce a new plan or change the terms of a defined benefit plan after an
employee has already provided a few years of service. Such a change could result in either:
an increase in the obligation (improved benefits for the employee); or
a decrease in the obligation (reduced benefits for the employee).
The increase or decrease in the obligation is referred to as a past service cost and is
recognised as a past service cost expense. This past service cost could be positive (when the
obligation increases) or negative (if the obligation decreases).
For example: if the benefits due to an employee are improved (i.e. causing an increase in our
obligation to the employee), the following journal would be processed:
Debit Credit
Employee benefit expense: Past service (E) XXX
Defined benefit plan: Obligation (L) XXX
All benefits resulting from past service is recognised immediately
Past service costs are recognised as an expense regardless of whether the benefits have vested.
The reason for this is that the services required in order to qualify for the benefits have
already been provided. The past service cost is recognised as an expense at the earlier of the
following dates:
when the plan amendment or curtailment (reduction in benefits) occurs; and
when the entity recognises a related restructuring cost (IAS 37) or termination benefit
(IAS 19.167). IAS 19.103
The past service cost is measured as the change in the present value of the plan obligation that
results from a plan amendment or curtailment: IAS 19.102
an amendment includes an entity introducing a new plan, withdrawing an old plan or
changing the terms of an existing plan; IAS 19.104
a curtailment occurs when an entity significantly reduces the number of people covered
by a plan – for example, when a factory is closed down or a plan is terminated). IAS 19.105
Example 11: Defined benefit plan: past service cost

A company has a defined benefit plan, agreed to on 1 January 20X1. Details relating to its
plan obligation are as follows:
Balance on 1 January 20X2: 68 301 (the PV of an estimated future amount of
C100 000, payable on 31 December 20X5).
Services provided during 20X2 increase the future obligation by C20 000 (PV of
C15 026).
On 31 December 20X2, the company changed the terms of the plan such that the future
obligation increased by C30 000 (PV C22 539). The condition attaching to this
increase in benefit is that the employee provides 3 years of service. As at 31 December
20X2, of the additional present value:
- 20% relates to employees who have already provided 3 years of service; and
- 80% relates to employees who have already provided an average of 1 year service.
Services provided during 20X3 increase the future obligation by C15 000 (PV of
C12 397).
The discount rate remained unchanged at 10% each year.
All present values were calculated assuming the transactions/ services happened at year-end.
900 Chapter 19
Required:
A. Show the journal entries posted in the ledger accounts in 20X1, 20X2 and 20X3.
B. Assuming that the fair value of the plan assets are C111 000 at 31 December 20X2, calculate the
balance to be reflected in the statement of financial position.
Solution 11A: Defined benefit plan: ledger accounts
The effective interest rate table:

O/ balance Interest Current & past costs C/ balance
A x 10% (provided end of yr) (A + B + C)
A B C D
20X1 62 092 (1) 6 209 68 301 given
(2)
20X2 68 301 given 6 830 15 026 given 90 157
(3)
22 539 given 112 696
(2)
20X3 112 696 11 270 12 397 given 136 363
20X4 136 363 13 637 150 000
20X5 150 000 15 000 165 000
52 946
Calculations:
(1) 68 301 / 1.1 = 62 092
(2) current service cost
(3) past service cost due to change in terms
The ledger accounts:

20X2 Jnl 5 EB Exp: past cost 22 539
Employee benefit expense: Current service cost (E)

Employee benefit expense: Interest cost (E)

Employee benefit expense: Past service cost (E)

Chapter 19 901
Solution 11B: Defined benefit plan – balance in the statement of financial position
Net defined benefit asset or liability balance (statement of financial position): 20X2
C
Plan obligation Present value of future obligation 112 696

Less plan assets Given (plan asset account) (111 000)
Deficit 1 696
Adjustment for asset ceiling N/A: Asset ceilings only apply if you have a 0
surplus (not a deficit)
Net defined benefit liability (asset) 1 696
3.3.2.3.4 Benefits paid
The plan may require a lump sum payment on a specific day in the future or may require the
payment of an annuity (e.g. a pension) or a combination thereof. The previous example
assumed a plan in which:
one lump sum was to be paid to employees of C165 000:
initially, the lump sum was going to be C100 000, but then
this increased by:
- current service costs of C20 000 and C15 000 (services provided in 20X2 and
20X3 respectively) and
- past service costs of C30 000 owing to an adjustment to the terms of the plan; and
all employees will be paid on one day: 31 December 20X5.
The reality is that there are normally many employees, each of whom would be paid at
different times and where the payments could be annuities, or single payments or both.
A payment of benefits is simple to account for though:

the plan assets that were set aside for such payments are reduced (credit plan asset); and
the plan obligation to the employee is reduced (debit plan obligation).
The following journal is therefore processed for benefits paid:

Debit Credit
Defined benefit obligation (L) XXX
Defined benefit asset (A) XXX
Payment of benefits under defined benefit plan
Example 12: Defined benefit plan: benefits paid

The present value of the plan obligation on 1 January 20X2 was C68 301.
At 31 December 20X2, the discount rate was estimated to be 10%.
The discount rate and all actuarial assumptions remained unchanged throughout 20X2.
Note 20X3 20X2
C C
Current service costs (present value) 12 397 15 026
Past service costs (present value) (1) N/A 22 539
Benefits paid to employees 5 000 0
Note 1: Past service costs arose due to a change made to the terms of the plan on 31 December 20X2.
The increase in the obligation was valued at C22 539 (20% was vested and 80% was not yet vested but
was expected to vest within 2 years).
Present values were measured using discount rates determined at year-end.
Assume that all transactions occurred at the end of the year.
Required: Show the journal entries in 20X3.
902 Chapter 19
Solution 12: Defined benefit plan: benefits paid

Employee benefit expense: interest cost (E) 112 696 x 10% 11 270
Defined benefit obligation (L) 11 270
Unwinding of discount on opening present value of the obligation [O/bal
in 20X2: 68 301 + Movement during 20X2: (68 301 x 10% + 15 026 +
22 539) = 112 696] x the discount rate estimated at year end: 10%
Employee benefit expense: current cost (E) Given 12 397

Defined benefit obligation (L) 12 397
Current costs present valued at 10% (20X3 services)
Defined benefit obligation (L) Given 5 000

Defined benefit assets (A) 5 000
Benefits paid to employees during 20X3
3.3.2.3.5 Curtailments and settlements (IAS 19.109 – 19.111)
A curtailment occurs when the entity is demonstrably committed to materially reduce the
number of employees covered by a plan, or where the entity amends the terms of the plan
such that a material part of the future services will either not qualify for benefits or will
qualify for materially reduced benefits. This occurs for example, when a branch is closed.
A settlement occurs when an entity enters into a transaction that eliminates part or all future
obligations under the plan (e.g. offers a cash sum in exchange for reduced future benefits).
It can also happen that a curtailment occurs together with a settlement. This happens when a
plan is terminated (ceases to exist) and the obligation is also settled (employees are paid).
A settlement gain or loss is recognised when it occurs (i.e. not when it is probable).
The measurement of the gain or loss requires re-measuring the plan obligation and plan assets
using current actuarial assumptions. The gain or loss will then be calculated as:
The present value of the defined benefit obligation being settled,
Less the settlement price, including any plan assets transferred.
When a curtailment occurs as part of a restructuring of the business, it is recognised at the

same time that the restructuring is recognised.
3.3.2.4 Measurement of the plan assets (IAS 19.113 – 19.119)
The plan assets are measured at their fair value. The movement in the plan asset account was
briefly introduced to you in section 3.3.1. This introduction showed you just some of the
adjustments that are possible, but other movements are also possible. A more detailed
summary of the movements possible, and the section in which it is discussed in this textbook,
is shown below:
Plan assets Paragraph C
Opening balance Example 13 Fair value of plan assets – beginning of year XXX
Interest income Example 13 O/ bal x interest rate estimated at beginning of year XXX
Contributions by employer Example 13 Investments made into the plan assets during the year XXX
Contributions by employee Example 13 Investments made into the plan assets during the year XXX
Less benefits/ settlements paid Example 13 Actual amounts paid to employees during the year (XXX)
Subtotal XXX
Actuarial gain/ (loss) 3.3.2.5/6 Balancing figure (XXX)
Closing balance Fair value of plan assets – end of year XXX
Chapter 19 903
Example 13: Defined benefit plan: plan assets

The fair value of the plan assets on 1 January 20X3 was C51 200.
At 31 December 20X2, the discount rate was estimated to be 8%.
The discount rate and all actuarial assumptions remained unchanged throughout 20X3.
20X3
Current contributions C9 000
Benefits paid to employees 5 000
Fair value of plan assets at 31 December 20X3 60 000
Required: Show the journals for 20X3 assuming that all transactions occur at the end of the year.
Solution 13: Defined benefit plan: plan assets

Plan asset (A) 51 200 x 8% 4 096
Employee benefit expense: Interest income (I) 4 096
Interest on assets at beginning of year (51 200) using the discount rate
at the beginning of the year (8%)
Plan asset (A) Given 9 000
Bank (A) 9 000
Contributions made by the company to the plan assets during 20X3
Plan obligation (L) 5 000
Plan asset (A) 5 000
Benefits paid to ex-employees
Plan asset (A) W1 704
Employee benefit expense: actuarial gain (OCI) 704
Actuarial gain on plan assets recognised
W1: Actuarial gain or loss
Opening FV of assets: 1/1/20X3 Given 51 200
Interest income 51 200 x 8% 4 096
Current contributions Given 9 000
Benefits paid to employees Given (5 000)
59 296
Actuarial gain Balancing 704
FV of assets at 31 December 20X3 Given 60 000
3.3.2.5 Actuarial assumptions (IAS 19.67. and IAS 19.75 – 19.98)

Due to the sometimes very complex calculations needed to measure the plan obligations, it is
advisable to use an actuary. Although IAS 19 does not make the use of an actuary a
requirement, it does require that the entity uses the projected unit credit method to value the
obligation.
The workings of the projected unit credit method are explained together with a relatively
simple example in IAS 19.67-68 but these are fairly complex in practice.
Whether the actuary does the calculations or you do, the measurement requires a number of
actuarial assumptions to be made (i.e. where you or the actuary will need to assume certain
things in order to estimate the value of the plan obligation).
There are many different actuarial assumptions to be considered, but they may be categorised
into the following two types:
demographic assumptions; and
financial assumptions.
Demographic assumptions involve assessing the characteristics of the employees who belong
to the plan.
904 Chapter 19
This involves estimating, for example:

how many employees may leave, become disabled, die or take early retirement;
how long employees will live after retirement age;
how many employees have dependants that will be eligible for benefits; and
how much the employees will claim against their medical plans (if relevant).
Financial assumptions involve assessing market expectations (at year-end) for the period over
which the plan is expected to settle its obligations. This involves estimating:
the discount rate to be used to calculate the present value of the plan obligation;
future salary and benefits levels;
future medical costs (in the case of medical plans).
The discount rate should ideally be based on market returns on high quality corporate bonds,
although, if these are not available, government bonds could be used instead. The bonds used
should be those that are in the same currency and have the same estimated term as the plan.
Future salaries and benefits are affected, amongst other factors, by inflation and promotions
and the calculation thereof is complex.
Similarly complex is the estimation of medical costs (where the plan is a medical plan), where
the expected costs are affected by inflation, expected increases in medical costs, expected
changes in health care technology, expected claims (which will be influenced, for example, by
the age, sex and number of dependants of the employees, their health and even their
geographic location). Employees may also be expected to contribute a portion of the medical
costs and this will need to be factored into the calculation as well.
3.3.2.6 Changes to actuarial assumptions (IAS 19.120 (c) and IAS 19.127 – 19.130)
The very nature of an assumption means that it may change from time to time. Logically, if
the assumptions that were used to value a plan obligation subsequently change, these values
will need to be re-estimated:
an actuarial gain results from a decrease in the obligation;
an actuarial loss results from an increase in the obligation.
Actuarial gains and losses arise when remeasuring plan obligations based on new assumptions
relevant at the end of the reporting period.
These remeasurement adjustments are recognised in other comprehensive income and may
not be reclassified to profit and loss in a subsequent period, but may however be transferred
within equity.
Worked example: Actuarial gains and losses
An entity’s obligation was previously measured based on a certain level of salary (an
actuarial assumption) and it has just been discovered that the salary level was under-
estimated (i.e. the obligation should be based on a higher level of salary).
The plan obligation is valued as follows:
present value using the old assumption: C100 000
present value using the new assumption: C120 000.
The present value of the plan asset remained unchanged at C70 000.
Required:
Show the effect of the change in the initial actuarial adjustment on the ledger accounts and the surplus/
deficit and asset/ liability balance.
Solution to worked example: Actuarial gains and losses

The ledger accounts:
OCI: Actuarial loss: financial assumptions Defined benefit plan: obligation
DBP: O 20 000 Balance 100 000
OCI: AL 20 000
Balance 120 000
Chapter 19 905
Solution to worked example: Continued …

Defined benefit plan: asset
Balance 70 000
The statement of financial position, is thus:

New Old
assumptions assumptions
Plan obligation Credit balance (120 000) (100 000)
Plan asset Debit balance 70 000 70 000
Deficit (50 000) (30 000)
Asset ceiling adjustment N/A: we have a deficit 0 0
Net defined benefit liability (asset) (50 000) (30 000)
Notice: the actuarial loss increases the plan obligation, plan deficit and plan liability by C20 000.
3.3.2.7 Asset balances: the asset ceiling (IAS 19.64-.65 and IAS 19.83)
The asset ceiling is a limitation that applies if your defined benefit plan has a surplus.
If the defined benefit plan reflects a surplus balance then the net defined benefit asset is to be
limited to the lower of:
The surplus in the defined benefit plan, and
The asset ceiling. IAS 19.64
The asset ceiling is:
the present value
of any economic benefits available in the form of:
- refunds from the plan, or
- reductions in future contributions to the plan. IAS 19.65 (c)
That is to say that the net defined benefit plan asset is limited to the present value of the
amount actually receivable by the entity.
The present value is measured using a discount rate equal to the rate of high quality corporate
bonds determined at year-end. IAS 19.83
Example 14: Defined benefit plan: asset ceiling
Amazing Limited has a defined benefit plan that began on 1 January 20X9, on which date it
had a zero opening balance. The defined benefit plan had the following balances at 31
December 20X9 (year-end):
Plan obligation (70 000) (110 000) (140 000)
Plan asset 50 000 120 000 200 000
(Deficit)/ surplus (20 000) 10 000 60 000
Present value of future refunds/ reductions in
future contributions 30 000 75 000 23 000
Required: For each of the scenarios, explain whether the ceiling of IAS 19.64(b) is a limiting factor. If
it is a limiting factor, present the journal entry that would need to be processed before year-end.
Solution 14A: Defined benefit plan: asset ceiling

The ceiling does not apply at all since there is a plan deficit and not a plan surplus. Regardless of
whether or not there are actually refunds available, the asset ceiling only applies when the entity has a
surplus in a defined benefit plan.
Solution 14B: Defined benefit plan: asset ceiling

There is a surplus and thus one needs to check if it is limited by the ceiling. In this scenario, the ceiling
is not a limiting factor since the present value future economic benefits (C75 000) is greater than the
plan surplus (C10 000).
906 Chapter 19
Solution 14C: Defined benefit plan: asset ceiling

The ceiling is a limiting factor since the expected future economic benefits is less than the plan surplus.
The amount guaranteed is limited to C23 000 and the plan asset should be reduced accordingly.
Journal adjustment Debit Credit

Employee benefit expense: IAS 19.64 reduction (E) See calculation 1 37 000
Defined benefit plan (A) 37 000
Reduction in asset balance: IAS 19.64 limitation to the asset ceiling
Calculation 1: ceiling adjustment required C

Surplus 60 000
Ceiling (23 000)
Ceiling limitation 37 000
Balance in asset ceiling adjustment account: 1 January 20X9 0
Asset ceiling adjustment still required 37 000
Example 15: Asset ceiling

Happy Ltd has a defined benefit plan which was introduced to its employees during the
year ended 31 December 20X1. At 31 December the balances were as follows:
20X2 20X1
Plan obligation 130 100
Plan assets 165 150
Other information:
The present value of the future benefits to be received from the fund amounted to C40 in 20X1 and
C10 in 20X2.
The interest rates on high quality corporate bonds have been consistent year on year at 10%.
Service costs for the year amounted to C20 for the 20X2 year end.
There were no other movements during 20X2 other than those evident from the information provided.
Required: Prepare the ledger accounts with all balances and movements for the year ended 31/12/20X2.
Solution 15: Asset ceiling

The general ledger accounts are presented below for the two years.
20X1 Closing balance Given 100
31/12/X2 EBE: Interest expense (1) 10
Balance c/f 130 31/12/X2 EBE: Current service (2) 20
130 130
Defined benefit plan: Asset (A)

20X1 Closing balance Given 150
31/12/X2 EBE: Interest income (3) 15 Balance c/f 165
165 165
Defined benefit plan: Asset ceiling adjustment (-A)

20X1 Closing balance (4) 10
31/12/X2 EBE: Interest expense (5) 1
Balance c/f 25 31/12/X2 OCI: DBP Remeasurement (6) 14
25 25
Chapter 19 907

OCI: DBP: Remeasurements: asset ceiling
31/12/X2 DBP: Asset ceiling (6) 14 Balance c/f 24
24 24
Employee benefit expense: interest expense on obligation

31/12/X2 DBP: O (1) 10
Employee benefit expense: interest income on asset

31/12/X2 DBP: A (3) 15
Employee benefit expense: interest expense on asset ceiling

31/12/X2 DBP: A ceiling (5) 1
Employee benefit expense: current service cost

31/12/X2 DBP: O (2) 20
Workings:
1) Interest on obligation: opening balance 100 x interest rate at beginning of year 10% = 10
2) Current service cost: given
3) Interest on asset: opening balance 150 x interest rate at beginning of year 10% = 15
4) Asset ceiling balance and adjustment at end of 20X1: 20X1
Surplus balance: 31/12/20X1 20X1: 150 – 140 50
Ceiling: 31/12/20X1 PV of future refunds/ reductions in future contr. (40)
Ceiling limitation: 31/12/20X1 This must be the asset ceiling adj. c/bal in 20X1 10
Asset ceiling adjustment a/c bal is: O/bal in 20X1: nil (the plan started in 20X1) 0
Asset ceiling adjustment required in 20X1 10
5) Interest on asset ceiling: opening balance 10 x interest rate at beginning of year 10% = 1
6) Asset ceiling balance and adjustment at end of 20X2: 20X2
Surplus balance: 31/12/20X2 20X1: 165 – 130 35
Ceiling: 31/12/20X2 PV of future refunds/ reductions in future contr. (10)
Ceiling limitation: 31/12/20X2 This must be the asset ceiling adj. c/bal in 20X2 25
Asset ceiling adjustment a/c bal is: O/bal in 20X2: 10 (W4) + interest: 1 (W5) 11
Asset ceiling adjustment required in 20X2 14
The economic benefits from a refund or a reduction in future contributions may be considered
available even if these are not immediately realisable. They simply need to be realisable
during the life of the plan or on settlement of plan liabilities.
Whether a refund is actually available to the entity depends on the rules of the fund and may
be affected by statutory requirements in the jurisdiction of the plan (IFRIC 14). For a future
refund to be considered available, the entity must have an unconditional right to it. Future
refunds are measured as:
the surplus:
- the fair value of the plan assets
- less the present value of the defined benefit obligation;
less any associated costs.
Whilst the availability of a refund depends on the rules of the fund, reductions in future
contribution are not affected by the rules of the fund.
908 Chapter 19
Future expected reductions in contributions are simply measured as the lower of:
the surplus; and
the present value of the estimated:
- service cost to the entity for future services;
- less the minimum funding contributions needed for the future accrual of benefits.
3.3.2.8 Minimum Funding requirements
AC 504 provides guidance to South African entities having to comply with statutory
minimum funding requirements to ensure that their fund is financially sound. These minimum
funding requirements could involve having to pay in extra in order to cover:
an existing shortfall for past services; and/ or even
the expected future accrual of benefits for future services.
If there is a minimum funding requirement to pay an additional amount for services already
received, a further liability must be recognised to the extent that:
the amounts to be paid will create a surplus (for accounting purposes); and
the amounts will not be available to the entity as either a refund or reduction in future
contributions (i.e. the amounts to be paid into the fund will belong to the employees).
The recognition of this extra liability is based on the principle of an onerous contract.
4 Other Long-Term Benefits (IAS 19.153 – 19.158)
Whereas short-term benefits are due before twelve months after the end of the period during
which the employee rendered the service, long-term benefits are due after twelve months after
the end of the period during which the employee rendered the service. Examples of other
long-term benefits include: long-term disability benefits, long-term compensated absences
and profit-sharing or bonuses that are simply not payable within 12 months of reporting date.
Other long-term employee benefits are recognised and measured in the same way as post-
employment benefits with the exception that all changes to the carrying amount of liabilities
are recognised in profit or loss (e.g. re-measurements of other long-term benefits are not
recognised in other comprehensive income).
The line item in the statement of financial position is thus calculated simply as:
C
Less plan assets Fair value of plan assets (XXX)
Liability/ (asset) XXX
The line items in the statement of comprehensive income include:
Comments C
Interest cost XXX
Current service cost XXX
Past service cost XXX
Curtailments or settlements XXX
Expected return on assets (XXX)
Actuarial gains and losses Recognised in profit or loss XXX
Income/ expense XXX
5 Termination Benefits (IAS 19.159 – 19.171)
Whereas all other benefits are earned by the employee for services provided to the employer,
termination benefits are those that arise due to a termination of a service (i.e. the past event is
the termination rather than the employee services provided).
Termination benefits are those that are not conditional to future services. Instead, they relate
purely to the termination of employment.
Chapter 19 909
For example: an entity decides to terminate an employment contract and offers to pay the
employee C10 000 on termination plus a further C40 000 if the employee agrees to work for a
further 6 months:
C40 000 relates to future services and thus does not relate to the termination of
employment: it is not a termination benefit but a short-term benefit for services rendered.
C10 000 is a termination benefit since it relates to the termination of services.
Termination benefits are
Termination benefits are benefits that become payable as the only employee benefits
a result of either: that:
the entity’s decision to terminate the employment; or do not arise from a service provided
by the employee.
the employee’s decision to accept an offer of
(they arise from an entity’s decision
termination. IAS 19.159
to terminate employment).
Be careful! If the benefit payable on termination does

not relate to either a forced termination or an offer of a voluntary termination, the benefit is
recognised as a post-employment benefit and not as a termination benefit. This means, if an
employee requests early termination (i.e. is not offered or forced into an early termination),
this would be recognised as a post-employment benefit and not as a termination benefit.
The termination benefits are recognised as an expense and related liability at the earlier of:
When the entity can no longer withdraw the offer of those benefits, and
When the entity recognises the related restructuring costs in terms of IAS 37 and involves
the payment of termination benefits. IAS 19.165
If the termination benefit is payable as a result of an employee’s decision to accept an offer of

termination, the date on which the entity can no longer withdraw an offer of termination is
considered to be the earlier of:
The date when a restriction (e.g. legal, regulatory or contractual) on the entity’s ability to
withdraw the offer takes effect (e.g. if labour law does not allow an entity to withdraw an
offer of termination, then the date would be the day on which the offer is made); or
The date when the employee accepts the offer. IAS 19.166
If the termination benefit is payable as a result of an employer’s decision to terminate an

employee’s employment, the date on which the entity can no longer withdraw the offer is:
The date on which the entity has communicated the plan of termination to the affected
employees; where this plan:
- The plan identifies the number of employees whose employment will be terminated,
their job classification/ function, their locations and the expected completion date;
- It is unlikely that significant changes to the plan will be made; and
- The plan gives sufficient detail such that employees are able to determine the type
and amount of benefit that they will receive upon termination. IAS 19.167
Since termination benefits do not provide the entity with future economic benefits, they are
recognised as an expense. If they are not paid at the same time, a liability will be recognised.
The measurement of the termination benefits depends on the following:

if the benefits are entirely payable within 12 months after the end of the reporting period
(i.e. they are payable in the short-term), they are measured like short-term benefits: these
would not be discounted to present values;
if the benefits are not entirely payable within 12 months after the end of the reporting
period (i.e. they are payable in the long-term) they are measured like long-term employee
benefits: these would be discounted to present values;
if the benefits are enhancements of existing post-employment benefits, then they will be
measured like post-employment benefits. see IAS 19.169
910 Chapter 19
When the termination benefit is an offer of benefits that is made in order to encourage
termination, the measurement of the termination benefits will be based on the number of
employees who will probably accept the offer:
If we are able to estimate this number of employees who will accept this offer, we must
measure the provision using this number of employees.
If we are unable to estimate the number of employees who may accept the offer, we
won’t recognise a liability at all (since we are unable to measure it) but will disclose a
contingent liability instead.
For example: if we offered each of our 100 employees a C1 000 retrenchment package, and:
we estimate that 20 of these employees will accept the package, we must recognise a
liability and expense equal to C20 000 (C1 000 x 20 employees); or
we are unable to estimate the number of employees who may accept the offer, we would
simply disclose in the contingent liability note the fact that we have offered employees a
redundancy package together with as many details as we possibly can.
6 Disclosure
6.1 Short-term employee benefits (IAS 19.25)
The disclosure required for short-term employee benefits is as follows:

IAS 19 Employee benefits: no disclosure requirements
IAS 24 Related party disclosures: disclose the short-term employee benefits relating to
key management personnel
IAS 1 Presentation of financial statements: disclose the employee benefit expense, if
material.
6.2 Post-employment benefits
6.2.1 Defined contribution plans (IAS 19.53 – 19.54)
The disclosure required for defined contribution plans is as follows:

IAS 19 Employee benefits: disclose the amount of the defined contribution plan expense
that is included in the employee benefit expense
IAS 24 Related party disclosures: disclose defined contribution plans relating to key
management personnel
6.2.2 Defined benefit plans (IAS 19.135 – 19.152)
The disclosure of a defined benefit plan is copious and therefore only the main aspects of the
disclosure are summarised here.
The entity must:

Explain the characteristics of the defined benefit plan and the risks associated with it;
Identify and explain the amounts in the financial statements that arise from the plan;
Explain how the plan may affect the amount, timing and uncertainty of the entity’s future
cash flows. IAS 19.135
In order to identify and explain the amounts in the financial statements that arise from the
plan, a reconciliation of each of following is required:
The net defined benefit liability (asset), showing separate reconciliations for:
- the obligation: showing the movement between the opening and closing balances;
- the plan asset, showing the movement between the opening and closing balances;
- the effect of the asset ceiling; and
Any reimbursement rights. IAS 19.140
Chapter 19 911
For each of the above reconciliations, the following basic items must be separately disclosed:
Current service cost;
Interest income or interest expense;
Remeasurements of the net defined benefit liability (asset);
Past service costs;
Gains and losses arising from settlements (these can be shown together with the past
service costs if they occur together);
Contributions to the plan made by the employer;
Contributions to the plan made by the employee;
Payments from the plan other than settlement payments;
Payments from the plan that are settlements payments. IAS 19.141
For the remeasurements of the net defined benefit liability (asset) shown in the reconciliations
above, the following need to be disclosed separately:
The return on plan assets (excluding amounts included in interest income or expense);
The actuarial gains or loss arising from changes in demographic assumptions;
The actuarial gains or loss arising from changes in financial assumptions; and
Changes in the effect of limiting a defined benefit asset to the asset ceiling (excluding
amounts included in interest income or interest expense). IAS 19.141 (c)
The remeasurements of a defined benefit plan are recognised in other comprehensive income
and would thus be disclosed:
in the statement of changes in equity, under the heading ‘Other comprehensive income:
Defined benefit plan remeasurements’; and
on the face of the statement of comprehensive income, as other comprehensive income,
under the sub-heading ‘items that may never be reclassified to profit or loss’ and where
the tax effect thereof would need to be reflected either on the face or in a supporting note.
The employee benefit expense is required to be disclosed (in terms of IAS 1 – not IAS 19).
Disclosure in the various financial statements are illustrated on the next pages.
Suggested disclosure in the notes to the financial statements is as follows:
Name of Company
17. Net defined benefit plan 20X5 20X4
C C
Reconciliation: Net defined benefit plan liability/ (asset)
Opening balance of liability/ (asset) xxx xxx
Net interest expense/ (income) xxx xxx
Current service cost xxx xxx
Past service cost xxx xxx
Contributions to plan asset by employer (xxx) (xxx)
Contributions to plan asset by employee (xxx) (xxx)
Remeasurements on defined benefit plan liability/ (asset): xxx xxx
- Return on plan assets (xxx) (xxx)
- Actuarial gains or (loss) on obligation due to change in xxx xxx
demographic assumptions
financial assumptions
- Adjustments due to limiting the defined benefit asset to the xxx xxx
asset ceiling (if applicable)
Closing balance of liability/ (asset) xxx xxx
912 Chapter 19
Name of Company
17. Net defined benefit plan continued ... 20X5 20X4
C C
Reconciliation: Plan obligation
Interest expense xxx xxx
Current service cost xxx xxx
Past service cost xxx xxx
Payments from the plan other than settlement payments (xxx) (xxx)
Remeasurements on defined benefit plan obligation: xxx xxx
demographic assumptions
- Actuarial gains or (loss) on obligation due to change in financial xxx xxx
assumptions
Closing balance xxx xxx
Reconciliation: Plan asset

Interest income xxx xxx
Payments from the plan other than settlement payments (xxx) (xxx)
Contributions to plan asset by employer xxx xxx
Contributions to plan asset by employee xxx xxx
Remeasurements on defined benefit plan asset: xxx xxx
- Return on plan assets xxx xxx
Reconciliation: Plan asset ceiling

Interest expense xxx xxx
Remeasurements on defined benefit plan liability/ (asset): xxx xxx
- Adjustments due to limiting the defined benefit asset to the asset xxx xxx
ceiling (if applicable)
Name of Company
20X5 20X4
C C
23. Other comprehensive income: Defined benefit plan remeasurements
Return on plan assets xxx xxx

Actuarial gain/ (loss) caused by changes in demographic assumptions xxx (xxx)
Actuarial gain/ (loss) caused by changes in financial assumptions xxx (xxx)
Adjustment due to plan asset limited to asset ceiling (xxx) xxx
xxx xxx
Tax on remeasurements of defined benefit plan (xxx) (xxx)
Cash flow hedge gain/ (loss), net of reclassification and tax xxx xxx
Chapter 19 913
Suggested disclosure in the statement of changes in equity is as follows:

Name of Company
Retained earnings OCI: Total
DBP remeasurement
C C C
Balance: beginning of the year xxx xxx xxx
Total comprehensive income xxx xxx xxx
Balance: end of the year xxx xxx xxx
Suggested disclosure in the statement of comprehensive income is as follows:
Name of Company
Note 20X5 20X4
C C
Revenue xxx xxx
Other income:
Fair value adjustment of financial asset through profit or loss xxx xxx
Distribution costs (xxx) (xxx)
Profit before finance costs xxx xxx
Finance costs (xxx) (xxx)
Taxation expense xxx xxx
Other comprehensive income for the year xxx xxx
Items that may be reclassified to profit of loss
- ... xxx xxx
- Defined benefit plan remeasurements, net of tax 23 xxx xxx
Total comprehensive income for the year xxx xxx
Example 16: Defined benefit plan: disclosure

The following information relates to Sharp Limited’s defined benefit plan:
Note 20X3 20X2

Plan obligation C C
Present value of obligation – 1 January 160 000 68 301
Interest cost at discount rate estimated at 1 January (5) 16 000 6 830
Current service cost 12 397 15 026
Past service cost 0 22 539
Benefits paid to employees (5 000) (0)
Present value – 31 December (1) 183 397 112 696
Actuarial (gain)/ loss (4) 11 333 47 304
Revised present value – 31 December (2) 194 730 160 000
Plan assets
Fair value of asset – 1 January 55 000 40 000
Interest income (5) 5 500 4 000
Current contributions (3) 9 000 8 000
Benefits paid to employees (5 000) (0)
Fair value – 31 December (1) 64 500 52 000
Return on plan assets 8 904 3 800
Revised present value – 31 December (2) 73 404 55 800
Average expected remaining working lives of employees 10 years 10 years
914 Chapter 19
Note 1: This present value and fair value was based on actuarial assumptions at 1 January.
Note 2: This present value and fair value was revised actuarial assumptions at 31 December
Note 3: 60% of the contributions came from employers and 40% from employees
Note 4: All actuarial gains/ losses arose due to changes in financial assumptions
Note 5: Interest was calculated using a discount rate of 10%, which remained unchanged throughout
20X1, 20X2 and 20X3. The rate is based on the market yields on high quality corporate bonds.
Additional information:
The net cumulative remeasurements on the defined benefit plan as at 31 December 20X1,
recognised in other comprehensive income, was C50 000 net credit balance in OCI.
The profit for the year ended 31 December 20X3 was C400 000.
Assume that all transactions occurred at the end of the year.
Ignore tax.
Required: Disclose the asset/ liability and the employee benefit expense in the financial statements for
the year ended 31 December 20X3 (in as much detail as is possible).
Solution 16: Defined benefit plan: disclosure
Sharp Limited
Note 20X3 20X2
C C
Profit for the year (given) 400 000 xxx
Other comprehensive income for the year (2 429) (43 504)
- ... 0 0
- Defined benefit plan remeasurements, net of tax 24 (2 429) (43 504)
Total comprehensive income for the year 397 571 xxx
Sharp Limited
Retained OCI: Total
earnings DBP Remeasurement
C C
C
Balance: 1 January 20X3 xxx 6 496 xxx
20X2 o/bal: 50 000 cr O/bal - 20X2 loss:
43 501
Total comprehensive income 400 000 (2 429) 397 571
Balance: 31 December 20X3 xxx 4 067 xxx
Sharp Limited
2.10 Employee benefits

The company has a defined benefit final salary (assumed) pension plan that is governed by the
South African Pensions Fund Act, 1956.
2.11 Actuarial gains and losses
Actuarial gains and losses are recognised in other comprehensive income. No reclassification is
made in subsequent periods between other comprehensive income and profit and loss. Any transfers
are recorded directly in equity.
Chapter 19 915

Sharp Limited
20X3 20X2
17. Net defined benefit plan C C
Opening balance of liability/ (asset) 105 000 28 301
20X3: 160 000 – 55 000; 20X2: 68 301 – 40 000
Net interest expense/ (income) [20X3: 16 000 – 5 500; 20X2: 6 830 – 4 000] 10 500 2 830
Contributions to plan asset by employer (5 400) (4 800)
20X3: 9 000 x 60%; 20X2: 8 000 x 60%
Contributions to plan asset by employee (3 600) (3 200)
20X3: 9 000 x 40%; 20X2: 8 000 x 40%
Remeasurements on defined benefit plan liability/ (asset): 2 429 43 504
- Return on plan assets (8 904) (3 800)
- Actuarial gain/ (loss) from change in financial assumptions (Given: 100%) 11 333 47 304
Closing balance of liability/ (asset) 121 326 104 200
Interest expense 16 000 6 830
Payments from the plan other than settlement payments (5 000) (0)
Remeasurements on defined benefit plan obligation: 11 333 47 304
- Actuarial gain/ (loss) from change in financial assumptions 11 333 47 304
Closing balance 194 730 160 000
Interest income 5 500 4 000
Payments from the plan other than settlement payments (5 000) 0
Contributions to plan asset by employer 5 400 4 800
20X3: 9 000 x 60%; 20X2: 8 000 x 60%
Contributions to plan asset by employee 3 600 3 200
20X3: 9 000 x 40%; 20X2: 8 000 x 40%
Remeasurements on defined benefit plan asset: 8 904 3 800
- Return on plan assets 8 904 3 800
Closing balance 73 404 55 800
22. Employee benefit expense
DBP: Net interest expense 10 500 2 830
DBP: Current service cost 12 397 15 026
DBP: Past service cost 0 22 539
22 897 40 395
24 Other comprehensive income: Defined benefit plan remeasurements
Return on plan assets 8 904 3 800
Actuarial gain/ (loss) caused by changes in financial assumptions (11 333) (47 304)
Actuarial gain/ (loss) caused by changes in demographic assumptions 0 0
Adjustment due to plan asset limited to asset ceiling 0 0
(2 429) (43 504)
Tax on remeasurements of defined benefit plan (question ignores tax) N/A N/A
Cash flow hedge gain/ (loss), net of reclassification and tax (2 429) (43 504)
916 Chapter 19
Example 17: Defined benefit plan disclosure: asset ceiling

Happy Ltd has a defined benefit plan that was introduced to its employees during the year
ended 31 December 20X1. At 31 December the balances were as follows:
20X2 20X1
Plan obligation 130 100
Plan assets 165 150
Other information:
The present value of the future benefits to be received from the fund was C10 in 20X2 (20X1: C40).
The interest rates on high quality corporate bonds have been consistent year on year at 10%.
Service costs for the year amounted to C20 for the 20X2 year end.
Profit for the 20X2 year was C400.
There is no other comprehensive income other than that which arose as a result of the above.
There were no other movements in the defined benefit plan during 20X2 other than those evident
from the information provided.
Required: Prepare the related disclosure for the year ended 31/12/20X2.
Solution 17: Defined benefit plan asset ceiling: disclosure
Happy Limited
Retained earnings OCI: Total
DBP remeasurement
C C C
Balance: beginning of the year xxx xxx xxx
Balance: end of the year xxx xxx xxx
Happy Limited
Note 20X3 20X2
C C
Profit for the year 400 xxx
Other comprehensive income for the year 14 xxx
- ... 0 xxx
- Defined benefit plan remeasurements 23 14 xxx
Total comprehensive income for the year 414 xxx
Happy Limited
20X3 20X2
C C
23. Other comprehensive income: Defined benefit plan remeasurements
Return on plan assets 0 xxx
Actuarial gain/ (loss) caused by changes in financial assumptions 0 (xxx)
Actuarial gain/ (loss) caused by changes in demographic assumptions 0 (xxx)
Adjustment due to plan asset limited to asset ceiling (14) xxx
(14) xxx
Tax on remeasurements of defined benefit plan (ignored tax) N/A (xxx)
Cash flow hedge gain/ (loss), net of reclassification and tax (14) xxx
Chapter 19 917

Happy Limited
20X3 20X2
36. Net defined benefit plan C C
Opening balance of liability/ (asset) (100 + 10 - 150) (40) xxx
Net interest expense/ (income) (10 + 1 – 15) (4) xxx
Current service cost 20 xxx
Remeasurements on defined benefit plan liability/ (asset): 14 xxx
- Return on plan assets 0 xxx
- Actuarial gain/ (loss) on obligation due to change in demographic 0 xxx
assumptions
- Actuarial gain/ (loss) on obligation due to change in financial assumptions 0 xxx
- Adjustments due to limiting the defined benefit asset to the asset ceiling 14 xxx
(if applicable)
Closing balance of liability/ (asset) (10) xxx
Opening balance 100 xxx
Interest expense 10 xxx
Current service cost 20 xxx
Remeasurements on defined benefit plan obligation: 0 xxx
- Actuarial gain/ (loss) due to change in demographic assumptions 0 xxx
- Actuarial gain/ (loss) due to change in financial assumptions 0 xxx
Closing balance 130 xxx
Interest income 15 xxx
Remeasurements on plan asset: 0 xxx
- Return on plan assets 0 xxx
Reconciliation: Plan asset ceiling
Interest expense 1 xxx
Remeasurements on defined benefit plan asset: 14 xxx
- Adjustments due to limiting the DBA to the asset ceiling (if applicable) 14 xxx
6.3 Other long-term employee benefits (IAS 19.158)

The disclosure required for other long-term employee benefits is as follows:
IAS 24 Related party disclosures: disclose the other long-term employee benefits relating
to key management personnel
IAS 1 Presentation of financials: disclose the employee benefit expense, if material.
6.4 Termination benefits (IAS 19.171)
The disclosure required for termination benefits is as follows:
IAS 24 Related party disclosures: disclose the termination benefits relating to key
management personnel
IAS 1 Presentation of financials: disclose the employee benefit expense, if material
IAS 37 Provisions, contingent liabilities and contingent assets: a contingent liability for
an offer of termination benefits where there is uncertainty about how many employees
will accept the offer (unless the possibility of the outflow is remote).
918 Chapter 19
7. Summary
Employee benefits
Defined in IAS 19 as: All forms of consideration given by an
entity in exchange for services rendered by the employees
or for the termination of their services.
Short-term Post-employment Other long-term Termination

benefits benefits benefits benefits
Defined in IAS 19 Defined in IAS 19 Defined in IAS 19 Defined in IAS 19 as:
as: Those that are as: All employee as: Those that are Those that are
due to be settled benefits (other not due to be payable as a result of
within 12 months than termination settled within 12 either the:
after the end of benefits and short- months after the entity’s decision to
the period in which term employee end of the period in terminate the
the employee benefits) that are which the employee employment before
renders the service payable after the renders the service normal retirement
completion of date
Other than employment Other than post- employee’s decision
termination employment and to accept a voluntary
benefits termination redundancy package
benefits in exchange for
those benefits
Other long-term employee benefit: Termination benefit:

(e.g. long-service benefits) (e.g. retrenchment package)
Recognise: Recognise:
As and when the employee provides the services When entity is demonstrably committed to
the termination
Measurement: Measurement:
Statement of financial position: Balance Statement of financial position:
net asset or liability: liability (or credit bank):
Obligation: PV of benefit promised (Credit) amount of the benefit
Plan assets: FV of separate plan Debit
assets
Net asset or liability Dr/ (Cr)
Statement of comprehensive Statement of comprehensive income:

income: employee benefit expense: employee benefit expense:
movement in the net asset/ amount of the benefit
liability
The measurements are subject to: The measurements are subject to:
actuarial assumptions: the actuarial gains/ discounting only if the termination is
losses are recognised immediately in OCI payable more than 12 months after the
past service costs are recognised immediately end of the reporting period
in P/L
discounting
Chapter 19 919
Short-term benefits
Wages, salaries Short-term Profit sharing Use of non-

and social security compensated and/ or bonuses monetary benefits
contributions (e.g. absences (e.g. a company
medical aid) (s-t paid leave) car)
Short-term profit sharing and bonuses

(i.e. those due within 12 months of year-end)
Recognise when:
entity has an obligation,
the settlement of which cannot be reasonably avoided, and
a reliable estimate is possible
Measurement:
Measure using:
Formula stipulated in the plan (or contract);
The entity determined amount; or
Past practice where this gives a clear indication of amount of
the obligation
Factor into the calculation the probability that the employee
may leave without receiving his profit share/ bonus.
Short-term compensated absences

(i.e. paid leave)
Accumulating: unused leave Non-accumulating: unused leave
Recognise when: Recognise when:

Employee renders the service Employee is absent
Measure at: Measure at:
Vesting Non-vesting N/A: No journal entry

Expected cost of: Expected cost of: No liability or expense is recognised because
all accumulated the accumulated the employee simply loses his unused leave at
unused leave unused leave that year-end: there is no obligation to either allow
will probably be the employee to take this leave in the future
used in the future or to pay the employee out for unused leave
Annual salary / working Annual salary /

days x number of working days x number
employees x days: (all of employees x days:
days owed at year-end) (only the days c/f that
the entity expects the
employee to take)
Note: the number of actual working days can either be given (i.e. 260-day working year)
or, if not explicitly given, then a reasonable calculation may be 365 x 5 / 7 days.
920 Chapter 19
Post-employment benefits
Defined contribution Defined benefit

(e.g. a provident fund) (e.g. a pension fund)
Economic substance Economic substance

Obligation: limited to agreed upon Obligation: provide certain benefits to
contributions the employee
Risks: belong to the employee Risks: belong to the employer
Variations
Single employer plans
Multi-employer plans
Group administration plans
Common control shared risk plans
State plans
Insured benefit plans
Post-employment benefit: Post-employment benefit:

Defined contribution plans Defined benefit plans
(i.e. obligations limited to (i.e. obligations = benefit promised)
contributions)
Recognise: Recognise:
as and when the employee provides the As and when the employee provides the
services services
Measurement: Measurement:
The amount of the contributions: Statement of financial position: Balance
no actuarial assumptions needed net asset or liability:
undiscounted normally (but will need to Obligation: PV of benefit promised (Credit)
discount if the contributions become Plan assets: FV of separate plan assets Debit
payable after 12 months from the end of Subtotal: surplus/ (deficit) Dr/ (Cr)
the period in which the employee provides Adjustment for asset ceiling Dr/ (Cr)
the service)
Net defined liability/ (asset) Dr/ (Cr)
Statement of comprehensive income:

employee benefit expense:
movement in the net asset/ liability
The measurements are subject to:

actuarial assumptions: actuarial gains and
losses recognised in OCI
past service costs: past service costs are
recognised in P/L immediately
discounting
Chapter 19 921
Gripping GAAP Foreign currency transactions
Chapter 20
Foreign Currency Transactions
Reference: IAS 21, IFRS 7 and IFRS 9 (all including any amendments to 10 December 2014)
Contents: Page
1. Introduction 923
2. Foreign currency transactions 923
2.1 Overview 923
2.2 How exchange rates are quoted 923
Example 1: Exchange rates 924
2.3 Transactions 924
2.4 Dates 924
2.4.1 Determining the transaction date 924
2.4.2 Determining the settlement date 925
2.4.3 Determining the reporting date 925
Example 2: Dates: transaction, settlement and reporting dates 925
2.5 Recognition and measurement 926
2.5.1 Initial recognition and measurement 926
2.5.2 Subsequent measurement: monetary items 926
2.5.2.2 Translation at the end of the reporting period 927
2.5.2.3 Translation at settlement date 927
2.5.2.4 Exchange differences 927
Example 3: Exchange differences – monetary item: debtor 927
2.5.3 Subsequent measurement: non-monetary items 928
Example 4: Non-monetary item: measurement of plant purchased from foreign
supplier 929
Example 5: Non-monetary item: measurement of inventory owned by foreign branch 930
Example 6: Non-monetary item: measurement of plant owned by foreign branch 931
2.6 Exchange differences on monetary items 932
2.6.1 Import and export transactions 932
2.6.1.1 Transaction and settlement on same day 932
Example 7: Import transaction: settled on same day 932
Example 8: Export transaction: settled on same day 933
2.6.1.2 Settlement deferred (credit transactions) 933
2.6.1.2.1 Settlement of a credit transaction before year-end 933
Example 9: Import: credit transaction settled before year-end 933
Example 10: Export: credit transaction settled before year-end 934
2.6.1.2.2 Settlement of a credit transaction after year-end 934
Example 11: Import: credit transaction settled after year-end 935
Example 12: Export: credit transaction settled after year-end 935
Example 13: Import: credit transaction: another example 936
2.6.2 Foreign loans 938
Example 14: Foreign loans received 938
Example 15: Foreign loan granted 939
2.7 Exchange differences on non-monetary items 940
Example 16: Revaluation of PPE owned by a foreign branch 941
3. Presentation and Functional Currencies 942
3.1 General 942
3.2 Determining the functional currency 942
3.3 Accounting for a change in functional currency 942
3.4 Using a presentation currency other than the functional currency 943
3.4.1 Explanation of foreign currency translation reserve 943
Example 17: Foreign currency translation reserve 943
4. Presentation and Disclosure 944
5. Summary 945
922 Chapter 20
1. Introduction
IAS 21 The effects of changes in foreign exchange rates explains how an entity accounts for
transactions that involve foreign currency, how to account for foreign operations and how to
translate a set of financial statements into a foreign presentation currency.
This section is not difficult and simply requires that you Foreign currency is
understand that currencies are being traded every day, and defined as:
thus the value of a foreign currency today is not the same
as it will be tomorrow, or was yesterday. If we happen to a currency
have, for example, a transaction that involves a foreign other than the functional currency of
currency, the changing value of the foreign currency may the entity. IAS 21.8:
need to be taken into consideration in our accounting records.
Transactions that businesses frequently enter into with foreign entities, which could involve a
combination of income, expenses, assets and/ or liabilities, may be denominated in foreign
currencies (e.g. an invoice that is in dollars, is referred to as ‘denominated in dollars’). Since
financial statements are prepared in one currency only, any foreign currency amounts must be
converted into the currency used for the financial statements (presentation currency). This
conversion may involve converting certain items at the exchange rate ruling on the date of the
conversion (spot exchange rate). To complicate matters, there is often a considerable time lag
between the date that a foreign debtor or creditor is created and the date upon which that
debtor pays or creditor is paid. As explained above, currencies are being traded daily and thus
the spot exchange rate used to measure a foreign debtor or creditor on initial recognition will
no doubt be different to the spot rate on the date the debtor pays or the creditor is paid. This
difference is referred to as an exchange difference.
The rest of this chapter is dedicated to:
Foreign currency transactions
Presentation and functional currencies
Presentation and disclosure issues.
2. Foreign Currency Transactions
2.1 Overview
To be able to account for foreign currency transactions, Foreign currency
we will need to understand how exchange rates are transaction is defined as:
quoted, what transactions could be involved and the dates
a transaction that:
on which we will need to convert our various foreign
- is denominated; and/or
currency denominated amounts. The important dates are
essentially transaction dates, settlement dates and - requires settlement
reporting dates. in a foreign currency. IAS 21.20 extract
Then we will need to consider how the fact that a Exchange difference is
transaction is denominated in a foreign currency impacts defined as the:
on both the initial recognition and measurement of that
transaction and the subsequent measurement thereof. The difference resulting from
subsequent measurement of monetary (e.g. cash) and non- translating a given number of units of
monetary items (e.g. plant) differs as does the accounting one currency into
treatment of the exchange differences relating to each. another currency
at different exchange rates. IAS 21.8
:
2.2 How exchange rates are quoted
An exchange rate is the price of one currency in another currency. For example, if we have
two currencies, a local currency (LC) and a foreign currency (FC), we could quote the
exchange rate directly as, for example, FC1:LC4. This effectively means that to purchase
1 unit of FC, we would have to pay 4 units of LC.
Chapter 20 923
It is also possible to quote the same exchange rate indirectly as LC1: FC0.25. This effectively
means that 1 unit of LC would purchase 0.25 units of the FC.
Global market forces determine currency exchange rates. Exchange rate is defined
If you ask a bank or other currency dealer to buy or sell a as the:
particular currency, you will be quoted an exchange rate
ratio of exchange
that is valid for that particular day only (i.e. immediate
for two currencies. IAS 21.8:
delivery). This exchange rate is called a ‘spot rate’.
Example 1: Exchange rates

You are quoted a spot exchange rate on 1 March 20X1 of £1: $2.
Required:
A. If you had £1 000 to exchange (i.e. sell), how many $ would you receive (i.e. buy) from the
currency dealer?
B. If you had $1 000 to exchange (i.e. sell), how many £ would you receive (i.e. buy) from the
currency dealer?
C. Restate the exchange rate in the format £ …: $1.
Solution 1: Exchange rates

A: £1 000 / 1 x 2 = $2 000
B: $1 000 / 2 x 1 = £500
C: £1 / 2 = £0.5 therefore, the exchange rate would be £0.5: $1
2.3 Transactions
The types of foreign currency transactions that can be entered into are numerous. Common
examples of transactions with foreign entities include:
borrowing or lending money;
purchasing or selling inventory; and
purchasing or selling depreciable assets.
2.4 Dates
Dates involved with foreign currency transactions are very important because exchange rates
differ from day-to-day. The following dates are significant when recording the foreign
currency transaction:
transaction date – this is when a loan is raised/made or an item is purchased or sold;
settlement date – this is when cash changes hands in settlement of the transaction (e.g. the
creditor is paid or payment is received from the debtor); and
reporting date – this normally refers to the financial year-end of the local entity (or could
refer to any other date upon which financial information is to be reported).
The transaction is recognised on transaction date, which is the date on which the definition
and recognition criteria (per the Conceptual Framework) are met. If an order is placed before
the risks and rewards are transferred, then the order date is separate from the transaction date.
Since we are normally not interested in the events before transaction date, the order date is
normally irrelevant. However, sometimes events before transaction date must be considered:
for example when hedging with a forward exchange contract (see IFRS 9 and chapter 21).
2.4.1 Determining the transaction date (IAS 21.22)
The first thing that must be determined in a foreign currency transaction is the transaction
date. The date on which the transaction must be recognised is established with reference to the
IFRS that applies to the type of transaction in question. A rule of thumb for a purchase or sale
transaction is that the transaction date would be when the risks and rewards of ownership
transfer from one entity to the other entity.
For regular import or export transactions, establishing the date that risks and rewards are
transferred is complicated by the fact that goods sent to or ordered from other countries
usually spend a considerable time in transit (e.g. in a ship at sea).
924 Chapter 20
The exact wording of the terms in shipping documentation must always be investigated first
before determining the transaction date as it can often be confusing and can vary
considerably. The general principle is that risks and rewards transfer to the buyer when the
seller has completed their primary duties. In order to assist one in determining when the risks
and rewards have transferred, the International Chamber of Commerce produced a list of
trading terms, called the International Chamber of Commerce Terms of Trade (commonly
referred to as “Incoterms”). The following are some of the common terms used.
Free on Board (F.O.B.) – risks and rewards transfer Transation date is: the date
when goods are delivered over the ship’s rail at the on which the risks and rewards
port of shipment; are transferred.
Carriage, Insurance and Freight (C.I.F.) – The seller arranges and pays for the carriage
and insurance costs of shipping the goods so some might think the risks and rewards
remain with the seller until the goods reach the destination port. However, the buyer is the
beneficiary of the insurance and the seller has completed their primary duties from the
date that the goods are loaded onto the ship. Therefore, risks and rewards transfer when
the goods are delivered over the ship’s rail at the port of shipment;
Delivery at terminal (D.A.T.) – risks and rewards transfer when goods are unloaded at the
named destination terminal; and
Delivered Duty Paid (D.D.P.) – risks and rewards transfer when goods arrive at the
named destination port or other place and import clearances have been obtained.
2.4.2 Determining the settlement date
Next, the settlement date must be determined. The settlement date is the date on which:
a foreign creditor is fully or partially paid; or Settlement date is: the date
full or partial payment is received from a foreign on which a foreign debtor pays
debtor. or a foreign creditor is paid.
The settlement date is generally not difficult to establish.

2.4.3 Determining the reporting date (if applicable)
It is possible for a foreign currency transaction to spread Reporting date is:
over more than one financial year. In other words, where the financial year-end of the
such a transaction is spread over more than one financial local entity (or any other
year, at least one year-end (or other reporting date) occurs date upon which the financial
between transaction date and settlement date. Every time information is to be reported).
that a reporting date falls between the transaction and settlement date, there will be a foreign
currency monetary item (e.g. a creditor balance) that will need to be translated into the local
currency. Thus the reporting date is often referred to as the translation date.
Example 2: Dates: transaction, settlement and reporting dates
Home Limited purchased bicycles from Far Away Limited, a bicycle manufacturer in
Iceland:
13 January 20X4: Home Limited faxed an order for 1 000 yellow bicycles to Far Away Limited.
16 January 20X4: Home Limited received a faxed confirmation from Far Away Limited
informing them that the order had been accepted.
25 January 20X4: Far Away Limited finished manufacturing the 1 000 bicycles and packed them
for delivery.
1 February 20X4: the bicycles were delivered to one of Iceland’s many harbours and were loaded
onto a ship. The ship set sail on 4 February 20X4.
Due to stormy weather it only arrived at the port in Home Limited’s country on 31 March 20X4.
The bicycles were offloaded and released from customs on the same day.
5 April 20X4: the bicycles finally arrived in Home Limited’s warehouse.
Far Away Limited was paid on 30 April 20X4.
Home Limited has a 28 February financial year-end
Required:
A. State the transaction, reporting and settlement dates assuming the bicycles were shipped F.O.B.
B. State the transaction, reporting and settlement dates assuming the bicycles were shipped D.A.T.
Chapter 20 925
Solution 2: Dates: transaction, settlement and reporting dates

Comment:
Please bear in mind that the events before the transaction date have no influence on the foreign
currency transaction unless the transaction has been hedged (see chapter 21).
A.
The transaction date is 1 February 20X4: in terms of an F.O.B. transaction, the risks of ownership
of the bicycles pass to Home Limited on the date the bicycles are loaded at the originating port.
The reporting date is 28 February 20X4 since this is Home Limited’s year-end: on this date, the
foreign currency monetary item (foreign creditor) still exists, (the transaction date has occurred and
the settlement has not yet happened) and thus it will need to be converted from foreign currency
into local currency.
The settlement date is 30 April 20X4, the date on which Home Limited pays the foreign creditor.
B.
The transaction date is 31 March 20X4: in terms of a D.A.T. transaction, the risks of ownership
pass to Home Limited on the date that the bicycles are unloaded at the destination port.
The reporting dates are 28 February 20X4 and 28 February 20X5: no translation is required on
this date, however, since no foreign currency monetary item (foreign creditor) existed (at
28 February 20X4 the transaction date had not yet occurred and the foreign transaction had already
been settled by 28 February 20X5).
The settlement date is 30 April 20X4 being the date when the foreign creditor was paid.
Note: If the bicycles had been shipped under the terms ‘Delivered Duty Paid – destination port’
(DDP) instead of ‘Delivery at terminal (DAT)’ and were only cleared from customs a few days
later, for example on 4 April 20X4, then 4 April 20X4 would have been the transaction date (not
31 March 20X4).
2.5 Recognition and measurement
2.5.1 Initial recognition and measurement (IAS 21.20 - .22)
The foreign currency transaction is initially recognised on transaction date.
The foreign currency transaction is measured by:
Spot exchange rate is
multiplying the foreign currency amount defined as the:
by the spot exchange rate (between foreign currency
and functional currency) exchange rate
on transaction date. for immediate delivery. IAS 21.8:
Thus we are measuring both the monetary and non-monetary items at the spot exchange rate.
It is permissible to use an average exchange rate for the past week or month as long as it
approximates the spot exchange rate.
2.5.2 Subsequent measurement: monetary items (IAS 21.23)
2.5.2.1 Overview
Monetary items are essentially cash or cash equivalents
(currency) and amounts of currency receivable (e.g. Monetary items are
defined as:
debtors) or amounts of currency payable (e.g. creditors).
As the exchange rate changes (and most fluctuate on a units of currency held, and
hourly basis!), the measurement of amounts owing to or assets to be received, and
receivable from a foreign entity changes. For example, an liabilities to be paid
exchange rate of FC1: LC4 in January can change to an in a fixed or determinable number of
exchange rate of FC1: LC7 in February and strengthen units of currency. IAS 21.8
back to FC1: LC6 in March. Due to this, a foreign
debtor or creditor will owe different amounts depending on which date the balance is
measured.
926 Chapter 20
Monetary items (amounts owing or receivable) are translated to the latest exchange rates:
on each subsequent reporting period; and
on settlement date.
2.5.2.2 Translation at the end of the reporting period
If the monetary item is not settled by end of the reporting Closing rate is defined as
period, then an exchange difference is likely to be the:
recognised. This is because the item was originally
measured at the spot rate on transaction date and must be spot exchange rate
restated to the spot rate on the reporting date (sometimes at reporting date. IAS 21.8 slightly reworded
referred to as the closing rate). If there is a difference between the spot rate on transaction
date and the spot rate on reporting date then an exchange difference arises.
2.5.2.3 Translation at settlement date
The amount paid or received is based on the spot rate on settlement date. If the spot rate on
transaction / reporting date (whichever is applicable) is different to the spot rate on settlement
date, an exchange difference will arise.
2.5.2.4 Exchange differences
The translation of monetary items will almost always Exchange differences on
result in exchange differences: gains or losses (unless monetary items: are
there is no change in the exchange rate since transaction generally recognised in P/L (in
date). certain cases, they are
recognised in OCI). See IAS 21.28
Any exchange difference on monetary items is:
recognised in profit or loss in the period in which they arise; unless
if the exchange difference relates to the consolidation of a foreign operation, the exchange
(IAS 21.28 & .32)
gain or loss is recognised in other comprehensive income.
Consolidations are not covered in this book and thus all exchange gains or losses will be
recognised in profit or loss.
Example 3: Exchange differences – monetary item: debtor
On 31 January an entity has a foreign debtor of FC2 000.
The local currency is denominated as LC and the foreign currency is denominated as FC.
The exchange rates of FC: LC are as follows:
31 January: FC1: LC4
28 February: FC1: LC7
31 March: FC1: LC6
Required:
A. Calculate the foreign debtor balance in local currency at the end of January, February and March.
B. Calculate the exchange differences arising over those 3 months and in total.
C. Show how the debtor and exchange differences would be journalised in the entity’s books on
31 January, 28 February and 31 March. Assume the debtor was created on 31 January through a
sale of goods. Ignore the journal required for the cost of the sale.
Solution 3: Exchange differences – monetary item: debtor

A. On 31 January the foreign debtor balance would be FC2 000 x LC4 = LC8 000.
On 28 February the foreign debtor balance would be FC2 000 x LC7 = LC14 000.
On 31 March the foreign debtor balance would be FC2 000 x LC6 = LC12 000.
B. An exchange gain arises between 31 January - 28 February: LC14 000-LC8 000 = LC6 000
An exchange loss arises between 28 February - 31 March: LC12 000-LC14 000 = LC2 000
Thus a net exchange gain arises between 31 January - 31 March: LC12 000-LC8 000 = LC4 000
All these gains or losses are recognised in profit or loss in the respective financial years.
Chapter 20 927

C. Journals: Debit Credit
31 January
Foreign debtor (A) 8 000
Sales (I) 8 000
Sold goods to foreign customer
28 February
Foreign exchange gain (I) 6 000
Translating foreign debtor
31 March
Foreign exchange loss (E) 2 000
Translating foreign debtor
Comment: Notice that the amount of sales income is unaffected by changes in the exchange rates.
2.5.3 Subsequent measurement: non-monetary items (IAS 21.23 - .26)
A non-monetary item is one to which there is neither a right to receive nor an obligation to
deliver a fixed or determinable number of units of currency. Non-monetary items include:
property, plant and equipment;
intangible assets;
inventories; and
prepaid expenses.
Foreign currency can affect non-monetary items in two basic ways:
Local currency denominated non-monetary items:
They could have been purchased using foreign currency, in which case they are converted
into the local currency at the spot rate on transaction date, and are thereafter denominated
in the local currency (called the functional currency)
Foreign currency denominated non-monetary items:
They could be owned by a foreign branch or foreign operation of the entity (the latter
would require consolidation into the books of the entity), in which case they are
denominated in foreign currency in the books of the branch (these will have to be
converted into the local currency).
Non-monetary items that are denominated in a foreign currency:
are measured at historical cost, translated using the exchange rate on transaction date;
are measured at a value other than historical cost (e.g. fair value or recoverable amount),
are translated using the exchange rate when the fair value (or other amount, for example a
recoverable amount) was determined. (IAS 21.23(b) and (c))
The subsequent measurement of non-monetary items that Foreign currency non-
are denominated in local currency is simply done in terms monetary items with CA
of the relevant IFRS. These items are not affected by based on historical cost
subsequent changes in exchange rates. For example, if an are translated:
item of plant is purchased where the purchase was using the spot rate on
denominated in a foreign currency, this is converted into original transaction date. See IAS 21.23 (b)
the local currency on transaction date and the plant is then measured in terms of IAS 16
Property, plant and equipment without any subsequent translations.
The subsequent measurement of non-monetary items that Foreign currency non-
are denominated in foreign currency, whilst measured in monetary items with CA
terms of the relevant IFRS, may be affected by a change based on fair value are
in an exchange rate. This occurs when the measurement translated:
of the item depends on the comparison of two or more using the spot rate on
amounts. date FV was measured. See IAS 21.23 (c)
928 Chapter 20
Typical examples include:

investment properties measured under the fair value, where measurement involves a
comparison of the previous fair value with the fair value at year-end (translated at the spot
rate at year-end);
plant, where the measurement at year-end involves a comparison of the carrying amount
with the recoverable amount (translated at the spot rate at year-end);
inventory, where the measurement at year-end involves a comparison of the cost with the
net realisable value (translated at the spot rate at year-end).
The reason that an exchange rate can affect such items is because:
the cost or carrying amount is translated at the spot rate on transaction date; and
the net realisable value or recoverable amount, for example, is translated at the spot rate
on, for example, reporting date.
Example 4: Non-monetary item: measurement of plant purchased from
foreign supplier
On 1 January 20X1 (transaction date), a South African company bought plant from an
American company for $100 000. The South African company settled the debt on 31 March 20X1.
Spot rates
Date (Rand: Dollar)
1 January 20X1 R6.0: $1
31 March 20X1 R6.3: $1
31 December 20X1 R6.5: $1
31 December 20X2 R6.2: $1
The plant is depreciated to a nil residual value over 5 years using the straight-line method.
The recoverable amount was calculated on 31 December 20X2: R320 000.
Required: Show all the SA entity’s journals for the years ended 31 December 20X1 and 20X2.
Solution 4: Non-monetary item: measurement of plant purchased from foreign supplier
Comment:
Notice how the measurement of the non-monetary asset (plant) is not affected by the changes in
the exchange rates. This is because it is a local-currency-denominated item. Had the recoverable
amount been determined in foreign currency it could result in an impairment loss measured in one
of the currencies, foreign or local, see example 6.
This example also deals with a monetary item (foreign creditor), which is affected by the exchange
rates. This is because the monetary item is denominated in a foreign currency.
Plant: cost (A) $100 000 x R6 600 000
Foreign creditor (L) 600 000
Purchased plant from a foreign supplier (translated at spot rate)
31 March 20X1
Foreign exchange loss (E) $100 000 x R6.30 – R600 000 30 000
Foreign creditor (L) 30 000
Translating foreign creditor on settlement date (at latest spot rate)
Foreign creditor (L) $100 000 x R6.30 630 000
Bank (A) 630 000
31 December 20X1
Depreciation (E) (R600 000 – 0) / 5 years 120 000
31 December 20X2
Depreciation (E) (R600 000 – 0) / 5 years 120 000
Impairment loss (E) CA: 600 000 –120 000 –120 000 40 000
Plant: accumulated impairment loss – Recoverable amount: 320 000 40 000
Impairment of plant
Chapter 20 929
Example 5: Non-monetary item: measurement of inventory owned by foreign

branch
A South African company (local currency: Rand: R) has a branch in Britain (local
currency: Pound: £). On 1 January 20X1 (transaction date), the British branch bought
inventory from a British supplier for £100 000 in cash:
Date Spot rates (Rand: Pound)

1 January 20X1 R10: £1
31 December 20X1 R12: £1
The inventory is still in stock. Its net realisable value is estimated to be £90 000 at 31 December 20X1.
Required: Show all journal entries for the years ended 31 December 20X1:
A. in the books of the British branch; and
B. in the books of the South African entity.
Solution 5A: Inventory: journals in the books of a foreign branch

Comment: Notice how, in the branch’s books, the inventory is written down since the net realisable
value in Pounds is less than the carrying amount in Pounds.
Journals in the foreign (British) branch: denominated in Pounds Pounds £

Debit Credit
1 January 20X1
Inventory (A) Given: £100 000 100 000
Bank (A) 100 000
Purchased inventory from a local supplier (British)
31 December 20X1
Inventory write-down (E) £100 000 – £90 000: See W1.1 10 000
Inventory written down to lower of cost or net realisable value
Solution 5B: Inventory: journals in the books of the local entity
Comment: The British branch recognises a write-down whereas the South African branch does not.
There is no write-down of inventory in the SA entity’s books because the net realisable value is
measured using the spot rate on the date at which the net realisable value is calculated (R12: £1)
yet the cost is measured using the lower spot rate on transaction date (R10: £1). See W1.2 (Rand).
The fact that the British branch recognises a write-down whereas the South African branch does
not, is purely as a result of the difference in the exchange rates!
Journals in the local (South African) entity: denominated in Rands Rands

Debit Credit
1 January 20X1
Inventory (A) £100 000 x R10 1 000 000
Bank (A) 1 000 000
Purchased inventory from a foreign supplier (translated at spot rate)
W1: Calculation of possible write-down W1.1 W1.2
Pounds Rands
Cost: 31/12/20X1 Pounds: £100 000 100 000 1 000 000
Rands: £100 000 x R10
Net realisable value: Pounds: £90 000 90 000 1 080 000
31/12/20X1 Rands: £90 000 x R12
Write-down 10 000 N/A
(1) (2)
(1) NRV is less than CA, therefore a write-down is needed
(2) NRV is greater than CA, therefore no write-down is processed
930 Chapter 20
Example 6: Non-monetary item: measurement of plant owned by foreign

branch
A South African company (local currency: Rands: R) has a branch in United States (local
currency: Dollar: $). On 1 January 20X1 (transaction date), the branch in United States
bought a plant for $100 000 in cash.
Date Spot rates: (Rand: Dollar)
1 January 20X1 R12.0: $1
31 December 20X1 R10.7: $1
31 December 20X2 R10.0: $1
The plant is depreciated to a nil residual value over 5 years using the straight-line method.
The recoverable amount was calculated on 31 December 20X2: $70 000.
Required:
Show all journal entries for the years ended 31 December 20X1 and 31 December 20X2:
A. in the books of the United States branch; and
B. in the books of the South African entity.
Solution 6A: Plant: journals in the books of the foreign branch

Comment: Notice how:
In the branch’s books, the asset is not considered to be impaired, since the recoverable amount in
Dollars ($70 000) is greater than the carrying amount in Dollars ($100 000 – 20 000 – 20 000).
There are obviously no exchange differences in this example since the purchase in Dollars is
recorded in Dollars in the books of the United States branch.
Journals in the books of the foreign (United States) branch: Dollars
denominated in Dollars Debit Credit
1 January 20X1
Plant: cost (A) Given: $100 000 100 000
Bank (A) 100 000
Purchased plant
31 December 20X1
Depreciation (E) ($100 000 – 0) / 5 years 20 000
31 December 20X2
Depreciation (E) ($100 000 – 0) / 5 years 20 000
Solution 6B: Plant: journals in the books of the local entity

the South African entity reflects an impairment loss on the plant despite the fact that, in Dollar
terms, the plant is not impaired! This is because of the change in the exchange rate.
- the recoverable amount in the SA entity’s books is measured using the spot rate on the date at
which the recoverable amount is calculated (R10: $1); whereas
- the cost and related accumulated depreciation is measured using the spot rate on transaction
date (R12: $1).
It is thus the change in exchange rate that causes a South African impairment loss despite the fact
that the British branch does not recognise an impairment loss!
Dollars Rands
Carrying amount: 31/12/20X2 Dollars: $100 000 x 3 / 5 yrs 60 000 720 000
Rands: $100 000 x 3 / 5 yrs x R12
Recoverable amount: 31/12/20X2 Dollars: $70 000 70 000 700 000
Rands: $70 000 x R10
Impairment N/A 20 000
Chapter 20 931

Journals in the books of the local entity: denominated in Rands Rands
Debit Credit
1 January 20X1
Plant: cost (A) $100 000 x R12 1 200 000
Bank (A) 1 200 000
Purchased plant from a foreign supplier (translated at spot rate)
31 December 20X1
Depreciation (E) (1 200 000 – 0) / 5 years 240 000
31 December 20X2
Depreciation (E) (1 200 000 – 0) / 5 years 240 000
Impairment loss (E) CA: 1 200 000 – 240 000 – 20 000
Plant: accumulated imp loss (-A) 240 000 – RA: $70 000 x R10 20 000
Impairment of plant (CA measured at spot rate on transaction date; RA
measured at spot rate at year-end)
2.6 Exchange differences on monetary items (IAS 21.28)

It should now be quite clear that fluctuating currency exchange rates will therefore have an
effect on all monetary items that are denominated in a foreign currency, including:
sales to a foreign customer (export) on credit;
purchases from a foreign supplier (import) on credit;
loans made to a foreign borrower; and
loans raised from a foreign lender.
Exchange differences that arise on the translation of monetary items are recognised in profit
or loss (e.g. a foreign exchange gain or loss). Although the basic principles apply to import,
export and loan transactions, loan transactions have an added complexity, being the interest
accrual. Let us therefore first look at the journals involving exports and imports and then let
us look at loan transactions.
2.6.1 Import and export transactions
2.6.1.1 Transaction and settlement on the same day (cash transaction)
If the date on which the transaction is journalised (transaction date) is the same date on which
cash changes hands in settlement of the transaction (settlement date), then there would
obviously be no exchange differences to account for.
Example 7: Import transaction - settled on same day (cash transaction)
On 5 March 20X1 (transaction date), a company in Botswana (in which the local / functional
currency is the Pula: P) purchased inventory for £100 from a company in Britain (the local /
functional currency is the Pound: £). The purchase price was paid on this same day, when the
spot rate was P3: £1.
Required: Show the journal entry/ies in the books of the company in Botswana.
Solution 7: Import transaction - settled on same day

Comment: No exchange difference arises since there is no balance payable needing translation.
Debit Credit
5 March 20X1
Inventory (A) 300
Bank (A) 300
Purchase of inventory: £100 x 3 = P300
932 Chapter 20
Example 8: Export transaction - settled on same day (cash transaction)

A company in the United Kingdom sold inventory for P1 200 to a company in Botswana
on 17 May 20X5, the transaction date.
The sale proceeds were received on the same day when the spot rate was P4: £1.
The cost of the inventory to the UK company was £150.
The local currency (functional currency) in Botswana is the Pula (P).
The local currency (functional currency) in the United Kingdom is the Pound (£).
Required: Show the journal entries in the books of the company in the United Kingdom.
Solution 8: Export transaction - settled on same day
17 May 20X5 Debit Credit

Bank (A) 300
Sales (I) 300
Sale of inventory for cash: P1200 / 4 = £300
Cost of sales (E) 150
Inventory (A) 150
Recording cost of the inventory sold: amount given
2.6.1.2 Settlement deferred (credit transactions)
Exchange differences arise when the settlement date occurs after transaction date.
The non-monetary item e.g. asset acquired, expense incurred or sale earned (the initial
transaction) is recorded at the spot rate on the transaction date (no exchange differences).
The non-monetary item is unaffected by movements in the exchange rates.
The monetary item, being the amount payable or receivable, is affected by the movement
in the exchange rate after transaction date. The monetary item is translated at the spot
rates on reporting dates and payment dates and any increase or decrease in the monetary
item is recognised in profit or loss as either a foreign exchange gain or loss.
2.6.1.2.1 Settlement of a credit transaction before year-end
When the settlement of a credit transaction occurs before year-end:

record the initial transaction at spot rate on transaction date;
convert the outstanding monetary item balance (i.e. payable or receivable) to the spot rate
on settlement date; and
record the payment (made or received).
Example 9: Import - credit transaction settled before year-end

A company in Botswana purchased inventory for £100 from a company in Britain on
5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1.
Date Spot rates (Pula: Pound)
5 March 20X1 P3: £1
5 April 20X1 P4: £1
Required: Show the journal/s in Botswana’s journal the year ended 30 April 20X1.
Solution 9: Import - credit transaction settled before year-end
Comment: Notice that since the £ became more valuable/costly (i.e. £1 cost P3 on transaction date but
cost P4 on date of settlement), and thus the Botswana company made a loss of P100 by not paying for
the inventory on date of acquisition (transaction date).
The cost of the inventory, however, remains unaffected since inventory is a non-monetary item!
Chapter 20 933

5 March 20X1 Debit Credit
Inventory (A) 300
Foreign creditor (L) 300
Purchase of inventory on credit: £100 x 3 = P300
5 April 20X1
Foreign exchange loss (E) (£100 x 4) - 300 = P100 100
Translation of creditor to spot rate on settlement date:
Foreign creditor (L) £100 x 4 = P400 400
Bank (A) 400
Payment of creditor at spot rate on settlement date:
Example 10: Export - credit transaction settled before year-end

A company in the United Kingdom sold inventory for P1 200 to a company in Botswana
on 17 May 20X5, the transaction date. The inventory was paid for on 13 June 20X5.
The inventory cost the UK company £150.
The year-end of the company in the United Kingdom is 30 September .
Relevant exchange rates are:
Spot rates
Date (Pound: Pula)
17 May 20X5 £1: P4
13 June 20X5 £1: P3
Required:
Show the journal entries in the books of the company in the United Kingdom.
Solution 10: Export - credit transaction settled before year-end

Comment: Notice that since the P became more valuable (£1 bought P4 on transaction date but £1
bought only P3 on date of settlement ), the UK company made a gain of £100.
The sales income, however, remains unaffected by the changes in the exchange rates: this is because
sales are non-monetary (only monetary items – payables or receivables – are affected!).
Foreign debtor (A) 300
Sales (I) 300
Sale of inventory: P1 200 / 4 = £300
Cost of sales (E) 150
Inventory (A) 150
Recording cost of sale of inventory: Cost = £150 (given)
13 June 20X5
Foreign exchange gain (I) 100
Translating debtor at settlement date: P1 200 / 3 – 300
Bank (A) 400
Amount received from foreign debtor: P1 200 / 3
2.6.1.2.2 Settlement of a credit transaction after year-end
When the settlement of a credit transaction occurs after year-end:

record the initial transaction at spot rate on transaction date;
translate the outstanding monetary item balances (payable or receivable):
- to the spot rate on translation date (year-end); and then again
- to the spot rate on settlement date;
record the payment (made or received).
934 Chapter 20
Example 11: Import - credit transaction settled after year-end

A company in Botswana purchased inventory for £100 from a company in Britain on
5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1. The year
end of the company in Botswana is 31 March.
Spot rates
Date (Pound: Pula)
5 March 20X1 £1: P3
31 March 20X1 £1: P3.70
5 April 20X1 £1: P4
Required:
Show the journal entry/ies in the books of the company in Botswana.
Solution 11: Import - credit transaction settled after year-end
Comment:
Notice that since the £ became more expensive (£1 cost P3 on transaction date but cost P4 on date
of settlement), the Botswana company made a loss of P100 by not paying for the inventory on the
date of acquisition (transaction date).
This loss is recognised partially in the year ended 31 March 20X1 (P70) and partially in the year
ended 31 March 20X2 (P30), because the P depreciated against the £ in each respective period.
Notice how the cost of inventory remains unaffected by the changes in the exchange rate. This is
because inventory is a non-monetary item and is thus translated at the spot rate on transaction date.
Debit Credit
5 March 20X1
Inventory (A) £100 x 3 = P300 300
Purchase of inventory on credit
31 March 20X1
Foreign exchange loss (E) (£100 x 3.7) – 300 = P70 70
Translation of creditor to spot rate at year-end
5 April 20X1
Foreign exchange loss (E) (£100 x 4) – (£100 x 3,7) = P30 30
Conversion of creditor to spot rate on settlement date
Foreign creditor (L) £100 x 4 = P400 400
Bank (A) 400
Payment of creditor at spot rate on settlement date
Example 12: Export - credit transaction settled after year-end

A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on
17 May 20X5, the transaction date. The sale proceeds were received on 13 June 20X5.
The cost of the inventory to the UK company was £150.
The UK company has a 31 May financial year-end.
Spot rates
Date (Pound: Pula)
17 May 20X5 £1: P4
31 May 20X5 £1: P3.4
13 June 20X5 £1: P3
Required:
Show the journal entries in the books of the company in the United Kingdom.
Chapter 20 935
Solution 12: Export - credit transaction settled after year-end

Comment: Notice how the sales figure of 300 remains unaffected by changes in the exchange rate. This
is because sales is a non-monetary item (you may want to read the definition of monetary items).

Foreign debtor (A) P1200 / 4 = £300 300
Sales (I) 300
Sale of inventory
Cost of sales (E) Cost = £150 (given) 150
Inventory (A) 150
Recording the cost of the inventory sold
31 May 20X5
Foreign debtor (A) P1200 / £3.4 = £353 - 300 53
Translating the foreign debtor at year-end
13 June 20X5
Foreign debtor (A) P1200 / £3 = 400 – (300 + 53) = £47 47
Translating foreign debtor at settlement date
Bank (A) P1200 / £3 400
Proceeds received from foreign debtor
Example 13: Import – credit transaction – another example

A company in the United Kingdom ordered inventory to the value of $900 from an
American company on 16 January 20X1. The transaction date is 5 February 20X1.
The year-end is 31 March 20X1. The relevant exchange rates are as follows:
Spot rates
Date (Pound: dollar)
16 January 20X1 £1: $2.2
5 February 20X1 £1: $2.5
31 March 20X1 £1: $2.25
5 April 20X1 £1: $3.0
Required:
Show all journal entries and show the balances in the trial balance of the UK company as at
31 March 20X1 assuming in the following 3 scenarios that the UK entity paid the American entity on:
A. 5 February 20X1 (on transaction date).
B. 31 March 20X1 (at year-end).
C. 5 April 20X1 (after year-end).
Solution 13A: Import – credit transaction – payment before year-end

Journals:
Debit Credit
5 February 20X1
Inventory (A) $900 / £2.5 360
Bank (A) 360
Purchase of inventory: exchange rate £1: $2.5
Trial balance as at 31 March 20X1 (extracts)

Debit Credit
Inventory 360
Creditor 0
936 Chapter 20
Solution 13B: Import – credit transaction – payment at year-end

Journals:
Inventory (A) $900 / £2.5 360
31 March 20X1
Foreign exchange loss (E) $900 / 2.25 – 360 40
Translation of foreign creditor before payment
Foreign creditor (L) $900 / 2.25 = 400 400
Bank (A) 400
Payment of foreign creditor:
Trial Balance
As at 31 March 20X1 (extracts)
Debit Credit
Inventory 360
Foreign creditor 0
Foreign exchange loss (P/L) 40
Solution 13C: Import – credit transaction – payment after year-end

Journals:
Inventory (A) $900 / £2.5 360
31 March 20X1
Foreign exchange loss (E) $900 / 2.25 – 360 40
Translation of foreign creditor at year-end
5 April 20X1
Foreign creditor (L) $900/ 3 – (360 + 40) 100
Translation of the foreign creditor before payment
Foreign creditor (L) $900/ 3 300
Bank (A) 300
Trial Balance
As at 31 March 20X1 (extracts)
Debit Credit
Inventory 360
Foreign creditor 400
Foreign exchange loss (P/L) 40
Comment on A, B and C:
Notice that there is no exchange gain or loss when the amount is paid on transaction date (part A).
Contrast this with:
part B where the foreign exchange loss recognised to payment date is 40; and
part C where a foreign exchange loss of 40 is recognised in 20X1 and a foreign exchange gain of
100 is recognised in 20X2 (i.e. a net foreign exchange gain of 100 – 40 = 60 on this transaction).
In all 3 scenarios, the inventory remains at £360 because inventory is a non-monetary item.
Chapter 20 937
2.6.2 Foreign loans
The third type of possible transactions is the granting of loans to foreign entities or the receipt
of a loan (in a foreign currency) from a foreign lender.
Interest receivable (on loans made) or interest payable (on loans received) must be calculated
based on the outstanding foreign currency amount and then translated into the local currency
(IAS 21.22)
at the average rate over the period that the interest was earned or incurred.
The easiest way to do this correctly is:

calculate the loan amortisation table in the foreign currency;
journalise all receipts and payments at the spot rate;
journalise the interest at the average rate; and
calculate the value of the balance payable / receivable at spot rate at year end, and
recognising the difference between the this value and the carrying amount of the loan as a
foreign exchange gain or loss.
This is best explained by way of an example:
Example 14: Foreign loan received

On 1 January 20X4 (transaction date), Brix ’n Stones Limited, a South African brick
making entity, raised a long term loan from Gill Bates of the Cayman Islands.
The terms of the loan were as follows:
Gill transfers EUR100 000 into Brix ’n Stones Limited’s bank account on 1 January 20X4.
The interest rate on the loan was 7,931% p.a.
Brix ‘n Stones is required to make repayments on the loan of EUR25 000 annually in arrears,
with the first payment falling due on 31 December 20X4.
Brix ’n Stones Limited has the ZAR (South African Rand) as its functional currency.
The currency used in the Cayman Islands is the EUR (Euro).
Brix ‘n Stones Limited has a 31 December financial year-end.
Date Spot rates Average rates
1 January 20X4 EUR1: ZAR8.00
31 December 20X4 EUR1: ZAR8.50
31 December 20X5 EUR1: ZAR7.50
20X4 EUR1: ZAR8.20
20X5 EUR1: ZAR7.70
Required: Show the journal entries required to record the above loan transaction in Brix ’n Stones
Limited’s accounting records for the years ended 31 December 20X4 and 31 December 20X5.
Solution 14: Foreign loan received

the loan is translated at the spot rate on transaction date (TD);
the interest is translated at the average exchange rate for the year;
the payments made are translated at the spot rate on settlement date (SD); and
the foreign exchange gain or loss is calculated as the difference between the closing balance
translated at the closing rate and the carrying amount in Rands to date.
Journals:
Debit Credit
1 January 20X4
Bank (A) EUR100 000 x R8 (spot rate on TD) 800 000
Long-term loan (L) 800 000
Proceeds received on the foreign loan raised from Cayman Islands
938 Chapter 20

Finance cost (E) EUR 7 931 (W1) x R8.20 (Av rate) 65 034
Interest expense on the foreign loan (converted at average rates)
Long-term loan (L) EUR 25 000 x R8.50 (spot rate) 212 500
Bank (A) 212 500
Payment of instalment on loan: (at spot rate on pmt date)
Foreign exchange loss (E) EUR: 82 931 (W1) x R8.5 (spot rate) – CA 52 380
Long-term loan (L) so far:(R800 000 + R65 034 – R212 500) 52 380
Translating foreign loan at year end (at spot rate at year-end)
31 December 20X5
Finance cost (E) EUR 6 577 (W1) x R7.70 (Av rate) 50 643
Interest expense raised on loan (converted at average rates)
Long-term loan (L) EUR 25 000 x R7.5 (spot rate) 187 500
Bank (A) 187 500
Payment of instalment on loan: (at spot rate on pmt date)
Long-term loan (L) EUR 64 508 (W1) x R7.5 (spot rate) – CA 84 247
Foreign exchange gain (I) so far *: (R800 000 + R65 034 – R212 500 84 247
+R52 380 + R50 643 – R187 500)
Translating foreign loan at year end (at spot rate at year-end)
*: Alternative calculation: CA so far = EUR 82 931 (W1) x R8.5 (spot rate end prior year) + R50 643 – R187 500
Working 1: Effective interest rate table in foreign currency: Euros
Date Interest Payments Balance

(7,931%) (in Euros)
100 000
20X4 7 931 (25 000) 82 931
20X5 6 577 (25 000) 64 508
20X6 5 116 (25 000) 44 624
20X7 3 539 (25 000) 23 163
20X8 1 837 (25 000) 0
25 000 (125 000)
Example 15: Foreign loan granted

On 1 January 20X5 (transaction date), Incredible Limited (a South African company:
functional currency of Rands: ZAR), granted a loan to Amazing Limited (registered in the
USA: functional currency of Dollars: $).
The loan was for $10 000 and Amazing Limited is required to make 4 annual payments in arrears of
$3 000, commencing 31 December 20X5. Interest is levied at 7,714% per annum.
Incredible Limited’s year-end is 31 December.
Date Spot rates Average rates
1 January 20X5 $1: ZAR7.00
31 December 20X5 $1: ZAR7.50
31 December 20X6 $1: ZAR6.00
20X5 $1: ZAR7.30
20X6 $1: ZAR6.70
Required: Show the journals to record the above loan in Incredible Limited’s accounting records for
Chapter 20 939
Solution 15: Foreign loan granted

Comment: If the loan made to Amazing Limited was repayable in Rands instead of Dollars, Incredible
Limited would not have been exposed to foreign currency risks and this would therefore not be a
foreign currency transaction. The fact that Amazing Limited has a functional currency other than the
Rand would then have been irrelevant.

Foreign loan (A) $10 000 x R7(spot rate on TD) 70 000
Bank (A) 70 000
Loan granted to Amazing Limited
31 December 20X5
Foreign loan (A) $771 (W1) x R7.30 (Av rate) 5 628
Interest income (I) 5 628
Interest income converted at average rates
Bank (A) $3 000 x R7.50 (spot rate on SD) 22 500
Foreign loan (A) 22 500
Receipt of first instalment on the loan
Foreign loan (A) $7 771 (W1) x R7.5 (spot rate at YE) – CA so 5 155
Foreign exchange gain (I) far: (R70 000 + R5 628 – R22 500) 5 155
Translating loan at year-end
31 December 20X6
Foreign loan (A) $600 (W1) x R6.70 (Av rate) 4 020
Interest income (I) 4 020
Interest income converted at average rates
Bank (A) $3 000 x R6 (SR on SD) 18 000
Foreign loan (A) 18 000
Receipt of second instalment on the loan
Foreign exchange loss (E) $5 371(W1) x R6 (spot rate at YE) 12 077
Foreign loan (A) – CA so far*: (R70 000 + R5 628 – R22 500 + 12 077
R5 155 + R4 020 – R18 000)
Translating loan at year-end
*: Alternative calculation: CA so far = ($7 771 (W1) x R7.50 (spot rate end prior year) + R4 020 – R18 000
Working 1: Effective interest rate table in foreign currency: Dollars
Date Interest Payments Balance

(7,714%) (in Dollars)
10 000
20X5 771 (3 000) 7 771
20X6 600 (3 000) 5 371
20X7 414 (3 000) 2 785
20X8 215 (3 000) 0
2 000 (12 000)
2.7 Exchange differences on non-monetary items
As mentioned in section 2.5.3 above, the subsequent measurement of foreign currency

denominated non-monetary items may be affected by a change in an exchange rate.
When a gain or loss on a non-monetary item is recognised in other comprehensive income,

any exchange component of that gain or loss shall be recognised in other comprehensive
income (IAS 21.30). For example: IAS 16 requires gains and losses arising on a revaluation
of property, plant and equipment to be recognised in other comprehensive income.
940 Chapter 20
When such an asset is measured in a foreign currency, IAS 21 requires the revalued amount to
be translated at the date the value is determined.
Conversely, when a gain or loss is recognised in profit or loss, any exchange component of
that gain or loss shall be recognised in profit or loss. For example: IAS 40 requires fair value
adjustments on investment property carried under the fair value model to be recognised in
profit or loss. When such an asset is measured in a foreign currency, IAS 21 requires the
revalued amount to be translated at the date the value is determined.
Example 16: Revaluation of PPE owned by a foreign branch

A South African company (local currency: Rand: R) has a branch in the United States
(local currency: dollar: $). On 1 January 20X1, the branch in United States bought a plant
for $100 000 cash.
Date Spot rates
1 January 20X1 R12.00: $1
31 December 20X1 R10.70: $1
31 December 20X2 R10.00: $1
The plant is depreciated to a nil residual value over 5 years using the straight line method.
The plant was revalued on 31 December 20X2 to $110 000 using the net method.
Required: Show all journals for the years ended 31 December 20X1 and 20X2 (Ignore tax effects):
A. In the general journal of the US branch ; and
B. In the general journal of the SA entity.
Solution 16: Revaluation of PPE owned by a foreign branch

Comment:
A: Notice that there is obviously no exchange difference in this example since the purchase in
dollars is recorded in dollars in the books of the United States branch.
B: Notice how the difference between the exchange rate on date of purchase (R12: $1) and the
exchange rate on date of revaluation (R10: $1) gets absorbed into the revaluation surplus (OCI).
Ex 16A Ex 16B
US Jnl SA Jnl
$ R
Plant: cost (A) A: Given as $100 000 100 000 1 200 000
Bank (A) B: $100 000 x R12 (100 000) (1 200 000)
Purchase of plant
31 December 20X1
Depreciation (E) A: ($100 000 – 0)/5yr x 1 20 000 240 000
Plant: accum. depreciation (-A) B: R1 200 000 / 5yr x 1 (20 000) (240 000)
31 December 20X2
Depreciation (E) A: ($100 000 – 0)/5yr x 1 20 000 240 000
Plant: accum. depreciation (-A) B: R1 200 000 / 5yr x 1 (20 000) (240 000)
Plant: accum. depreciation (-A) A: $20 000 x 2 years 40 000 480 000
Plant: cost (A) B: R240 000 x 2 years (40 000) (480 000)
NRVM: set-off of accumulated depreciation before revaluation
Plant: cost (A) A: W1 50 000 380 000
Revaluation surplus (OCI) B: W1 (50 000) (380 000)
Revaluation of plant to fair value of $110 000
Chapter 20 941

W1: Calculation of revaluation surplus on 31 December 20X2 Ex 16A: Ex 16B:
Dollars Rands
Carrying amount: 31/12/X2 A: Cost: $100 000 – AD: 40 000 60 000 720 000
B: Cost: R1 200 000 – AD: R480 000
Fair value: 31/12/X2 A: Given: $110 000 110 000 1 100 000
B: $110 000 x R10 (SR at year end)
Revaluation surplus: 31/12/X2 50 000 380 000
3. Presentation and Functional Currencies (IAS 21.9 – 14)
3.1 General
IAS 21 allows an entity to present its financial statements in whichever currency it chooses to,
this is then known as the presentation currency. However, IAS 21 requires that an entity’s
transactions and balances be measured in that entity’s functional currency. Thus entities must
establish their functional currencies. An entity’s functional and presentation currency is often
the same currency, but where it is not the same, a translation reserve will result.
3.2 Determining the functional currency (IAS 21.9 – 12)
A functional currency is defined as the currency of the primary economic environment in

which the entity operates. The primary economic environment in which an entity operates is
usually taken to be the environment in which it primarily generates and expends cash.
In establishing its functional currency, an entity should consider:

the currency that mainly influences the sales prices Functional currency is
for goods and services (this will often be the currency defined as:
in which prices for its goods and services are
denominated and settled); the currency of the
the currency of the country whose competitive forces primary economic environment
and regulations mainly determine the sales prices of in which the entity operates. IAS 21.8
its goods and services;
the currency that mainly influences labour, material and other costs of providing goods or
services (this will often be the currency in which such costs are denominated and settled);
the currency in which funds from financing activities (i.e. issuing debt and equity
instruments) are generated; and
the currency in which receipts from operating activities are usually retained. IAS 21.9 & .10
As these factors usually do not change often, once a functional currency is determined it is not
changed unless an entity’s circumstances have changed so significantly that the above factors
would result in a different functional currency being more appropriate. IAS 21.13
3.3 Accounting for a change in functional currency (IAS 21.35 - .37)
An entity may not change its functional currency unless there is a change in the underlying
transactions and conditions that result in changes to the factors discussed in 3.2 above. For
example: a change in the currency that influences the sales price of goods and services could
therefore very well lead to a change in an entity’s functional currency (substance over form).
Should there be a change in functional currency, it must be accounted for prospectively from
the date of change of functional currency.
Accounting for such a change is relatively simple. All items are translated into the functional
currency using the spot exchange rate available at the date of change. For non-monetary
items, the new translated amount shall now be considered to be their historical cost.
942 Chapter 20
3.4 Using a presentation currency other than the functional currency (IAS 21.38 - .41)
As stated before, an entity may choose to present it
financial statements in a currency of its choice. That Presentation currency is
currency is then known as the presentation currency. defined as:
Should an entity choose to disclose financial statements in
the currency in which the
a currency other than its functional currency, it will have
to translate all of its items from the functional to the financial statements are presented.
IAS 21.8
presentation currency at year end. :
The following procedure (often referred to as the closing rate method) is used to translate an
entity’s trial balance into a presentation currency different to its functional currency:
all assets and liabilities (including comparative amounts) shall be translated into the
presentation currency using the closing rate available at the reporting date;
all incomes and expenses shall be translated at the If functional currency ≠
spot rate available at the dates of the various presentation currency
transactions (for practical purposes, it is often translate:
acceptable to use the average rate for the presentation assets & liabilities @ spot rate at
period, provided the currency did not fluctuate too reporting date (e.g. YE)
much); and
income & expenses @ spot rate on
all resulting exchange differences are recognised in
transaction date (or at average SR).
other comprehensive income (the account in which
these exchange differences are accumulated is often referred to as the foreign currency
translation reserve, being an equity account). (IAS 21.39)
3.4.1 Explanation of the foreign currency translation reserve (IAS 21.41)
Exchange differences arise upon translation because:
assets and liabilities are translated at one rate, while movements in those assets and
liabilities (represented by incomes and expenses) are translated at a different rate; and
opening balances of net assets are translated at a rate different to the previous closing rate.
As these exchange rate differences have no effect on future cash flows from operations (i.e.
they are really just book-entries), they are not recognised in profit or loss, but rather in other
comprehensive income (equity).
Example 17: Foreign currency translation reserve
StickyFingers Limited, a sweet manufacturer in NeverNever Land, has a functional
currency of Chocca’s (C). It decided to present its financial statements in the currency of
Faraway Land, (an island nearby), as most of its shareholders reside on this island. Faraway Land’s
currency is the Flipper (F). The following exchange rates are available:
Dates Exchange Rates
20X5 1chocca: 6.5 flippers Average rate
31 December 20X5 1chocca: 7 flippers Spot rate
Trial balance of Sticky-Fingers Ltd at 31 December 20X5 Debit Credit
Accounts payable 294 600
Accounts receivable 155 000
Bank 300 000
Land & buildings 944 300
Property, plant & equipment 600 000
Investments – at fair value 120 000
Ordinary share capital 403 300
General reserve 680 900
Long-term loan 810 500
Sales 1 509 500
Operating expenses 407 000
Taxation 439 300
3 698 800 3 698 800
Required:
Translate this trial balance into the presentation currency using IAS 21.
Chapter 20 943
Solution 17: Foreign currency translation reserve

Comment: This example shows how to use the closing rate method. It is used when the functional
currency and the presentation currency are different.
Account Working Debit Credit

Accounts payable 294 600 x 7 2 062 200
Accounts receivable 155 000 x 7 1 085 000
Bank 300 000 x 7 2 100 000
Land & buildings 944 300 x 7 6 610 100
Property, plant & equipment 600 000 x 7 4 200 000
Investments – at fair value 120 000 x 7 840 000
Ordinary share capital 403 300 x 7 2 823 100
General reserve 680 900 x 7 4 766 300
Long-term loan 810 500 x 7 5 673 500
Sales 1 509 500 x 6.5 9 811 750
Cost of sales 733 200 x 6.5 4 765 800
Operating expenses 407 000 x 6.5 2 645 500
Taxation 439 300 x 6.5 2 855 450
Foreign currency translation reserve* Balancing figure 35 000
25 136 850 25 136 850
* this reserve appears in three places in the financial statements, it is presented:
in the statement of comprehensive income as other comprehensive income (the movement therein),
as a column in the statement of changes in equity (the balances and movement therein), and
as part of the total issued capital and reserves in the statement of financial position (the balances).
If the foreign currency translation reserve relates to a foreign operation and if this foreign
operation is subsequently disposed of, the reserve would be:
reclassified from other comprehensive income (where the exchange differences are
accumulated as a separate component of equity) to profit or loss, and
disclosed as a reclassification adjustment. IAS 21.48
4. Presentation and Disclosure (IAS 21.51 - .57)
The following disclosures are required by IAS 21:

the amount of the exchange differences recognised in profit and loss except for those
arising on financial instruments measured at fair value through profit or loss;
the net exchange difference recognised in other comprehensive income and accumulated
in a separate component of equity, reconciling the amount of such exchange differences at
the beginning and end of the period.
if there is a change in the functional currency, state this fact and the reason for the change
in functional currency.
where the presentation currency differs from the functional currency:
- state the functional currency and the reason for using a different presentation
currency;
- it shall describe the financial statements as complying with the IFRSs only if they
comply with all the requirements of each applicable IFRS including the method
required for translating functional currency items to presentation currency amounts.
when an entity displays its financial statements or other financial information in a
currency that is different from either its functional currency or its presentation currency
and the IFRS requirements (referred to in the above bullet) are not all met, it shall:
- clearly identify the information as supplementary information to distinguish it from
the information that complies with IFRSs;
- disclose the currency in which the supplementary information is displayed; and
- disclose the entity’s functional currency and the method of translation used to
determine the supplementary information.
944 Chapter 20
5. Summary
Foreign currency transactions
Functional currency Exchange rates Presentation currency

Is the currency used in Two formats: The currency used to
the primary economic How much LC must present its financial
environment be paid for 1 unit statements in
The currency that we of FC (direct); or The presentation
must use in our own How much FC can currency may be any
records (i.e. all be bought for 1 currency
transactions/ balances unit of LC (indirect) Functional currency is
must be measured in translated into
the functional currency) presentation currency
Effects of changes in foreign exchange rates
Foreign currency transactions Translation of financial statements
Dates Currencies
Dates: Currencies:
Transaction date (TD) The functional currency is used in our
Translation (reporting) date (RD) own records
Settlement (payment) date (SD) Presentation currency is the
currency we use to present our F/S’s
Initial Subsequent
Spot rate on TD MI: If functional currency differs from
Spot rate on: presentation currency; translate:
RD or SD Asset and liabilities:
@ spot rate at year-end
Income and expenses:
@ spot rate on transaction date
(otherwise an average spot rate)
NMI:
Historic cost:
SR on TD
Fair value:
SR on FV date
Interest on loan:
Average SR
Exchange difference recognised in Exchange difference recognised in

Profit or loss: for all monetary items Other comprehensive income:
OCI: for some adjustments to non- foreign currency translation reserve
monetary items (e.g. RS on PPE)
Abbreviations:
MI: monetary item SR: spot rate RD: reporting date
NMI: non-monetary item TD: transaction date SD: settlement date
Chapter 20 945
Gripping GAAP Hedging with forward exchange contracts
Chapter 21
Hedging with Forward Exchange Contracts
Reference: IAS 32, IFRS 7, IFRS 9 and IFRS 13 (including any amendments to 10 December 2014)
Contents: Page
1. The basics of hedge accounting 947
1.1 Overview 947
1.2 What is a hedge? 947
1.3 What is a hedged item? 947
1.3.1 Forecast transactions (uncommitted future transaction) 948
1.3.2 Firm commitments (committed future transaction) 949
1.4 What is a hedging instrument? 949
1.5 How hedging is achieved using a forward exchange contract 950
Example 1: FEC to hedge an export transaction 950
1.6 How to discount a forward exchange contract 951
Example 2: Present value of a FEC 951
1.7 Designation of hedging instruments 952
Example 3: Splitting the interest element and the spot price of a FEC 953
2. Hedge accounting 953
2.1 Hedging accounting may only be used if certain criteria are met 954
2.2 Hedge effectiveness 954
2.3 Types of hedges 954
2.3.1 Overview 954
2.3.2 Fair value hedges 954
2.3.3 Cash flow hedges 955
2.3.4 Comparison: accounting for cash flow hedges versus fair value hedges 956
2.4 Discontinuance of hedge accounting 956
2.5 Periods relevant to hedging 956
2.5.1 Post-transaction period 956
2.5.2 Pre-transaction period 956
2.5.3 Diagrammatic summary of the periods relevant to hedging 957
2.6 The methods of accounting for hedges during each of these periods 957
2.7 Cash flow hedge effectiveness 958
Example 4: Cash flow hedge effectiveness 958
2.8 Accounting for hedges 959
2.8.1 Overview 959
2.8.2 Hedged item: foreign currency transactions 959
2.8.3 Hedging instrument: forward exchange contract 959
2.9 FEC’s in the period post-transaction date 960
Example 5: FEC in the post-transaction period: fair value hedge Overview 961
2.10 FEC’s in the period pre-transaction date 962
2.9.1 Overview 962
2.9.2 If there is no firm commitment 962
Example 6: FEC in the pre-transaction period (no firm commitment): cash flow
hedge: basis adjustment 962
Example 7: FEC in the pre-transaction period (no firm commitment): cash flow
hedge: reclassification adjustment 964
2.9.3 If there is a firm commitment 965
Example 8: FEC in the pre-transaction period: firm commitment: cash flow hedge 966
Example 9: FEC in the pre-transaction period: firm commitment: fair value hedge 967
Example 10: FEC taken out in the pre-transaction period with a year-end after
firm commitment but before transaction date 968
3. Tax consequences 970
4. Disclosure 971
Example 11: Disclosure: cash flow hedge: basis versus reclassification adjustments 971
5. Summary 974
946 Chapter 21
1.1 Overview
You may be forgiven for thinking that a hedge is simply a row of green bushes planted around the
perimeter of a property. You may then also be forgiven for thinking that the hedged item is the
house in the middle of the property and that the hedging instrument is the pair of garden shears
that you use to trim the hedge.
A forward exchange
As you are hopefully beginning to realise, the world of
contract (FEC) is defined as:
accounting has many odd and exciting things (perhaps
exciting is not quite the right word?), including hedges, an agreement between two parties
hedged items and hedging instruments. But these obviously to exchange a given amount of
do not relate to fuzzy green bushes! currency
for another currency
at a predetermined exchange rate
In this chapter, we will focus on the hedging of foreign
and
currency transactions using the most common method, being at a predetermined future date.
the use of a forward exchange contract (FEC). http://www.nasdaq.com/investing/glossary
1.2 What is a hedge?
So what is a hedge if it is not a green bush?
There are various definitions of ‘hedging’ including the following:

‘to minimise or protect against loss by counterbalancing one transaction, such as a bet against
another’; The American Heritage® Dictionary of the English Language, Fourth Edition and
‘any technique designed to reduce or eliminate financial risk; for example, taking two
positions that will offset each other if prices change’. WordNet ® 2.0, © 2003 Princeton University
When hedging a foreign currency transaction, it means: A financial instrument is

taking a position in a financial instrument; defined as:
that would counter any change in value of the hedged
any contract
item;
caused by an exchange rate fluctuation. that gives rise to a financial asset of
one entity and
a financial liability/ equity instrument
1.3 What is a hedged item? (IFRS 9.6.3) of another entity. IAS 32.11
And now... what is a hedged item if it is not the house in the For example:
middle of the hedged property? Accounts receivable, trade payables
and cash (primary)
The hedged item is an item that is exposed in some way or Derivatives: options, futures, swaps
and forward exchange contracts
other (related cash flows or fair value) to a risk or many (FEC’s) etc Note 1
risks (e.g. the risk that the cash outflow will increase if the
Note 1. A derivative is defined as:
exchange rate deteriorates - this risk being referred to as a - an item for which the
foreign currency risk). - value is determined by
- some underlying influence (e.g.
A hedged item can be any: interest rate, commodity price,
recognised asset or liability, or index of prices etc).
unrecognised firm commitment, (a) or Please see the chapter on financial
unrecognised highly probable forecast transaction; (b) or a instruments for more information.
net investment in a foreign operation.
(a): The meaning of ‘firm commitments’ is explained in section 1.3.2.
(b): These are unrecognised since the definition and recognition criteria of the elements would not be met.
A hedged item can be a single asset or liability, firm commitment or forecast transaction or a
group thereof – or even just a part thereof (called a component).
Chapter 21 947
If it is a group thereof, certain extra criteria must be met

A hedged item is defined as:
(e.g. the items in the group must, individually, be eligible
hedged items, and must be managed together for risk
an asset or liability, or
purposes etc: see IFRS 9.6.6.1).
a firm commitment, or
highly probable forecast transaction, or
A hedged item could even be part of one of these items (e.g.
net investment in a foreign operation,
the hedged item could be part of an asset), in which case the that:
hedged item is referred to as a component. This is - is reliably measured, and
explained below. IFRS 9.6.1.3(reworded) - involves a party external to the
reporting entity IFRS 9.6.3 (reworded)
Generally a hedged item is made up of all changes in the
cash flows or fair value of that item (e.g. all changes in the cash flows or fair value of a recognised
asset). However, an entity may choose to designate only a part of the changes in the cash flows or
fair value as the hedged item in a hedging relationship. If only parts of the changes are designated
as the hedged item, we refer to that hedged part as a hedged component. We are only allowed to
designate the following types of components as hedged items (although combinations of the
following are also possible):
Only changes in fair value or cash flows linked to a specific risk which must be separately
identifiable and reliably measured; IFRS 9.6.3.7(a) or
Selected contractual cash flows; IFRS 9.6.3.7(b)or
Components of a nominal amount (a specified part of the amount of an item). See IFRS 9.6.3.7(c)
In all cases, hedged items must be reliably measurable and must involve parties external to the
entity – in other words, we may not designate a firm commitment as a hedged item unless it
involves a commitment with a third party. See IFRS 9.6.3.2 and 6.3.5
Before continuing, let’s look at the meaning of forecast transactions and firm commitments.
1.3.1 Forecast transactions (an uncommitted future transaction)
A forecast transaction is a transaction that: A forecast transaction is

has not yet happened; and defined as:
has not yet been committed to (e.g. no firm order exists);
but an uncommitted but anticipated
is expected to happen. future transaction. IFRS 9 Appendix A
We can hedge a forecast transaction, but actually accounting for it as a hedge is only allowed if:
the forecast transaction is highly probable to occur ( ‘expecting it’ is not good enough!).
The term highly probable is not defined in IFRS 9, but it is defined in IFRS 5 as something that is:
Significantly more likely than probable, IFRS 5 App A
In other words the term means that something is ‘likely to occur’. See IFRS 5.BC81
The probability of the expected future transaction occurring must be assessed on observable facts
and relevant circumstances and not just on management’s intentions, because intentions are not
verifiable. In assessing the probability of a transaction occurring, the following circumstances
should be considered:
the frequency of similar past transactions; and
the financial and operating ability of the entity to carry out the transaction;
substantial commitments of resources to a particular activity;
the extent of loss/disruption of operations that may result if the transaction does not occur;
the likelihood that transactions with substantially different characteristics might be used to
achieve the same business purpose (e.g. an entity that intends to raise cash may have several
ways of doing so, from raising a bank loan to offering ordinary shares); and
the entity’s business plan.
Highly probable forecast transactions are always accounted for as cash flow hedges (see
IFRS 9.6.5.2). A cash flow hedge is a hedge of the exposure to variability in cash flows. (See
section 2.3.3 for an explanation on cash flow hedges).
948 Chapter 21
1.3.2 Firm commitments (committed future transaction)

A firm commitment is defined as ‘a binding agreement for A firm commitment is defined
the exchange of a specified quantity of resources at a as: IFRS 9Appendix A
specified price on a specified future date or dates’. In other a binding agreement
words, it is a transaction that has not yet happened but for the exchange of a specified
either we, or the other party, have committed to the quantity of resources
transaction (i.e. the transaction cannot be avoided). at a specified price
A commitment is binding if it is enforceable, legally or on a specified future date/ dates.

otherwise. Something would be enforceable if non-performance would result in penalties, whether
these were stipulated in the agreement or would apply for other reasons (e.g. through legal
remedies).
An example of a firm commitment to a future transaction is when the entity signs a legally
binding contract either ordering goods from a foreign supplier or agreeing to supply goods to a
foreign customer. The emphasis is on the enforceability of the commitment.
If a firm commitment is made, it remains in force until the date of the transaction. In other words,
a firm commitment exists between the date the firm commitment is made and the transaction date
(i.e. the date that the risks and rewards transfer).
Just as we can hedge forecast transactions, we can also hedge firm commitments. However,
whereas forecast transactions are always accounted for as cash flow hedges, firm commitments
are generally accounted for as fair value hedges (the only time a firm commitment may be
accounted for as a cash flow hedge is if the entity is hedging a related foreign currency risk – see
IFRS 9.6.5.4). Cash flow hedges and fair value hedges are explained in section 2.3.
A summary of the periods during which items may be hedged are as follows:
Transaction highly Firm commitment Transaction happens Transaction
probable made Settled
N/A Hedge of a Hedge of a Hedge of a transaction N/A

forecast transaction firm commitment
Pre-transaction period Post-transaction period
1.4 What is a hedging instrument? (IFRS 9.6.2)

So what is a hedging instrument if it is not the pair of garden shears that keeps the hedge around
the house neat, tidy and effective?
A hedging instrument could
There are many financial instruments that can be utilised as be:
hedging instruments, for instance:
designated derivatives measured at
derivatives can include options, swaps, forward FV through P/L (except for some
exchange contracts and futures contracts; written options), or
non-derivatives can include natural hedges such as a designated non-derivative financial

asset or non-derivative financial
internal matching which minimises the foreign currency liability measured at FV through P/L
risk by having foreign debtors and foreign creditors in (except for financial liabilities in
the same currency. which FV changes due to credit risk
are recognised in OCI); and
An asset or liability denominated in a foreign currency Only contracts with parties external to
(hedged item) can be hedged by any financial instrument the reporting entity may be designated
IFRS 9.6.2.1-3(reworded)
that is expected to gain in value when the hedged item loses as hedging instruments.
value or vice versa. The most common method of hedging foreign exchange denominated
transactions is through the use of forward exchange contracts (FEC’s).
This chapter’s focus is hedging foreign currency transactions and we will therefore focus
exclusively on using forward exchange contracts (FEC’s) as the hedging instrument.
Chapter 21 949
1.5 How hedging is achieved using a forward exchange contract
A forward exchange contract (FEC) is: Important comparison!

an agreement between two parties;
to exchange a given amount of currency; The spot rate is the rate that is being
offered at any one given point in time.
for another currency;
at a predetermined exchange rate; and The forward rate is the rate you
at a predetermined future date. http://www.nasdaq.com/investing/glossary agree to pay or receive in the future.
A forward contract enables an entity to ‘lock-in’ at an exchange rate and thereby avoid or
minimise losses (of course, possible gains may also be lost or minimised!) on the hedged item that
may otherwise have resulted from fluctuations in the exchange rate.
The forward rate agreed upon in the FEC contract will be different to the spot rate available on
that same date. This is because the forward rate of a FEC approximates the expected spot rate on
the date that the FEC will expire. Thus, the forward rate that will be offered to us will consist of:
the current spot rate;
plus a premium (if the exchange rate is expected to appreciate); or
less a discount (if the exchange rate is expected to depreciate).
Example 1: FEC to hedge an export transaction

Happy Limited, a British company, sold a tractor for $100 000 to Lame Co, a company based in
the USA:
The tractor was loaded F.O.B. onto a ship on 1 March 20X5 (transaction date).
Lame Co paid $100 000 to Happy Limited on 31 May 20X5 (due date for repayment).
In order to protect itself against adverse fluctuations in the $: £ exchange rate,
Happy Limited entered into a FEC on 1 March 20X5 (expiring on 31 May 20X5).
Date Spot rates Forward Rate

1 March 20X5 $1: £0.845 $1: £0.840
31 May 20X5 $1: £0.830 N/A
Required:
A. Calculate the £ values of Happy Limited’s debtor on 1 March 20X5 and 31 May 20X5.
B. Calculate the £ amount actually received by Happy Limited.
C. Prepare the journals in Happy Limited’s books for the year ended 30 June 20X5.
Solution 1: FEC to hedge an export transaction

A. 1 March 20X5: Debtor £84 500 ($100 000 x 0.845)
31 May 20X5: Debtor £83 000 ($100 000 x 0.830)
B. 31 May 20X5: Received from bank £84 000 ($100 000 x 0.840).
Had we been exposed to the spot exchange rate on the settlement date, Happy Limited would have
received £83 000, but because it had entered into an FEC at a forward rate of $1: £0.840, the $100 000
is exchanged into £84 000 ($100 000 x 0.840). Thus, the FEC limited the loss that Happy Limited
would have made of £1 500 (£84 500 - £83 000) to a loss of only £500 (£84 500 - £84 000), on its
debtor due to exchange rate fluctuations.
Note that if the exchange rate had moved in the opposite direction, i.e. if the £ had weakened against the
$ (i.e. the UK company will have to pay more pounds for $1), then the FEC would have prevented
Happy Limited from making a gain on its debtor.
C. Journals Debit Credit
1 March 20X5
Debtor 84 500
Sales 84 500
Recording sale on transaction date: (100 000 x 0.845)
950 Chapter 21

Foreign exchange loss (profit or loss) 1 500
Debtor 1 500
Translating debtor at settlement date: (100 000 x 0.83) – 84 500
FEC asset 1 000
Foreign exchange gain (profit or loss) 1 000
Recognising FEC asset at settlement date: (0.84-0.83) x 100 000
Bank (0.84 x 100 000) 84 000
FEC asset (balance in the account) 1 000
Debtor (balance in the account) 83 000
Expiry of FEC and payment by debtor.
Comment: Note that the debtor is not affected by the hedge.
The debtor is still measured at the spot rates on the respective dates as done in chapter 20.
It is only the amount actually received that changes due to the addition of the hedge.
1.6 How to discount a forward exchange contract

When an FEC expires, the difference between the FEC rate agreed to in the contract and the spot
rate on expiry date is settled (i.e. it is paid to or received from the financing house). Thus the
measurement of the final and actual gain or loss on the FEC can only be done on expiry date (i.e.
settlement date). However, until settlement date we obviously can’t know what the final spot rate
will be and thus the gain or loss on the FEC (i.e. whether the FEC represents an asset or liability to
the entity) can only be estimated at the difference between:
the forward rate agreed to in our FEC contract; and
the forward rate currently (i.e. on valuation date) being offered in FEC contracts that expire on
the same date as our original FEC.
As this value will only be payable or receivable in the future it should be discounted to its present
value, assuming that the effects of present valuing are material.
Apart from this next example that shows the effect of present valuing, all other examples will
ignore present valuing so that you are better able to learn and understand the principles.
Example 2: Present value of a FEC
A German entity enters into an FEC on 28 February 20X5 to hedge an import transaction worth
¥1 000 000, due to be settled on 30 November 20X5.
The following FECs were available on the following dates:
Forward Rate to 30 November 20X5
28 February 20X5 €0.007131: ¥ 1
30 June 20X5 €0.007404: ¥1
31 August 20X5 €0.068200: ¥1
Required:
A. Calculate the value of the FEC in € on;
30 June 20X5;
31 August 20X5.
B. Show all journals needed to recognise the FEC in the German entity’s books.
Solution 2A: Present value of a FEC

Answer: the value of the FEC is as follows:
30 June 20X5 (where there are 5 months to expiry): €263 Asset W1
31 August 20X5 (where there are 3 months to expiry): €304 Liability W2
W1. Value of the FEC on 30 June 20X5:

Amount payable Present values
30 June 20X5 Rate Amount (¥) (€ ) (5 months to expiry)
Rate acquired 0.007131 1 000 000 7 131 1 000 000 x 0.007131 6 853 7 131 / [1.1 ^ (5/12)]
Rate now available 0.007404 1 000 000 7 404 1 000 000 x 0.007404 7 116 7 404 / [1.1 ^ (5/12)]
€273 Asset/ gain €263 Asset/ gain
Chapter 21 951

The present value can be calculated using a financial calculator:
(1) FV = 7 131 N = 5/12 I = 10 Comp PV: 6 853
(2) FV = 7 404 N = 5/12 I = 10 Comp PV: 7 116
Explanation: at 30 June 20X5

The German entity took out an FEC on 28 February 20X5 and has thus locked in at an exchange rate of
€0.007131 and will have to pay €7 131.
Had it waited and taken out the FEC on 30 June 20X5, it would have obtained a rate of €0.007404 and
had to pay €7 404.
By taking out the FEC on 28 February rather than on 30 June 20X5, it saved €273 in absolute terms.
There are 5 months to the settlement of the contract and therefore the present value of the gain is based
on the present value factor for the next 5 months: €263 (i.e. FEC asset/ gain measured in ‘real money’).
W2. Value of the FEC on 31 August 20X5:
31 August 20X5 Rate Amount (¥) Amount payable (€ ): FV Present values (3 months to expiry)
Rate acquired 0.007131 1 000 000 7 131 1 000 000 x 0.007131 6 963 7 131 / [(1.1 ^ (3/12)]
Rate now available 0.006820 1 000 000 6 820 1 000 000 x 0.006820 6 659 6 820 / [1.1 ^ (3/12)]
€ (311) Liability/ loss € (304) Liability/ loss
The present value can be calculated using a financial calculator:

(1) FV = 7 131 N = 3/12 I = 10 Comp PV: 6 963
(2) FV = 6 820 N = 3/12 I = 10 Comp PV: 6 659
Explanation: at 31 August 20X5
The German entity took out an FEC on 28 February 20X5 and has thus locked in at an exchange rate of
€0.007131 and will have to pay €7 131.
Had it waited and taken out the FEC on 31 August 20X5, it would have obtained a rate of €0.00682 and
had to pay €6 820.
By taking out the FEC on 28 February rather than on 31 August 20X5, it has to pay an extra €310 thus
losing €310 (in absolute terms).
There are now only 3 months to the settlement of the contract and therefore the present value is based
on the present value factor for the next 3 months: €304 (i.e. the latest estimate is that the FEC
represents a liability / loss, measured at €304 in ‘real money’).

Not Present Valued Present Valued
30 June 20X5 Debit Credit Debit Credit
FEC asset W1 273 263
Recognising FEC asset.
31 August 20X5
FEC asset 273 263
Reversing previous FEC asset and gain
Foreign exchange loss (profit or loss) 311 304
FEC liability W2 311 304
Re-measuring the FEC on 31 August 20X5
1.7 Designation of hedging instruments (IFRS 9.6.2.4 – 6)

The change in the hedging instrument may be recorded in one of the following ways:
designating the entire instrument as a hedging instrument;
separating the intrinsic value and the time value of an option contract and only designating the
changes in the intrinsic value as the hedging instrument;
separating the forward element and the spot element of a forward contract and only
designating the changes in the value of the spot element as the hedging instrument; or
designating a portion of an instrument (e.g. 50% of the nominal amount) as the hedging instrument.
952 Chapter 21
Example 3: Splitting the interest element and the spot price of a FEC
On 31 March 20X1 a South African company entered into a forward cover agreement for
$100 000 to hedge the import of a special widget used in production.
Date Spot rates Forward rates
31 March 20X1 R7.50: $1 R8.00: $1
30 June 20X1 R7.90: $1 R8.10: $1
Required: Prepare the journal for the year ended 30 June 20X1 to record the movement on the FEC if the
spot element is designated as the hedging instrument and accounted for as a cash flow hedge.
Solution 3: Splitting the interest element and the spot price of an FEC
Comment: Note that:
the FEC asset is still recorded using the forward rate, but
the equity component of the cash flow hedge is determined using the spot rates because the spot rates
were designated as the hedging instrument.
FEC asset 100 000 ×(8.10 – 8) 10 000
FEC equity (OCI) 100 000 × (7.90 – 7.50) 40 000
Interest income Balancing figure 30 000
Recognising the movement on the FEC until 30 June 20X1
1. Hedge Accounting
2.1 Hedge accounting may only be used if certain criteria are met (IFRS 9.6.4)
If you have an item that you believe is at risk, you may decide to hedge these risks, by using an
instrument that you believe will offset these risks. At this point you would have what is called a
hedged item and a hedging instrument.
Although you have the two ingredients necessary for hedge accounting, you may not necessarily
be allowed to account for the relationship between the hedged item and the hedging instrument as
a hedge.
Before you may account for this relationship as a hedge (i.e. before you may use hedge
accounting), you need to meet 3 criteria. These are listed in the grey block below.
Hedge accounting may only be applied if all of the following 3 criteria are met:
The hedging relationship must consist only of eligible hedging instruments and eligible hedged items. IFRS 9.6.4.1 (a)
At the inception of the hedging relationship, there must be a formal designation and documentation of the
hedging relationship and the entity’s risk management objectives and strategy for undertaking the hedge.
That documentation shall include identification of:

the hedging instrument,
the hedged item,
the nature of the risk being hedged (in the case of this chapter: being foreign exchange risk) , and
how the entity will assess the hedging instrument’s effectiveness. IFRS 9.6.4.1 (b) (slightly reworded)
The hedging relationship must meet all of the following hedge effectiveness requirements:
an economic relationship must exist between the hedged item and the hedging instrument,
the effect of credit risk must not dominate the value changes that result from that economic
relationship, and
the hedge ratio of the hedging relationship for accounting purposes must mirror the ratio for risk
management purposes. IFRS 9.6.4.1)(reworded)
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1.2 Hedge effectiveness Hedge ratio is defined as the

relationship between
The definition of hedge effectiveness requires some
elaboration. Do you remember that when hedging the quantity of the hedging instrument
foreign currency transactions, an entity is trying to and
the quantity of the hedged item
protect itself from losses due to exchange rate in terms of their relative weighting.
fluctuations (currency risk)? Well, for an entity to protect IFRS 9 Appendix A
itself against such losses, it uses a hedging instrument.
To explain how to account for hedges, this chapter will use a forward exchange contract (FEC) as
the hedging instrument which we will use to hedge against foreign currency risks. By hedging
against currency risks, the entity hopes that any gain or loss on the foreign currency denominated
item will be exactly offset by an equivalent and opposite gain or loss on the hedging instrument. If,
for example, due to a change in exchange rates we require an extra LC100 to settle a foreign
creditor, we will be hoping that the FEC will have increased in value by LC100.
If the hedging instrument perfectly offsets the change in the hedged item, as depicted above, the
hedging instrument is said to be 100% effective. It is, however, quite possible that the hedging
instrument is not 100% effective. For example, a weakening exchange rate may result in a foreign
creditor requiring an extra LC100 to settle, but the FEC only gains in value by LC80. In this case,
the hedge is no longer 100% effective, but 80% effective (80/ 100).
IFRS 9 defines an effective hedge as one that is characterised by 3 features: See IFRS 9.6.4.1(c)
An economic relationship exists between the hedging instrument and the hedged item. Since
the objective is to offset gains on one item with gains on the other – it is implied that the
values of the hedging instrument and the hedged item need to be moving in opposite
directions due to the same (but opposite) risks.
The fair value changes within the economic relationship are not driven primarily by the
impact of credit risk. This requires an entity to monitor changes in the fair value of the
instruments within the economic relationship and assess the extent to which such changes are
driven by changes in credit risk.
The hedge ratio for accounting purposes mirrors the hedge ratio for risk management purposes
provided the ratio does not reflect a deliberate imbalance designed to achieve an accounting
outcome that is not consistent with the purposes of hedge accounting or risk management.
1.3 Types of hedges (IFRS 9.6.5)
1.3.1 Overview
There are three types of hedges: fair value hedges, cash The 3 types of hedges:
flow hedges and a hedge of a net investment in a foreign
operation. We will not be discussing the hedge of a net Cash flow hedges;
investment in a foreign operation but we will now explain Fair value hedges; and
both the cash flow hedge and the fair value hedge. Hedges of a net investment in a
foreign operation. See IFRS 9.6.5.2
1.3.2 Fair value hedges (IFRS 9.6.5.2)
A fair value hedge is one that is trying to protect the profit A fair value hedge is defined
or loss from being affected by changes in the fair value of a as:
specific item, where these fair value changes are expected a hedge of the exposure to
due to certain risks. changes in fair value of:
Thus, a fair value hedge that is hedging (protecting) against a recognised asset or liability; or
the effects of foreign currency risks is a hedge that is trying an unrecognised firm commitment; or
to protect: a component of such asset, liability
or firm commitment ;
a recognised asset or liability (or portion thereof), or
that is attributable to a particular risk
an unrecognised firm commitment (or portion thereof), (e.g. a foreign currency risk); and
against changes in its fair value could affect profit or loss.IFRS 9.6.5.2(a)
that may result from fluctuations in exchange rates.
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Worked example: Fair value hedge of a foreign debtor

We have a foreign debtor denominated in a foreign currency, who owes us FC100 000.
At the end of the last year, it took LC5 to buy FC1. It now only takes LC4 to buy FC1.
The fair value of the foreign debtor has thus dropped from LC500 000 to LC400 000. A fair value hedge
would attempt to neutralise any such decrease in fair value.
Accounting for a fair value hedge requires that gains or losses on the hedging instrument are
recognised directly in profit or loss.
We stop using fair value hedge accounting if the hedge no longer meets the criteria for hedge
accounting. For example: the hedging instrument expires or is sold, terminated or exercised (the
replacement or rollover of a hedging instrument into another hedging instrument is not an
expiration or termination if it is part of the entity’s documented hedging strategy). See IFRS 9.6.5.6
We cease hedge accounting prospectively (i.e. we do not adjust our prior year figures).
1.3.3 Cash flow hedges (IFRS 9.6.5.2) A cash flow hedge is:
A cash flow hedge is one that is trying to protect the profit or a hedge of the exposure to
loss from being affected by changes in the cash flows relating changes in cash flows of:
to a specific item, where changes in the cash flows are a recognised asset or liability; or
expected due to certain identified risks. of a highly probable forecast
transaction;
The cash flow hedge definition refers specifically to hedges attributable to a particular risk; and
of recognised assets, recognised liabilities and highly that could affect P/L.IFRS 9.6.5.2(b)
probable forecast transactions. However, although not reworded
specifically mentioned in the cash flow hedge definition, a

hedge of a firm commitment can also be accounted for as a cash flow hedge, but only if:
the hedging instrument (e.g. FEC)
hedges against foreign currency risks (by the way, this is the only time an entity can choose to
account for a firm commitment as either a fair value hedge or cash flow hedge). IFRS 9.6.5.4
A cash flow hedge that is being used to hedge against foreign currency risks is a hedge that is
effectively protecting:
a recognised asset or liability; or
a highly probable forecast transaction; or
a firm commitment; (applies only to the hedge of currency risk!) IFRS 9.6.5.4
against any associated variability in cash flows attributable to exchange rate fluctuations.
Imagine that we have a foreign creditor to whom we owe a foreign currency amount. If between
transaction and settlement date the local currency weakens against the foreign currency, the
amount payable will increase. This is a risk – which we can hedge against.
Worked example: Cash flow hedge of a foreign creditor
We have a foreign creditor denominated in a foreign currency, who we owe FC100 000.
At transaction date, it took LC5 to buy FC1 and now it takes LC6 to buy FC1
The settlement of the foreign creditor will now require a cash outflow of LC600 000 instead of only
LC500 000. A cash flow hedge would attempt to neutralise such an increase in the potential cash outflow
arising from exchange rate fluctuations.
Accounting for a cash flow hedge requires that gains or losses on the cash flow hedge are
recognised in other comprehensive income and are later transferred to profit or loss using either a
basis adjustment or reclassification adjustment.
An entity shall stop using cash flow hedge accounting prospectively if:
the hedging instrument expires or is sold, terminated or exercised (the replacement or rollover
of a hedging instrument into another hedging instrument is not an expiration or termination if
it is part of the entity’s documented hedging strategy);
the hedge no longer meets the criteria for hedge accounting;
the forecast transaction is no longer expected to occur; or
the entity revokes the designation.
Chapter 21 955
2.3.4 Comparison: accounting for cash flow hedges versus fair value hedges
The main difference in accounting for cash flow hedges and fair value hedges is that:
For fair value hedges: gains and losses are immediately recognised in profit or loss;
For cash flow hedges: gains and losses (where the hedge is considered to be an effective
hedge) are initially recognised in other comprehensive income and then either:
reclassified to profit or loss (i.e. a reclassification adjustment); or
set-off against the carrying amount of the hedged item (i.e. a basis adjustment).
The choice between using the reclassification adjustment and basis adjustment approach is an
accounting policy choice and should be applied consistently.
2.4 Discontinuance of hedge accounting (IFRS 9.6.5.6)
When a hedging relationship is no longer effective due to an imbalance in the hedge ratio, the
entity shall adjust the hedge ratio of the hedging relationship if the risk management objective
remains the same. This ‘rebalancing’ exercise requires the quantities of the hedged item or
hedging instrument to be adjusted in a manner that leads to the entity maintaining a hedge ratio
that complies with the hedge effectiveness requirements of IFRS 9. Changes to the quantities of
the designated items for any other purpose are not classified as ‘rebalancing’ adjustments.
If, after applying the ‘rebalancing’ requirements of IFRS 9, a hedging relationship no longer meets
the criteria for hedge effectiveness, hedge accounting must stop and is discontinued prospectively.
This applies to both cash flow hedges and fair value hedges IFRS 9.6.5.6
2.5 Periods relevant to hedging
2.5.1 Post-transaction period
Just as we did when accounting for simple foreign currency

The post-transaction
transactions, a hedging relationship must be accounted for at period is simply the period:
transaction, reporting (translation) and settlement dates. starting: from transaction date
These dates obviously occur after the transaction has been
ending: on settlement date.
entered into, being a period that we will refer to as the post-
transaction period. As mentioned earlier, however, it is also possible to enter into a hedge before
transaction date. We will refer to the period before transaction date as the pre-transaction period.
2.5.2 Pre-transaction period
The pre-transaction period can be categorised into two periods:
an uncommitted; and/ or
a committed period.
A FEC may be taken out and designated as a hedge not only
The pre-transaction period
before a transaction takes place, but even before we have is simply the period:
committed to the transaction. If the future expected starting: from any date before
transaction is not certain but it is highly probable that it will transaction date
take place, it is still possible to use hedge accounting. We ending: just before transaction date.
will call the period between the date on which the transaction If a firm commitment is entered into,
becomes highly probable and the date on which the firm part of this period will be called the:
commitment is made (or the date of the transaction, if no uncommitted period (before FC date)
firm commitment is made), the uncommitted period. committed period (from FC date)
If an entity firmly commits to a future transaction, the period after making this firm commitment
but before the actual transaction date may be referred to as the committed period.
The ‘firm commitment’ date is the date upon which:
the entity accepts an order to supply goods to an overseas customer; or
the entity orders goods from a foreign supplier and the order is accepted by that supplier.
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It is important to determine whether a firm commitment is entered into during this pre-transaction
period and, if so, whether the FEC hedge came into existence:
before the firm commitment (uncommitted period);
between the firm commitment date and transaction date (committed period); and/ or
after transaction date
because a hedge during each of these periods may need to be accounted for differently.
2.5.3 Diagrammatic summary of the periods relevant to hedging
A summary of the different dates is as follows:
Transaction highly probable Firm commitment made Transaction happens Transaction settled
N/A Hedge of a forecast transaction Hedge of a firm commitment Hedge of a transaction N/A
Uncommitted pre-transaction period Committed pre-transaction period
2.6 The methods of accounting for hedges during each of these periods
The way that a hedging instrument (e.g. a FEC) is accounted for (i.e. as a cash flow hedge or a fair
value hedge) depends largely on whether we are looking at its existence during:
an uncommitted pre-transaction period (before a firm commitment is made and before
transaction date: a forecast transaction);
a committed pre-transaction period (after a firm commitment is made but before transaction
date: a firm commitment);
the post-transaction period (between the transaction date and settlement date).
If an FEC exists before the transaction date and before a firm commitment is entered into, the
movement in the FEC rates up to the date that a firm commitment is made (or up to transaction
date, if no firm commitment is made) is always treated as a cash flow hedge.
In all other periods of the FEC’s existence, the FEC may be treated as either a cash flow hedge or
a fair value hedge.
Although IFRS 9 allows a hedge after transaction date to be treated either as a cash flow hedge or
a fair value hedge, this chapter, for the sake of simplicity, shall treat all hedges in the post-
transaction period as fair value hedges.
The following timeline summarises all the possible hedging treatments:

Transaction date

No firm commitment We are now committed
i.e. a hedge of a highly probable forecast transaction): i.e. a hedge of a transaction
Cash flow hedge Fair value hedge* OR Cash flow hedge
* this chapter will treat all hedges during this period as
fair value hedges
Firm commitment:
Before firm commitment: After firm commitment:
(uncommitted period) (committed period)
i.e. a hedge of a highly i.e. a hedge of a
probable forecast transaction firm commitment
Cash flow hedge Cash flow hedge or
Fair value hedge \]
Chapter 21 957
2.7 Cash flow hedge effectiveness (IFRS 9.6.5.11)
When dealing with cash flow hedges we have an additional consideration when it comes to hedge
effectiveness. Gains or losses on cash flow hedges are initially recognised in other comprehensive
income. However, if a cash flow hedge is considered to be overly-effective, the overly-effective
portion must be recognised in profit or loss instead. See IFRS 9.6.5.11 (b) & (c)
A cash flow hedge is used to protect the entity from changes in the expected cash flows. However,
sometimes the hedging instrument is more effective than we expect and offsets more than just the
movement in the cash flows of the hedged item. If this happens, any movement of the hedging
instrument that exceeds the cash flows being hedged, is considered to be the overly-effective
portion and must be recognised in profit and loss (i.e. not in other comprehensive income).
Example 4: Cash flow hedge effectiveness
Joe Limited entered into a highly probable forecast transaction (a forecast purchase) on
1 January 20X4.
On this date the spot rate was R7:$1 and the expected value was $100 000.
Due to the volatility of the Rand, Joe decided to enter into an FEC to hedge the currency
risk of the transaction.
The FEC stipulated a contract rate of R8:$1 and an expiry date of 30 June 20X4.
The transaction became a firm commitment on 1 March 20X4 on which date the rate of a
similar FEC expiring on 30 June 20X4 was R10:$1.
The expected payment date was 30 June 20X4.
Required: Provide the journal entries of the FEC only for the period the hedge was considered a highly
probable forecast transaction (up to 1 March 20X4) if the spot rate on 1 March 20X4 was:
a) R8.50:$1
b) R9.50:$1
Assume all hedging requirements were met (i.e. per IFRS 9.6.4), including hedge effectiveness.
Solution 4: Cash flow hedge effectiveness

Comment:
Since it is a hedge of a highly probable forecast transaction, it is accounted for as a cash flow hedge.
When accounting for a cash flow hedge, we need to ensure that, if the hedge is overly-effective, the
extent to which the hedge is overly-effective must be recognised in profit or loss (the effective portion
is recognised in other comprehensive income)
The hedge was overly-effective in part (a): the hedging instrument offsets more than just the movement
in the hedged item (i.e. it is overly-effective). Only the effective portion may be recognised as a cash
flow hedge (OCI), and the rest will be recognised in profit or loss.
The hedge was under-effective in part (b): the hedging instrument did not move in the opposite
direction to a sufficient extent to offset the movement in the hedged item. The entire movement in the
hedging instrument may thus be recognised in other comprehensive income.
Debit Credit
Part a): Journal on 1 March
FEC asset FEC Amt: $100 000 x (Similar FEC rates: R10 – 200 000
Actual FEC rate: R8)
Cash flow hedge (OCI) Limited to movement in hedged item: $100 000 x 150 000
(Spot rate now: R8.50 – Spot rate then: R7.00)
Foreign gain (P/L) Balancing figure 50 000
Cash flow hedge: gain/ loss recognised as OCI (limited to movement in
hedged item) - the overly-effective portion is recognised in profit or loss.
Part b) Journal on 1 March
FEC asset $100 000 x (R10 – R8) 200 000
Cash flow hedge (OCI) Not limited as movement not greater 200 000
Cash flow hedge: gain/ loss recognised as OCI (limited to movement in
hedged item) - there was no overly-effective portion as the movement in the
hedged item = $100 000 x (SR now: R9.50 – SR then: R7.00) = R250 000
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2.8 Accounting for hedges (IFRS 9.6.5)

2.8.1 Overview
It is important to always separate in your mind:

the hedged item: the basic foreign currency transaction; and
the hedging instrument: the forward exchange contract entered into.
2.8.2 Hedged item: foreign currency transaction
The foreign currency transaction (the hedged item) is initially accounted for:
on transaction date: using the spot rate on transaction date; and
the monetary item (e.g. debtor’s balance) is translated at reporting date and settlement date:
using the spot rate on these respective dates.
Any foreign exchange gain or loss on the translation of the monetary item is recognised directly in
profit or loss. This is covered in the chapter on foreign currency transactions.
2.8.3 Hedging instrument: forward exchange contract
The forward exchange contract (the hedging instrument) is accounted for either as a:
cash flow hedge; or
fair value hedge.
The forward exchange contract (the hedging instrument) would be measured at firm commitment
date, year-end, transaction and settlement dates. Any gain or loss resulting from the measurement
of the FEC is recognised as follows:
Fair value hedges are
for fair value hedges: accounted for as follows:
recognised directly in profit or loss; IFRS 9.6.5.8(a)
or
gains/ losses: recognised in P/L
for cash flow hedges:
recognised in other comprehensive income (this equity account could have either a debit
or credit balance!). IFRS 9.6.5.11(b)
If the forward exchange contract is accounted for as a cash flow hedge, the gain or loss that was
recognised in other comprehensive income (OCI) is eventually transferred out of OCI and will
eventually find itself in profit or loss. The transfer out of
Cash flow hedges are
OCI happens in one of two ways, either using a basis accounted for as follows:
adjustment of reclassification adjustment:
gains/ losses: recognised in OCI
using a basis adjustment: OCI is then transferred to P/L
The gain or loss recognised in OCI is transferred using either:
out of OCI and set-off against the carrying amount - a basis adjustment
of the hedged item (e.g. imported plant). - a reclassification adjustment
This happens on transaction date; or
using a reclassification adjustment:
The gain or loss recognised in OCI is transferred When do we transfer the
out of OCI by reclassifying it to profit or loss. gains/losses on a CFH from
IFRS 9.6.5.11(d)
The reclassification takes place on the date that the OCI to P/L?:
hedged item affects profit or loss. This means that basis adjustment: transaction date
reclassification adjustment: as and
the entire OCI could be reclassified to P/L: when the underlying asset/ liability
- in one reclassification adjustment (e.g. if all the affects P/L
imported inventory is sold at once, the
reclassification takes place on the date that the inventory is sold and gets expensed as
cost of sales) or
- it may need to be done over a period of time (e.g. if we are talking about imported
plant (PPE), the OCI balance will be reclassified to P/L over the useful life of plant
and thus the reclassification adjustments happen gradually as the plant is expensed as
depreciation ).
Chapter 21 959
Basis adjustments and reclassification adjustments have the same effect on profit over a period of
time. If the basis adjustment is used, other comprehensive income (equity) is eventually
recognised in profit or loss but only when the hedged item affects profit or loss (thus other
comprehensive income reaches profit or loss indirectly).
For example:
Imagine that a gain that was recognised as other comprehensive income (i.e. the OCI account will
have a credit balance) was subsequently credited to inventory via a basis adjustment (debit the
OCI balance; credit inventory): because inventory is decreased, future cost of sales will decrease –
which effectively represents an increase in profit or loss. Thus, the gain will be recognised in
profit or loss as and when the inventory (at the reduced cost) is expensed as cost of sales.
The basis adjustment is only allowed if the hedged forecast transaction is going to result in non-
financial assets or liabilities.
Reclassification adjustments are allowed whether the hedged forecast transaction results in assets
or liabilities that are financial or non-financial.
Whether the forward exchange contract (FEC) is entered into on/after or before transaction date
affects the accounting thereof:
Forward exchange contracts (FEC’s) that are entered into on or after transaction date are
simpler in the sense that we will only need worry about the date it was entered into (FEC date)
and then how to account for it on any subsequent reporting date and on the settlement date.
Forward exchange contracts (FEC’s) that are entered into before transaction date are slightly
more complex in that we must also worry ourselves about whether a firm commitment was
entered into before the transaction date and then also whether the FEC was entered into before
or after this firm commitment was entered into. Thus, if the FEC was entered into before
transaction date, we need to know how to account for the FEC on firm commitment date (if
applicable), on transaction date, on any subsequent reporting date and on settlement date.
We will thus start by explaining how to account for an FEC that was entered into on or after
transaction date (i.e. during the period post-transaction date) since it is slightly simpler (see
section 2.9). Then, once you have mastered how to account for this situation, we will explain how
to account for an FEC that was entered into before the transaction date (i.e. during the period pre-
transaction date) (see section 2.10).
2.9 FEC’s in the period post-transaction date
Transaction date Settlement date

Post-transaction period
If the FEC exists in the post-transaction period (i.e. on or after the transaction date) it can be
accounted for as either:
a fair value hedge; or
a cash flow hedge.
Whether the FEC after transaction date is treated as a fair Important dates in the
value hedge or a cash flow hedge has no effect on the profit post-transaction period:
or loss over a period of time. Thus, for the sake of
simplicity, we will assume that all FECs in existence after transaction date
transaction date are all fair value hedges. settlement date
reporting date (normally a financial
The dates that are important during this period obviously year-end)
include the transaction date; settlement date and reporting
date (normally a financial year-end). A financial year-end (reporting date) may not necessarily
occur between transaction and settlement date, but it is equally possible that there may even be
more than one reporting date between these two dates.
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Example 5: FEC taken out in the post-transaction period: fair value hedge
Inventory is purchased for $100 000. All inventory was sold on 15 July 20X1 for C1 000 000.
A FEC is taken out on transaction date at the FEC rate of C9: $1: the FEC will expire on payment date.
At 30 June 20X1 (year-end), the rate available on similar FEC’s expiring on this date is C9,50: $1.
Fair value hedge
1 March 20X1 30 June 20X1 7 July 20X1

Dates: Transaction date Year-end Payment date
and FEC date
FEC rates (expiry date: 7/07/X1) 9.00 9.50 N/A
Spot rate: 9.15 9.55 10
Required: Show all related journals assuming that this FEC has been designated as a fair value hedge.
Assume all hedging requirements are met.
Solution 5: FEC in the post-transaction period as a fair value hedge

By entering into the FEC, we know that we will have to pay $100 000 x 9 = C900 000 since this is the
rate we committed to in the FEC.
If we look at the spot rate on payment date, we can see that had we not taken out the FEC, we would
have had to pay $100 000 x 10 = C1 000 000.
The FEC has therefore saved us C1 000 000 – C900 000 = C100 000.
This gain is recognised over the life of the FEC (50 000 at year-end and 50 000 on payment date).
1 March 20X1: transaction date Debit Credit
Inventory 100 000 x 9.15 (spot rate on transaction 915 000
Foreign creditor date) 915 000
Inventory purchased, measured at spot rate on transaction date
30 June 20X1: year-end
Forex loss (profit or loss) 100 000 x 9.55: spot rate at year-end – 40 000
Foreign creditor 100 000 x 9.15 previous spot rate 40 000
Foreign creditor translated to spot rate at year-end – loss
FEC asset 100 000 x 9.50 FEC rate at year-end – 50 000
Forex gain (profit or loss) 100 000 x 9 FEC rate obtained 50 000
Gain or loss on FEC recognised at year-end – gain
7 July 20X1: payment date
Forex loss (profit or loss) 100 000 x 10: spot rate at payment date – 45 000
Foreign creditor translated on payment date
FEC asset 100 000 x 10 spot rate on payment date – 50 000
Forex gain (profit or loss) 100 000 x 9.50 prior FEC rate (30/6/X1) 50 000
Gain or loss on FEC recognised on payment date
Foreign creditor (915 000 + 40 000 + 45 000) 1 000 000
FEC asset (50 000 + 50 000) 100 000
Bank (100 000 x 9) 900 000
Payment of creditor at FEC rate: the rate we agreed to in the contract
15 July 20X1: on sale of inventory (not required)
Inventory 850 000
Debtor 1 000 000
Sales 1 000 000
100% of inventory sold: 850 000 x 100%
Comment: Notice the following:

The cost of inventory remained unchanged even though there were fluctuations in the exchange rates.
The basic foreign currency transaction and the FEC are dealt with separately.
Chapter 21 961
2.10 FEC’s in the period pre-transaction date

2.10.1 Overview
If an FEC is entered into prior to transaction date, the pre-transaction period will be the period
from when the FEC was entered into up to transaction date.
FEC date Transaction date
Pre-transaction period
Note: the FEC date (see above timeline) is the date on which the FEC is entered into.
If the FEC exists in the pre-transaction period (i.e. before the transaction date) it may be
accounted for as either:
a fair value hedge; or
a cash flow hedge.
Whether the FEC is to be accounted for as a fair value or cash flow hedge in the pre-transaction
period is largely dependent on whether a firm commitment was in existence or not. Thus, where
an FEC exists in the pre-transaction period, one must ascertain whether a firm commitment was
made before transaction date or not. If a firm commitment was made, we will also need to plot the
date that we made this firm commitment onto our timeline. All of this is explained below.
2.10.2 If there is no firm commitment
FEC date Transaction date
Pre-transaction period (uncommitted): always a cash flow hedge
If no firm commitment is made, a FEC existing before transaction date is hedging an uncommitted
but highly probable future transaction (also referred to as a hedged forecast transaction) and is
always treated as a cash flow hedge.
In this case:
any gains or losses on the FEC up to transaction date are first recognised as other
comprehensive income (i.e. as a cash flow hedge); and
on transaction date, the other comprehensive income is used to adjust the related asset or
liability (basis adjustment) or reclassify it to profit or loss when the related asset or liability
affects profit or loss (a reclassification adjustment);
any changes in the FEC rate after transaction date are either:
taken directly to profit or loss, as explained above (i.e. as a fair value hedge) or are
first recognised as other comprehensive income and then reversed to profit or loss (i.e. as
a cash flow hedge).
Once again, for the sake of simplicity, we will always account for a FEC that is in existence after
the transaction date as a fair value hedge.
Example 6: FEC taken out in the pre-transaction period (no firm commitment):
cash flow hedge with a basis adjustment
Inventory is purchased for $100 000. A FEC was entered into before transaction date.
No firm commitment was made before transaction date.
The FEC rate obtained was C9: $1. This FEC will expire on payment date.
FEC rates available on the relevant dates, on similar FEC’s that would expire on this same payment
date, are shown below.
40% of the inventory was sold on 15 July 20X1 for C400 000 and 60% of the inventory was sold on
20 August 20X1 for C600 00.
Cash flow hedge Fair value hedge
15 February 20X1 1 March 20X1 30 June 20X1 7 July 20X1

Dates: FEC date Transaction date Year-end Payment date
FEC rates: 9.00 9.10 9.60 N/A
Spot rate: 8.90 9.00 9.60 10
962 Chapter 21
Required: Show all related journal entries assuming that this FEC is accounted for:
as a cash flow hedge to transaction date (using the basis adjustment for the OCI); and
as a fair value hedge thereafter.
Assume all hedging requirements of IFRS 9 were met and that if the hedge was found to be overly-effective,
the portion that was overly effective was considered to be immaterial.
Solution 6: FEC taken out in the pre-transaction period (no firm commitment): cash flow
hedge with a basis adjustment
Quick explanation:
We will have to pay $100 000 x 9 = C900 000 since this is the rate we have committed to in the FEC.
If we look at the spot rate on payment date, we can see that had we not taken out the FEC, we would
have had to pay $100 000 x 10 = C1 000 000.
The FEC has therefore saved us C1 000 000 – C900 000 = C100 000.
15 February 20X1: FEC entered into Debit Credit

No entries relating to the FEC are processed as the passage of time is
necessary for the FEC to have value
1 March 20X1: transaction date
Inventory 100 000 x 9.00 (spot rate on 900 000
Foreign creditor transaction date) 900 000
Inventory purchased at spot rate on transaction date
FEC asset 100 000 x 9.10 FEC rate on 10 000
Cash flow hedge (OCI) transaction date – 100 000 x 9 FEC 10 000
rate obtained
Cash flow hedge: gain/ loss recognised on transaction date as OCI
Cash flow hedge (OCI) 10 000
Inventory 10 000
Basis adjustment of the cash flow hedge: OCI set-off against the hedged
item on transaction date
FEC asset 100 000 x 9.60 FEC rate at year end – 50 000
Forex gain (profit or loss) 100 000 x 9.10 previous FEC rate 50 000
Gain or loss on FEC recognised at year-end
Foreign creditor translated to spot rate at year-end
FEC asset 100 000 x 10 spot rate on payment date 40 000
Forex gain (profit or loss) – 100 000 x 9.60 previous FEC rate 40 000
Forex loss (profit or loss) 100 000 x 10: spot rate at year end – 40 000
Foreign creditor translated to spot rate on payment date
Chapter 21 963

7 July 20X1: payment date continued ... Debit Credit
FEC asset (10 000 + 50 000 + 40 000) 100 000
Bank (100 000 x 9) 900 000
Payment of foreign creditor at FEC rate: (C9: $1)
15 July 20X1: on sale of inventory
Cost of sales (900 000 – 10 000) x 40% 356 000
Inventory 356 000
Debtor Given 400 000
Sales 400 000
40% of inventory sold: sales and cost of sales
20 August 20X1: on sale of inventory
Cost of sales (900 000 – 10 000) x 60% 534 000
Inventory 534 000
Sales 600 000
60% of inventory sold: sales and cost of sales
Comment:
The basis adjustment decreases the cost of inventory.
This then decreases cost of sales as the inventory is sold.
The gain is thus indirectly taken to profit or loss as and when the hedged item affects profit/ loss.
Example 7: FEC taken out in the pre-transaction period (no firm commitment):
cash flow hedge with a reclassification adjustment
Required: Repeat example 6, assuming the entity used a reclassification adjustment for its other
Solution 7: FEC in the pre-transaction period (no firm commitment):

cash flow hedge with reclassification adjustments
Comment:
This example is the same as example 6 except that the other comprehensive income is reclassified.
The journal that reversed equity to inventory on transaction date in example 6 therefore does not
happen in example 7 when using a reclassification adjustment.
The other differences have been highlighted in the following journals with asterisks so that you are
better able to compare the journals of example 7 (reclassification adjustment) with those of example 6
(basis adjustment).
15 February 20X1: FEC entered into Debit Credit
No entries relating to the FEC are processed
Inventory 100 000 x 9.00 (spot rate on transaction 900 000
Foreign creditor date) 900 000
Inventory purchased recognised at spot rate on transaction date
FEC asset 100 000 x 9.10 FEC rate on transaction date 10 000
Cash flow hedge (OCI) – 100 000 x 9 FEC rate obtained 10 000
Cash flow hedge: gain/ loss recognised on transaction date is OCI
Foreign creditor translated to spot rate at year-end:
964 Chapter 21
7 July 20X1: payment date Debit Credit

Gain or loss on FEC recognised on payment date to profit & loss
Forex loss (profit or loss) 100 000 x 10: spot rate at payment date – 40 000
FEC asset (10 000 + 50 000 + 40 000) 100 000
Bank (100 000 x 9) 900 000
Payment of foreign creditor at FEC rate: C9: $1
15 July 20X1: sale of inventory
Cost of sales 900 000 x 40% 360 000
Inventory 360 000
Sales 400 000
40% of inventory sold: sales and cost of sales recognised
Cash flow hedge (OCI) 10 000 x 40% 4 000
FEC gain (P/L) 4 000
Reclassification adjustment of the cash flow hedge: reclassifying 40% of
the OCI to profit or loss when 40% of the inventory is sold
20 August 20X1: on sale of inventory
Cost of sales 900 000 x 60% 540 000
Inventory 540 000
Sales 600 000
60% of inventory sold: sales and cost of sales recognised
Cash flow hedge (OCI) 10 000 x 60% 6 000
FEC gain (P/L) 6 000
Reclassification adjustment of the cash flow hedge: reclassifying 60% of
the OCI to profit or loss when 60% of the inventory is sold
Comment: By the way, if the entity had purchased an item of property, plant and equipment (instead of an
item of inventory) and had chosen to use a reclassification adjustment, then the FEC equity (OCI) would be
recognised as a gain (or as a loss, as the case may be) over the useful life of the asset (i.e as the depreciation
effects the “cash flows” of the company). Compare this to where a gain is recognised as inventory is sold.
2.10.3 If there is a firm commitment
FEC date Firm commitment Transaction date
Pre-transaction period
Uncommitted Committed
Always a cash flow hedge Cash flow hedge/ Fair value hedge
If the FEC exists before transaction date and a firm commitment (e.g. a firm order) is entered into,
the pre-transaction period is split into:
before firm commitment is made: the uncommitted period; and
after the firm commitment is made (but before transaction date): the committed period.
An FEC before commitment date (i.e. during an uncommitted period) is always accounted for:
as a cash flow hedge, (there is no option here): This was explained in the previous section and
in examples 6 and 7.
Chapter 21 965
An FEC after commitment date but before transaction date (i.e. during the committed period) may
be accounted for either:
as a cash flow hedge Note 1; or
as a fair value hedge.
Note 1: The FEC in a committed period may only be accounted for as a cash flow hedge if it is
specifically a hedge against the foreign currency risk. (IFRS 9.6.5.4)
The principles when accounting for an FEC as a cash flow hedge during the committed period are
the same as the principles when accounting for an FEC as a cash flow hedge during the
uncommitted period and will thus not be explained further.
If the entity chooses to account for the movement in the FEC rates during the committed period as
a fair value hedge, then the effect of the movement in both the spot rate and the FEC rates must be
recorded as follows IFRS 9.6.5.9 – 10 If we account for an FEC
firm commitment asset/ liability: as a FVH during the
measured using: the movement in the spot rates committed period:
recognise an FEC asset/ liability
journalised as: (measured at FEC rates) and
Dr/ Cr: Firm commitment asset/ liability and recognise a FC asset/ liability
Cr/ Dr Forex gains/losses (Profit or loss) (measured at spot rates).
reversed when: the firm commitment asset or liability is recognised on transaction date
(transferred to the related transaction);
forward exchange contract asset/ liability:
measured using: the movement in the FEC rates
journalised as:
Dr/ Cr: FEC asset/ liability and
Cr/ Dr Forex gains/losses (Profit or loss)
reversed when: the FEC asset or liability is ultimately settled.
Example 8: FEC taken out in the pre-transaction period: firm commitment as a

cash flow hedge
This example is the same as example 6 except that a firm commitment was entered into before
transaction date. The details from example 6 together with the details on the date the firm commitment was
made are given below.
Inventory is purchased for $100 000. A FEC is taken out before transaction date. After the FEC was taken
out, a firm commitment was made.
The FEC rate obtained was C9: $1. This FEC will expire on payment date.
FEC rates available on the relevant dates, on similar FEC’s that would expire on the same payment
date, are shown below. 40% of the inventory was sold on 15 July 20X1 for C400 000 and 60% of the
inventory was sold on 20 August 20X1 for C600 000.
Cash flow hedge Fair value hedge
15 Feb 20X1 22 February 20X1 1 March 20X1 30 June 20X1 7 July 20X1
FEC taken out Firm commitment Transaction date Year-end Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.96 9.00 9.60 10.00
Required:
Show only the extra journals relating to the firm commitment (i.e. you are not required to repeat the journals
that were given to example 6) assuming that the FEC is to be accounted for as:
a cash flow hedge for the entire period before transaction date; and
a fair value hedge after transaction date.
Assume all requirements of IFRS 9 were met and that any overly-effective portion of this cash flow hedge
would be considered to be immaterial.
966 Chapter 21
Solution 8: Firm commitment to transaction date as a cash flow hedge

There are no further journal entries to account for the fact that the entity has placed a firm order before the
transaction date is reached if the entity accounts for the hedge during this committed period (i.e. the period
between placing a firm order and the transaction date) as a cash flow hedge, as they are accounted for in the
same manner. The journals in such a situation would be identical to the journals presented in example 6.
Example 9: FEC taken out in the pre-transaction period: firm commitment as a

fair value hedge
Required: Show all journals using the information in example 8, except that the FEC is to be treated:
as a cash flow hedge before firm commitment date (using the basis adjustment); and
as a fair value hedge after firm commitment date
The revised timeline will look as follows:
Cash flow hedge Fair value hedge Fair value hedge
15 Feb 20X1 22 February 20X1 1 March 20X1 30 June 20X1 7 July 20X1
FEC taken out Firm commitment Transaction date Year-end Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.96 9.00 9.60 10.00
Solution 9: FEC taken out in the pre-transaction period: firm commitment as a FV hedge
Comment:
When a FEC exists before the firm commitment, there is no choice: it is always a cash flow hedge.
As with the previous examples, the FEC has saved us C1 000 000 – C900 000 = C100 000.
This gain is recognised as the hedged item affects profit or loss (the cash flow hedge: C6 000 as the
inventory is sold; and the fair value hedges: C4 000 on transaction date, C50 000 at year-end and
C40 000 on payment date)
15 February 20X1: date FEC entered into Debit Credit
22 February 20X1: firm commitment date
FEC asset 100 000 x 9.06 FEC rate on firm commit 6 000
Cash flow hedge (OCI) date – 100 000 x 9 FEC rate obtained) 6 000
Gain or loss on FEC recognised on firm commitment date
Inventory 100 000 x 9.00 (spot rate on transaction date) 900 000
Foreign creditor 900 000
Cash flow hedge (OCI) 6 000
Inventory 6 000
CFH: basis adjustment: tfr OCI to the hedged item on transaction date
FEC asset 100 000 x 9.10 FEC rate on transaction 4 000
Forex gain (profit or loss) date – 100 000 x 9.06 previous FEC rate 4 000
Gain or loss on FEC recognised on transaction date:
Forex loss (profit or loss) 4 000
Firm commitment liability 4 000
Gain or loss on firm commitment on transaction date: 100 000 x 9.00 spot rate
on transaction date – 100 000 x 8.96 spot rate on firm commitment date
Firm commitment liability 4 000

Inventory 4 000
Firm commitment transferred to the hedged item on transaction date
Chapter 21 967

30 June 20X1: year-end Debit Credit
Gain or loss on FEC recognised at year-end:
Foreign creditor translated to spot rate at year-end
Forex loss (profit or loss) 100 000 x 10: spot rate on payment date – 40 000
Foreign creditor translated on payment date
FEC asset (6 000 + 4 000 + 50 000 + 40 000) 100 000
Bank (100 000 x 9) 900 000
Payment of foreign creditor at FEC rate obtained: C9: $1
15 July 20X1: date of sale of inventory
Cost of sales (900 000 – 6 000 – 4 000) x 40% 356 000
Inventory 356 000
Sales 400 000
40% of inventory sold: sales and cost of goods sold
20 August 20X1: date of sale of inventory
Cost of sales (900 000 – 6 000 – 4 000) x 60% 534 000
Inventory 534 000
Sales 600 000
60% of inventory sold: sales and cost of goods sold
Notice that when using this basis adjustment approach to reversing OCI, the inventory is measured as follows:
Inventory recognised at spot rate on transaction date 100 000 x 9.00 900 000
Firm commitment liability reversed to inventory on transaction date (4 000)
FEC equity (OCI) reversed to inventory on transaction date (cash flow hedge) (6 000)
890 000
Had we used the reclassification approach instead, the OCI would have been reclassified directly to profit or loss and
would not have affected the inventory. The inventory would thus have been measured at the spot rate on the date that
the firm commitment was made:
Inventory recognised at spot rate on transaction date 100 000 x 9.00 900 000
Firm commitment liability reversed to inventory on transaction date (4 000)
100 000 x 8.96 896 000
Example 10: FEC taken out in the pre-transaction period with a year-end after
firm commitment but before transaction date
Inventory is purchased for $100 000. A FEC is taken out before transaction date and before a
firm commitment was made and will expire on 31 August (payment date).
FEC rates available on FEC’s expiring on 31 August 20X1 are shown below.
40% of this inventory was sold on 27 September 20X1 and 60% on 1 November 20X1.
968 Chapter 21
The timeline will look as follows:

1 March 20X1 15 April 20X1 30 June 20X1 20 July 20X1 31 August 20X1
FEC taken out Firm commitment Year-end Transaction date Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.96 9.00 9.60 10.00
The FEC is to be treated as:

A cash flow hedge before firm commitment date
A fair value hedge after firm commitment date.
Required: Show the related journals assuming that:
A. the basis adjustment approach is used for its cash flow hedges.
B. the reclassification approach is used for its cash flow hedges.
You may assume that all hedging requirements were met and that any portion of a cash flow hedge that may
be overly-effective would have been considered to be immaterial.
Solution 10: FEC taken out in the pre-transaction period with a year-end after firm
commitment but before transaction date
Ex 10A Ex 10B
1 March 20X1: date FEC entered into Dr/ (Cr) Dr/ (Cr)
15 April 20X1: firm commitment date
FEC asset 100 000 x 9.06 FEC rate on firm commitment 6 000 6 000
Cash flow hedge (OCI) date – 100 000 x 9 FEC rate obtained (6 000) (6 000)
Gain or loss on FEC recognised on firm commitment date
FEC asset 100 000 x 9.10 FEC rate at year-end – 100 000 4 000 4 000
Forex gain (profit or loss) x 9.06 previous FEC rate (4 000) (4 000)
Forex loss (profit or loss) 100 000 x 9.00 spot rate at yr-end – 100 000 x 4 000 4 000
Firm commitment liability 8.96 spot rate on firm commitment date (4 000) (4 000)
Gain or loss on firm commitment recognised at year-end
20 July 20X1: transaction date
Inventory 100 000 x 9.6 spot rate on transaction date 960 000 960 000
Foreign creditor (960 000) (960 000)
FEC asset 100 000 x 9.60 FEC rate on transaction date – 50 000 50 000
Forex gain (P/L) 100 000 x 9.10 previous FEC rate (50 000) (50 000)
Gain or loss on FEC recognised on transaction date
Forex loss (P/L) 100 000 x 9.60 spot rate on trans date – 60 000 60 000
Firm commitment liability 100 000 x 9.00 prior spot rate (60 000) (60 000)
Gain or loss on firm commitment recognised on transaction date
Firm commitment liability (4 000 + 60 000) 64 000 64 000
Inventory (64 000) (64 000)
Firm commitment reversed to inventory on transaction date
Cash flow hedge (OCI) ONLY Part A: 6 000 N/A
Inventory (6 000) N/A
Cash flow hedge – basis adjustment: transferring OCI against the hedged
item on transaction date
Chapter 21 969

Ex 10A Ex 10B
Dr/ (Cr) Dr/ (Cr)
31 August 20X1: payment date
FEC asset 100 000 x 10 spot rate on payment date – 40 000 40 000
Forex gain (P/L) 100 000 x 9.60 previous FEC rate (40 000) (40 000)
Forex loss (P/L) 100 000 x 10 spot rate on payment date – 40 000 40 000
Foreign creditor 100 000 x 9.60 previous spot rate (40 000) (40 000)
Foreign creditor (960 000 + 40 000) 1 000 000 1 000 000
FEC asset (6 000 + 4 000 + 50 000 + 40 000) (100 000) (100 000)
Bank (100 000 x 9 FEC rate obtained) (900 000) (900 000)
Foreign creditor paid at FEC rate obtained:
27 September 20X1: sale of 40% of the inventory
Cost of sales Part A: (960 000 – 64 000 – 6 000) x 40% 356 000 358 400
Inventory Part B: (960 000 – 64 000) x 40% (356 000) (358 400)
40% of inventory sold
Cash flow hedge (OCI) ONLY Part B: 6 000 x 40% N/A 2 400
FEC gain (P/L) N/A (2 400)
Cash flow hedge – reclassification adjustment: reclassifying 40% of the
OCI to profit or loss when 40% of the inventory is sold
1 November 20X1: sale of 60% of the inventory
Cost of sales Part A: (960 000 – 64 000 – 6 000) x 60% 534 000 537 600
Inventory Part B: (960 000 – 64 000) x 60% (534 000) (537 600)
60% of inventory sold
Cash flow hedge (OCI) ONLY Part B: 6 000 x 60% N/A 3 600
FEC gain (P/L) N/A (3 600)
Cash flow hedge – reclassification adjustment: reclassifying 60% of the
OCI to profit or loss when 40% of the inventory is sold
3. Tax Consequences
The current South African Tax Act and the IFRSs treat foreign exchange gains or losses and
forward exchange contracts in almost the same way (s24I of the SA Income Tax Act).
The Tax Act measures the tax base of an item at the spot rate on transaction date (s25D), which is
the same as the measurement of the item in terms of the IFRSs and thus there are generally no
temporary differences as the carrying amount and tax base would be the same.
Deferred tax could arise, however, from foreign exchange transactions and forward exchange
contracts in the following situations:
When the asset acquired is listed under s24I(7), the foreign exchange gain or loss and forward
exchange contract gain or loss are deferred and only recognised for tax purposes (i.e. taxed or
deducted) once the asset is brought in use. Thus, the entity may, for example, have a carrying
amount on its FEC asset but no related tax base as the asset is only recognised for tax
purposes in the future.
Deferred tax is provided on the equity (other comprehensive income) arising from a cash flow
hedge. This deferred tax is reversed according to the method used by the entity:
reclassification or basis adjustment.
970 Chapter 21
4. Disclosure (IAS 32 and IFRS 7)
Disclosure requirements for hedges are set out in IAS 32 and IFRS 7.
An entity shall describe its financial risk management objectives and policies including its policy
for hedging each main type of forecast transaction that is accounted for as a hedge.
An entity shall disclose the following for designated fair value and cash flow hedges:
a description of the hedge;
a description of the financial instruments designated as hedging instruments and their fair
values at the end of the reporting period;
the nature of the risks being hedged; and
for cash flow hedges: the periods in which the cash flows are expected to occur, when they are
expected to affect profit or loss and a description of any forecast transaction for which hedge
accounting had been used but which is no longer expected to occur.
When a gain or loss on a hedging instrument in a cash flow hedge has been recognised in other
comprehensive income, an entity shall disclose the amount that was:
recognised in other comprehensive income during the period;
reclassified from equity and included in profit or loss for the period (reclassification
adjustment); and
removed from other comprehensive income during the period and included in the initial
measurement of the acquisition cost or carrying amount of a non-financial asset or non-
financial liability (basis adjustment).
Example 11: Disclosure: cash flow hedge: basis versus reclassification adjustments
Inventory is purchased for $100 000. A FEC is taken out before transaction date and before a firm
commitment was made and will expire on 31 August (payment date).
40% of this inventory was sold on 27 September 20X1 and 60% on 1 November 20X1.
FEC rates available on FEC’s expiring on 31 August 20X1 are shown below.
1 March 20X1 15 April 20X1 30 June 20X1 20 July 20X1 31 August 20X1
FEC taken out Firm commitment Year-end Transaction date Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.10 8.30 8.45 8.50 10.00
The hedge between the firm commitment date and the transaction date is to be recognised as a fair value
hedge and that after transaction date, the hedge is also to be treated as a fair value hedge.
20X2 20X1
Revenue 1 000 000 600 000
Cost of sales ? 0
Revenue in 20X2 was constituted entirely by the 2 sales transactions involving the imported inventory.
Revenue in 20X1 was constituted entirely by services rendered.
Required:
Provide the disclosure for the year ended 30 June 20X2 (ignore tax) assuming:
A The entity uses the basis adjustment approach for cash flow hedges
B The entity uses the reclassification approach for cash flow hedges.
You may assume that all hedging requirements were met and that any portion of a cash flow hedge that may
be overly-effective would have been considered to be immaterial.
Chapter 21 971
Solution 11A: Disclosure: cash flow hedge: basis adjustment

Apple Limited
For the year ended 30 June 20X2
Notes 20X2 20X1
C C
Revenue 1 000 000 600 000
Cost of sales (329 600 + 494 400) (824 000) (0)
Other income 90 000 4 000
Other expenses (155 000) (15 000)
Tax expense (ignored) 0 0
Other comprehensive income for the year 11 (6 000) 6 000
Items that may be reclassified to profit
or loss:
- Cash flow hedges, net of tax (6 000) 6 000
Items that may never be reclassified to profit or loss: 0 0
Total comprehensive income for the year 105 000 595 000
Apple Limited
Retained Cash flow Total
earnings hedges
C C C
Balance 1/7/20X0 xxx 0 xxx
Balance 30/6/20X1 xxx 6 000 xxx
Apple Limited
20X2 20X1
This is stated after taking into account the following separately disclosable (income)/ expense items
Foreign exchange gain 20X2: 50 000 (2) + 40 000 (3) (90 000) (4 000) (1)
Foreign exchange loss 20X2: 5 000 (5) + 150 000 (6) 155 000 15 000 (4)
11. Other comprehensive income

-Items that may be reclassified to profit or loss:
Gain arising during the year on movement in cash flow hedge 6 000
Basis adjustment (adjustment for amounts transferred to the initial (6 000)
carrying amounts of the hedged items)
-Items that may not be reclassified to profit or loss:
(1) (9.10 – 9.06) x $100 000 = R4 000 (gain on FEC FV hedge at year-end)
(2) (9.60 – 9.10) x $100 000 = R50 000 (gain on FEC FV hedge on transaction date)
(3) (10.00 – 9.60) x $100 000 = R40 000 (gain on FEC FV hedge on payment date)
(4) (8.45 – 8.30) x $100 000 = R15 000 (loss on translation of firm commitment at year-end)
(5) (8.50 – 8.45) x $100 000 = R5 000 (loss on translation of firm commitment on transaction date)
(6) (10.00 – 8.50) x $100 000 = R150 000 (loss on translation of creditor on payment date)
972 Chapter 21
Solution 11B: Disclosure: cash flow hedge: reclassification adjustment

The main difference from 11A have been highlighted with asterisks so that you are better able to compare
11A and 11B
Apple Limited
Notes 20X2 20X1
C C
Revenue 1 000 000 600 000
Cost of sales (332 000 + 498 000) * (830 000) (0)
Other income A=(6000 + 90 000) B= 4000 10 * 96 000A 4 000B
Other expenses 10 (155 000) (15 000)
Tax expense (ignored) 0 0
Other comprehensive income for the year 11 (6 000) 6 000
- Cash flow hedges, net of tax (6 000) 6 000
Items that may never be reclassified to profit or loss 0 0
Apple Limited
Retained earnings Cash flow hedges Total
C C
C
Balance 30/6/20X1 xxx 6 000 xxx
Apple Limited
20X2 20X1
This is stated after taking into account the following separately disclosable (income)/ expense items
Foreign exchange gain 20X2: 50 000 (2) + 40 000 (3) (90 000) (4 000) (1)
Foreign exchange loss 20X2: 5 000 (5) + 150 000 (6) 155 000 15 000 (4)
FEC gain: reclassification adjustment* (6 000)
11. Other comprehensive income

Gain arising during the year on movement in cash flow hedge 0 6 000
Reclassification adjustment to profit or loss (2400 + 3600)* (6 000) 0
-Items that may not be reclassified to profit or loss:
(1) (9.10 – 9.06) x $100 000 = R4 000 (gain on FEC FV hedge at year-end)
(2) (9.60 – 9.10) x $100 000 = R50 000 (gain on FEC FV hedge on transaction date)
(3) (10.00 – 9.60) x $100 000 = R40 000 (gain on FEC FV hedge on payment date)
(4) (8.45 – 8.30) x $100 000 = R15 000 (loss on translation of firm commitment at year-end)
(5) (8.50 – 8.45) x $100 000 = R5 000 (loss on translation of firm commitment on transaction date)
(6) (10.00 – 8.50) x $100 000 = R150 000 (loss on translation of creditor on payment date)
Chapter 21 973
5. Summary
FECs and Important Dates /

Periods
Trans highly Firm commitment Transaction Transaction

probable made happens Settled
F-Commitment date Transaction date Settlement date
Hedge of a Hedge of a Hedge of a

forecast transaction firm commitment transaction
N/A N/A
Uncommitted period Committed period Transaction period
CFH CFH/ FVH FVH *
*: For purposes of this text, please assume all FECs after transaction date (i.e. during the post-
transaction period) are fair value hedges.
Accounting for FECs:
Fair value hedges Cash flow hedges

Gains and Losses: Gains and Losses:
go directly to P/L go first to OCI and
then go to P/L
If FEC is a FVH between FCD and TD, then
track gains or losses on FC as well (use SR
though!)
Reclassification Adjustment Basis Adjustment
Affects P/L Directly Affects P/L Indirectly
Journals: Journals:
Debit: OCI Debit: OCI
Credit: P/L Credit: the hedged item (e.g. PPE)
Or vice versa Or vice versa
This transfer is done gradually as and when the This transfer is done on transaction date (e.g.
hedged item affects profit or loss (e.g. when when inventory or PPE is purchased) and will
inventory is sold or PPE depreciated) thus affect P/L when the item (e.g. inventory/
PPE) affects P/L
The basis adjustment may not be used

if the related asset is a financial
asset/ liability
974 Chapter 21
Gripping GAAP Financial instruments
Chapter 22
Financial Instruments
Reference: IAS 1, IAS 32, IAS 39, IFRS 7, IFRS 9, and IFRS 13, IFRIC 19 (updated to July
2014)
Contents: Page
1. Introduction 977
2. Financial instruments 978
3. Financial assets 978
3.1 Financial assets: identification 978
Example 1: Financial assets 979
Example 2: Financial assets and financial instruments 979
3.2 Financial assets: classification 979
3.2.1 Overview 979
3.2.2 The business model criteria 981
Example 3: Classifying financial assets – considering the business model 981
3.2.3 The contractual cash flows criteria 982
Example 4: Classifying financial assets – considering the cash flows 982
3.3 Financial assets: recognition 982
3.4 Financial assets: measurement 982
3.4.1 Overview 982
3.4.1.1 Initial measurement: discussion of fair value and
transaction costs 983
3.4.1.2 Initial measurement: discussion of the loss allowance account
(impairments) 983
3.4.1.3 Initial measurement: discussion of fair value and day one gains
or losses 983
3.4.1.4 Subsequent measurement 983
Example 5: Simple interest calculation 984
3.4.2 Financial assets: measurement at fair value 985
Example 6: Fair value through profit or loss financial assets 986
Example 7: Fair value through other comprehensive income 987
3.5 Financial assets: de-recognition 987
4. Financial liabilities 988
4.1 Financial liabilities: identification 988
Example 8: Financial liabilities 988
4.2 Financial liabilities: classification 989
4.2.1 Overview 989
4.2.2 Financial liabilities at fair value through profit or loss 989
4.2.3 Financial liabilities at amortised cost 990
4.3 Financial liabilities: recognition 990
4.4 Financial liabilities: measurement at amortised cost 990
Example 9: Other financial liabilities 990
4.5 Financial liabilities: measurement at fair value through profit or loss 991
Example 10: Fair value through profit or loss 991
Example 11: Fair value through profit or loss with change in credit risk 992
4.6 Financial liabilities: de-recognition 992
5. Reclassification of financial instruments 993
5.1 Reclassifications overview 993
Example 12: Reclassification date 994
5.2 Reclassifying to fair value through profit or loss 994
Chapter 22 975

Example 13: Reclassifications of financial asset to fair value 995
5.3 Reclassifying to amortised cost 996
Example 14: Reclassification of financial asset to amortised cost 996
6. Compound financial instruments 997
Example 15: Splitting of compound financial instruments 998
Example 16: Compulsorily convertible preference shares 999
Example 17: Redeemable debentures issued at a discount 1000
7. Settlement in entity’s own equity instruments 1002
Example 18: Settlement in entity’s own equity instruments 1002
8. Derivatives 1002
8.1 Overview 1002
8.2 Options 1003
8.3 Swaps 1003
Example 19: Swaps 1003
8.4 Futures and forwards 1004
8.5 Embedded derivatives 1004
9. Impairment of financial assets 1004
9.1 Overview 1004
9.2 Expected credit loss model – the general approach 1005
9.2.1 Overview of the general approach 1005
9.2.2 Assessment of credit risk 1006
9.2.3 If no significant increase in credit risk 1007
Example 20: Expected credit loss measurement 1007
9.2.4 Significant increase in credit risk 1007
Example 21: Expected credit loss measurement – change in credit risk 1007
Example 22: Expected credit loss measurement – change in credit risk 1008
9.2.5 If the asset becomes credit-impaired 1009
Example 23: Simplified approach – trade receivables 1010
9.3 Expected credit loss model – the simplified approach 1010
Example 24: Expected credit loss measurement – simplified approach 1010
9.4 Measurement of expected credit losses 1011
10. Offsetting of financial assets and liabilities 1012
11. Financial risks 1012
11.1 Overview 1012
11.2 Market risk 1012
11.2.1 Interest rate risk 1013
11.2.2 Currency risk 1013
11.2.3 Other price risk 1013
11.3 Credit risk 1013
11.4 Liquidity risk 1013
12. Disclosure 1013
13. Summary 1017
976 Chapter 22
1. Introduction
With the completion of IFRS 9, the mystery that was financial instruments has now been
simplified. IFRS 9 is a new standard that replaced IAS 39 and deals with the classification,
measurement, impairments, and hedge accounting of financial instruments.
IFRS 9 is effective for financial years ending on or after 1 January 2018, but may be applied
from an earlier date.
IFRS 9 differs from IAS 39 in the sense that it advocates a principles-based model for the
classification and measurement of financial instruments. The table below summarises the
changes which occurred through the development of IFRS 9:
Differences between IAS 39 and IFRS 9

IAS 39 IFRS 9
Asset classification: Asset classification:
Financial assets were classified into 4 categories The classification has been simplified with only
which would ultimately affect the measurement of two categories within which to classify financial
the asset. They were: assets:
Fair value through profit or loss Fair value
Held-to-maturity Amortised cost
Loans and receivables
The criteria to classify the financial asset into the
Available-for-sale
categories have also been simplified.
Hybrid instrument classification: Hybrid instrument classification:
Embedded derivatives (a non-derivative host The embedded derivative contract must not be
contract with an embedded derivative) required split and the entire contract is accounted for as
the entity to split the instrument and allowed three one instrument provided the requirements in
different ways of then classifying the instrument. IFRS 9 are met.
Asset measurement: Asset measurement:
Each category was measured in its own way. The fair value through profit or loss and the
Fair value through profit or loss was measured at amortised cost methods are still measured in the
FV with changes going through the P/L section. same manner as previously under IAS 39.
Held-to-maturity assets and loans and receivables
were measured at amortised cost using the An entity will have the option on initial
effective interest rate method and available-for- recognition to designate an equity instrument at
sale financial assets were measured at FV with fair value through other comprehensive income.
changes going through OCI.
Impairment requirements were also unique to
each measurement method.
Asset reclassification: Asset reclassification:
Different criteria existed to reclassify a financial The rules for reclassification have been
asset. Numerous prohibitions existed with regards simplified. The entity is to reclassify between the
to which assets could be reclassified, how they two when the business model changes.
would be subsequently measured and where they Reclassification is conducted prospectively.
could be reclassified to.
Equity instruments: Equity instruments:
No provisions were made. On initial recognition the entity may designate
equity investments to be fair value through other
comprehensive income if such instruments are not
held for trading. (IFRS 9.5.7.5)
Liabilities classification: Liabilities classification:
Two categories existed: The same two classification categories exist:
Fair value through profit or loss Fair value through profit or loss
Amortised cost Amortised cost
Chapter 22 977
Differences between IAS 39 and IFRS 9 continued …

IAS 39 IFRS 9
Liability measurement: Liability measurement:
Liabilities classified under the amortised cost Liabilities classified under the amortised cost
method are measured using the effective interest method are still accounted for in the same manner
rate method. The interest expense to be as before. Amortised cost method with interest
recognised in profit or loss is the amount owing expense recognised in profit and loss.
multiplied by the effective interest rate.
Liabilities classified as fair value through profit or Liabilities classified at fair value through profit or
loss, had all their gains and losses recognised in loss must split their gains or losses: the gain or
profit or loss. loss due to changes in credit risk is recognised in
OCI (IFRS 9.5.7.7) and may not be reclassified to
P/L and the remaining gain or loss (not due to
changes in credit risk) is recognised in P/L.
The definitions that follow are important for you to know in relation to this chapter. They
come from a variety of standards, namely IFRS 7, IFRS 9, IFRS 13 and IAS 32.
The following definitions are important for this chapter:-

1. Amortised cost of a financial asset/liability, 8. Financial asset
2. Credit risk 9. Financial instrument
3. Derivative 10. Financial liability
4. Effective interest rate method 11. Financial liability at fair value through P/L
5. Equity instrument 12. Held for trading
6. Expected credit losses 13. Reclassification date
7. Fair value 14. Transaction costs
2. Financial Instruments
A financial instrument is either a financial asset or financial liability. IAS 32 provides

definitions for each of these three terms.
A financial instrument is
defined as:
If you look carefully at the definition of a financial
instrument (see pop-up), you will see that of critical any contract that gives rise to
a financial asset of one entity &
importance is that, first and foremost, it involves a a financial liability or equity
contract (this can even be a verbal contract, but, instrument of another entity IAS 32.11
whatever its form, there must be a contract). This
contract must lead to a financial asset in one entity and either a financial liability or equity
instrument in the other entity.
Interestingly, since a financial instrument involves a contract, by very definition a financial
asset is not always a financial instrument (i.e. if the asset does not involve a contract).
3. Financial Assets (IFRS 9. 4.1.1 – 4.4.3)
3.1 Financial assets: identification (IAS 32.11) A financial asset is defined

as
For an item to be identified as a financial asset, it must Cash,
meet the definition of a financial asset: Equity instrument of another entity
Cash; or Contractual right to:
An equity instrument of another entity, or - receive cash or other fin asset; or
A contractual right to receive cash or another - exchange financial A/L under
potentially favourable conditions;
financial asset from another entity; or or
A contractual right to exchange financial assets or Certain contracts to be settled in
financial liabilities with another entity under equity instrumentsIAS 32.11 (summarised)
conditions that are potentially favourable to the entity; or
978 Chapter 22
A contract that will or may be settled in the entity’s own equity instruments and is
- A non-derivative for which the entity is or may be obliged to receive a variable
number of the entities’ own equity instruments, or
- A derivative that will or may be settled other than by the exchange of a fixed amount
of cash or another financial asset for a fixed number of the entity’s own equity
instruments.
Example 1: Financial assets
Discuss whether any of the following are financial assets:
a. Inventory
b. Debtors
c. Cash
d. Property, plant and equipment
e. Prepaid expense
Solution 1: Financial assets
a. No, there is no contractual agreement to receive cash or otherwise simply by holding stock.
b. Yes, there is a contractual right to receive a payment of cash from the debtor.
c. Yes, it is cash
d. No, owning property, plant and equipment does not arise from a contractual right to cash or
other instrument.
e. No, there is a contractual right to receive goods and services and not a right to receive cash or
a financial asset.
Example 2: Financial assets and financial instruments
Explain briefly whether the following would be financial assets and financial instruments:
a. petty cash or cash floats held by an entity;
b. a deposit of cash with a bank or a similar financial institution
Solution 2: Financial assets and financial instruments
a. Petty cash or cash floats held by an entity will be a financial asset (since it meets the definition
thereof, being ‘cash’) but it is not a financial instrument as no contract exists.
b. A cash deposit is a financial asset (since it meets the definition thereof, being ‘cash’). It is also a
financial instrument since it represents the contractual right of the depositor to obtain cash from the
institution or to draw a cheque against the balance. IAS32.AG3
3.2 Financial assets: classification

3.2.1 Overview Fair value is defined as
There are two classifications of financial assets, classified The price that would be
according to measurement models: received to sell an asset or
Financial assets at amortised cost; and paid to transfer a liability
Financial assets at fair value. in an orderly transaction between
market participants
A financial asset shall be classified as amortised cost if both at measurement date. IAS 32.11
the following conditions are met (see IFRS 9.4.1.2):
The business model: if the business model is to collect contractual cash flows (i.e. the
entity does not intend dealing in the instruments), and
Contractual cash flow characteristics: if the contractual Amortised cost of a
terms of the financial asset give rise on specified dates financial asset/financial
liability is defined as
to cash flows that are solely payments of principal and
The amount at which the FA/FL is
interest (SPPI) on the principal amount outstanding. measured at initial recognition
minus the principal payments
If both these conditions are not met, the asset must be Less/add: cumulative amortisation
classified and measured at fair value. using the effective interest rate
method to account for the
Financial assets at fair value are sub-categorised as financial difference between the initial
assets: amount and maturity amount.
at fair value through other comprehensive income; and For financial assets: the amortised
at fair value through profit or loss. cost is also adjusted for any loss
allowance. IFRS 9 Appendix A (reworded)
Chapter 22 979
A financial asset shall be classified as fair value through other comprehensive income if both
the following conditions are met:
The business model: if the business model is to collect both contractual cash flows and
cash flows from selling the asset, and
Contractual cash flow characteristics: if the contractual terms of the financial asset give
rise on specified dates to cash flows that are solely payments of principal and interest
(SPPI) on the principal amount outstanding. See IFRS 9.4.1.2A
A financial asset shall be classified as fair value through profit or loss if it:
does not meet the criteria for classification at amortised cost; and
does not meet the criteria for classification as fair value through other comprehensive
income
unless the financial asset is an investment in equity instruments held for trading and the
entity elects to classify the as fair value through other comprehensive income. See IFRS 9.4.1.4
The above election to classify the financial asset as fair value through other comprehensive
income (i.e. instead of at fair value through profit or loss), is an irrevocable election (i.e. the
entity may not subsequently decide it would actually prefer to classify the financial asset as
fair value through profit or loss).
Despite the normal classification process described above, an entity may choose to designate
a financial asset as fair value through profit or loss if the other classifications would lead to
an accounting mismatch. This option to designate as fair value through profit or loss is only
available on initial recognition and would be an irrevocable designation (i.e. the entity may
not subsequently decide it would prefer to classify the financial asset as amortised cost etc).
Example of an accounting mismatch: An accounting mismatch can happen in a hedging
relationship where, for example, an asset is bought in order to offset risks in a liability and
where the liability is, for example, to be measured at fair value and yet the asset would
otherwise be measured at amortised cost. The result of this would be that the gains and losses
on the asset and liability would be recognised in different periods and on different bases. To
avoid this, one can designate the asset to be measured at fair value through profit or loss.
This classification process can be summarised as follows:

Consider the contractual cash flows:
Do the contractual terms of the FA give rise,
on specified dates,
to cash flows that are solely payments of :
- principal and
- interest (SPPI) on the principal amount outstanding?
And And
Consider the business Consider the business Is the FA an
FV through P/L
model (BM): model (BM): No investment in equity No

Is the BM to collect only Is the BM to collect both instruments?
the: the:
contractual cash flows contractual cash flows; Yes
(i.e. the entity does not and
intend dealing in the cash flows from selling Elect to classify at No
instruments) the asset FV through OCI?
Yes
Yes Yes
Would classification at amortised cost or at FV through Yes

OCI cause an accounting mismatch and, if so, do you wish
to designate as FV through P/L?
No No
Amortised cost FV through OCI
980 Chapter 22
Let us now take a look in more detail at the business model and its characteristics and then the
issues surrounding the contractual cash flows.
3.2.2 The business model criteria (IFRS 9. B4.1.1-B4.1.6)
The business model essentially considers the intention of the entity in holding the financial
asset/s. The question is really whether the entity is holding the financial asset in order to
receive contractual cash flows or whether it is being held, for example, to realise the gains in
changes in the fair value through sale thereof. It is the responsibility of key management
personnel (as defined in IAS 24 Related Party Disclosures) to determine the business model.
The business model is neither decided on an entity basis nor on an individual asset basis, but
somewhere in between. In other words:
An entity may have more than one business model, having for example, one business
model for one group of assets (portfolio of investments) and another business model for
another group of assets.
The business model is not decided on an instrument-by-instrument basis but rather on the
basis of collective groups of financial investments (portfolios). IFRS 9.B4.1.1 – B4.1.3
Interestingly, although the business model’s objective may be to hold financial assets in order
to collect contractual cash flows, the entity need not actually hold all of those instruments
until maturity (e.g. the entity may sell the investment because it may need the cash). If,
however, there are frequent sales from this portfolio of investments, the entity should
B4.1.3
reconsider whether the objective to collect contractual cash flows is still relevant.
Example 3: Classifying financial assets – considering the business model

(Adapted from illustrative example – IFRS 9 B4.1.4)
Determine whether the following business models would be considered to be business
models aimed at collecting contractual cash flows:
a) The entity has bought an investment in order to collect contractual cash flows but has
indicated that it would certainly sell the asset if it needed the cash.
b) The entity bought a portfolio of debtors. These debtors are charged interest on their
outstanding balances. Some of these debtors will not pay and many debtors need to be
phoned to encourage payment. On certain occasions the business found it necessary to
enter into interest rate swaps (swapping the variable rate with a fixed rate).
c) Entity A lends money to clients and then sells these loan assets to Entity B, being an
entity that focuses on collecting the cash flows. Entity A owns Entity B.
Solution 3: Classifying financial assets – considering the business model

a) The fact that the business would act with common sense in a situation of illiquidity would not
detract from the basic intention of holding the asset in order to collect contractual cash flows.
b) The fact that some of the debtors may lead to bad debts and the fact that the entity enters into
derivatives to protect its interest cash flows does not detract from the fact that the entity’s business
model relating to these debtors is simply to collect the principal and interest. There is no evidence
that the entity bought the portfolio in order to make a profit from the sale thereof.
c) For the purposes of Entity A’s financial statements, its business model involves trading the assets
rather than collecting the contractual cash flows (therefore the loan assets must be measured at
fair value in its separate financial statements).
For the purposes of Entity B’s financial statements, its business model involves collecting the
contractual cash flows.
For the purposes of the group financial statements, the loans are issued with the objective of
ultimately collecting the contractual cash flows.
Therefore in the case of Entity B’s separate financial statements as well as the consolidated
financial statements, these loan assets would be measured at amortised cost assuming the cash
flows related purely to interest and principal.
Chapter 22 981
3.2.3 The contractual cash flows criteria (IFRS 9.4.1.3 and B4.1.7-B4.1.19)
When assessing whether the financial asset should be classified at amortised cost, we need to
be sure that the contractual cash flows occur on specific dates and relate purely to a
repayment of the principal sum and interest on this principal.
Interest includes a return that compensates the holder for the time value of money and the
credit risk. IFRS 9.4.1.3
Example 4: Classifying financial assets – considering the cash flows
(Adapted from illustrative example – IFRS 9 B4.1.13 and .14)
Determine whether the following financial instruments would be classified as amortised
cost or not:
a) Instrument A is a bond over the manufacturing building of a local entity. Interest rates charged
are based on the applicant’s credit rating.
b) Instrument B is a bond that is convertible into the issuer’s own equity instruments.
c) Instrument C is a bond with the interest rate linked to an inflation index.
d) Instrument D is a bond with market interest rates charged and where payment is linked to the
performance of the debtor: interest will be deferred in the event that the debtor is in financial
difficulty and no interest will be charged on the deferred interest during the period of deferral.
Solution 4: Classifying financial instruments - considering the cash flows

a) Amortised cost – The interest charged is based on the risk of default of the debtor and thus the
interest would compensate the issuer not only for the time value of money but also for the credit
risk faced, both of which are considered to be interest for the purposes of classification at
amortised cost.
b) Not amortised cost – The payments will not be exclusively related to interest and the principal
amount but will also include an element that relates to the value of the equity instruments which
are to be issued at the conclusion of the bond.
c) Amortised cost – The interest will vary according to the inflation rates. Inflation is what causes the
time value of money to deteriorate. Payment of interest linked to inflation restates such interest to
the current monetary price and as such the payment shows return for time value and credit risk –
considered to be interest.
d) Not amortised cost – The interest charged can be deferred and since no interest is charged on the
deferred interest, the cash payments are not considered to be purely related to the time value of
money nor the credit risk faced.
3.3 Financial assets: recognition (IFRS 9.3.1.1)

Financial assets are initially recognised when, and only when, the entity becomes party to the
contractual provisions of the instrument.
3.4 Financial assets: measurement (IFRS 9.5)
3.4.1 Overview
The measurement of financial assets can be split into:
initial measurement; and
subsequent measurement.
3.4.1.1 Initial measurement: discussion of fair value and transaction costs
Initial measurement of all financial assets (and, in fact, all financial instruments), but with the
exception of trade receivables that do not have a significant financing component *, is based
on fair value. Depending on the asset classification, this fair value may or may not need to be
adjusted for the directly attributable transaction costs, summarised below.
Classification Initial measurement:
Fair value through profit or loss Fair value
Fair value through other comprehensive income Fair value + transaction costs
Amortised cost Fair value + transaction costs
* Trade receivables that have a significant financing component are measured in terms of
IFRS 15 Revenue from contracts with customers at an amount of consideration that reflects the
price that the customer would have paid if the customer had paid cash when the goods or services
were transferred. See IFRS 15.61
982 Chapter 22
3.4.1.2 Initial measurement: discussion of the loss allowance account (impairments)
With the introduction of the new forward-looking expected loss model, the initial recognition
of a financial asset classified at amortised cost or fair value through other comprehensive
income requires that we immediately recognise a loss allowance account – effectively
reflecting the future expected impairments on the asset.
A loss allowance is not recognised in the case of financial assets classified as fair value
through profit or loss because any possible future impairment will automatically be accounted
for in profit or loss when processing the fair value adjustments in profit or loss.
The recognition and measurement of the asset’s related loss allowance account is explained in
detail in section 9 and will thus not be explained further at this stage. However, it may be
helpful to know that, in the case of assets classified at fair value through other comprehensive
income, the statement of financial position must present the asset’s carrying amount (at fair
value) separately from the loss allowance account whereas the an asset classified at amortised
cost will be presented at the net of the asset’s carrying amount (at gross carrying amount:
GCA) and its related loss allowance account. This can be summarised as follows:
Classification Loss allowance

FV through profit or loss Not applicable
FV through other comprehensive income The asset is presented separately from its
loss allowance account:
Asset: FV
Loss allowance
Amortised cost The asset is presented net of its loss
allowance account:
Asset: GCA – Loss allowance
3.4.1.3 Initial measurement: discussion of fair value and day one gains or losses
What is also important to note is that the fair value at which the financial asset is initially
measured, is measured in terms of IFRS 13. This fair value is defined as the price that would
be received to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date.
It can thus happen that this fair value (which we use to initially recognise the asset) is actually
not equal to the transaction price, being the amount you actually paid for the asset. If the fair
value and the transaction price differ, this difference is referred to as a day-one gain or loss
and will either need to be immediately accounted for in profit or loss or be deferred:
the difference is accounted for immediately as an income or expense in profit or loss if
the fair value was measured using level 1 or level 2 inputs; whereas
the difference will be deferred as an asset or liability if the fair value was measured using
level 3 inputs.
3.4.1.4 Subsequent measurement
Subsequent measurement of financial assets differs significantly depending on the

classification of the asset, but a basic summary is provided below:
Classification Subsequent measurement:

FV through profit or loss Fair value on subsequent reporting dates with FV changes
accounted for in P/L
FV through other comprehensive income Fair value on subsequent reporting dates with FV changes
accounted for in OCI
Amortised cost Effective interest rate based on gross carrying amount
Chapter 22 983
3.4.1 Financial assets: measurement at amortised cost (IFRS 9.4.1.2; 9.5.1-2)

Financial assets classified as
Assets classified as amortised cost financial assets are: amortised cost are measured
initially measured at fair value plus transaction as follows:-
costs; IFRS 9.5.1.1 and Initially at FV plus transaction costs.
subsequently measured using the effective interest Subsequently measured using the
method. IFRS 9.5.2.1 effective interest method
The effective
The amortisation process results in gains and losses that must interest method is
be recognised in profit or loss. defined as –
the method that is used in the
At the end of each year, the entity is required to assess calculation of the amortised
whether the asset is impaired. Impairment testing is covered cost of a FA (or FL) and
in section 9 of this chapter. allocation and recognition of
the interest revenue (expense)
in profit or loss over the period
IFRS 9 Appendix A (Reworded)
Explanation of the effective interest rates:

Note: the effective interest rate is the rate that exactly discounts future cash flows throughout the life of
the financial instrument, to the net carrying amount of the financial asset or liability (i.e. present value).
This method, which is used to measure assets/ liabilities under amortised cost, allocates the interest
income/ expense over the life of the instrument.
The effective interest rate is often given in the question, but may be calculated as follows using a
financial calculator (Sharp EL-733A):
PV = Cash flow on purchase/ issue (after adjusting for transaction costs if applicable)
FV = Future cash flow on redemption/ conversion
n = number of annuity payments/ receipts during the discounting period until maturity
PMT = Actual amounts received or paid during the period to maturity (based on coupon rate)
Comp = i
Example: An entity purchases C100 000 (face value) debentures at a discount of 3%, redeemable in 5
years time at a premium of 7%. The debentures carry a coupon rate of 12% p.a., payable bi-annually.
The effective interest rate is calculated as follows:
PV = -97 000 (cash flow is negative because it is an outflow for us)
FV = 107 000 (cash flow is positive because it is an inflow for us)
n = 10 (5 years x 2 payments per year)
PMT = 6 000 (100 000 x 12% x ½ ) (actual amount received every 6 months)
Comp i = 6,934054179% per half year or 13,86810836% p.a.
Example 5: Simple interest calculation
Eternity Ltd purchased 10% debentures for C200 000 on 1 January 20X5, (redeemable at
C200 000 on 31 December 20X6). They intended to hold them to collect contractual cash
flows. Transaction costs were 10% of the cost. The fair value on 31 December 20X5 was C400 000.
Required: Prepare the necessary journals for the year ended 31 December 20X5, assuming:
A. the debentures are redeemable at C200 000 (effective interest rate: 4,6487%);
B. the debentures are redeemable at C250 000 (effective interest rate: 15,421%).
Solution 5A: Simple interest calculation

Debentures (asset) 200 000+(200 000×0.1) 220 000
Bank 220 000
Purchase of debentures
31 December 20X5
Bank 200 000 x 10% 20 000
Interest income 220 000 x 4,6487% 10 227
Debentures (asset) Balancing 9 773
Interest earned on debentures
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Solution 5B: Simple interest calculation

Debentures (asset) 200 000+(200 000×0.1) 220 000
Bank 220 000
Purchase of debentures
31 December 20X5
Bank 200 000 x 10% 20 000
Interest income 220 000 x 15,421% 33 926
Debentures (asset) Balancing 13 926
Interest earned on debentures
Comment: Notice that no journal is processed for the increase in fair value: journals for changes in fair
value at year end are made only for “fair value through profit or loss (FVPL)” financial assets.
3.4.2 Financial assets: measurement at fair value (IFRS 9.4.1.4-5, .5.2.1 .5.7, B5.1.2A)
Financial assets are classified and measured at fair value if:
they do not meet the criteria to be classified at amortised cost; or
if they are designated as such on initial recognition to remedy an accounting mismatch.
Initial measurement of financial assets measured at fair value requires:

the asset to be measured at fair value; and
transaction costs to be expensed if the financial asset is designated at fair value through
profit or loss, but if the asset is designated at fair value through other comprehensive
income, the transaction costs should be capitalised.
Transaction costs are
There may be situations where the transaction price differs defined as
from fair value: Incremental costs that are
If the fair value is evidenced by a quoted price in an directly attributable to the
active market for identical assets or liability, or based on acquisition, issue or disposal of a
financial asset or a financial
a valuation technique that uses only data from
liability IFRS 9 Appendix A (reworded)
observable markets, the entity shall recognise the
difference between the fair value at initial recognition and the transaction price as a gain
or loss.
In all other cases, the initial measurement is adjusted to
Treatment of
defer the difference between the fair value at initial transaction costs for
recognition and the transaction price. After initial financial assets at FV:-
recognition, the entity shall recognise that deferred fair value through P/L –
difference as a gain or loss only to the extent that it transaction costs are expensed
arises from a change in factor (including time) that fair value through OCI –
market participants would take into account when transaction costs are capitalised
pricing the asset or liability. IFRS 9.5.1.2A
Subsequent measurement of financial assets measured at fair value:

Requires that the asset be re-measured to its latest fair value.
Fair value gains/losses
Gains or losses on financial assets measured at fair value are on financial assets are
normally recognised in profit or loss but may be recognised recognised as follows –
in other comprehensive income. In P/L (in which case the
financial asset is referred to as
Fair value financial assets are thus categorised as follows: a financial asset classified at
FV through P/L)
Financial assets at fair value through profit or loss; and In OCI (in which case the
financial asset is referred to as
Financial assets at fair value through other a financial asset classified at
comprehensive income. IFRS9.5.2.1 FV through OCI)
Chapter 22 985
Fair value adjustments may be recognised in other comprehensive income:

If the financial asset is an investment in equity instruments, the entity may elect to
recognise fair value gains and losses in other comprehensive income (instead of in profit
or loss) on condition that they are not held for trading. Under this election, the following
principles apply:
- Dividend income from that investment should be recognised in profit or loss when the
right to receive payment has been established. IFRS 9.5.7.1A
- This election is irrevocable (i.e. it is not possible to change this decision at a later
date and recognise fair value gains and losses in profit or loss instead). IFRS 9.5.7.5
If the financial asset is part of a cash flow hedge, the fair value adjustments may be
recognised in other comprehensive income. IFRS 9.5.7.1 Hedges are covered in the chapter on
forward exchange contracts.
Gains or losses on financial assets that are recognised in other comprehensive income may or
may not be reclassified to profit or loss:
Gains or losses on an investment in an equity instrument that the entity elected to
recognise in other comprehensive income may never be reclassified to profit or loss;
Gains or losses on a cash flow hedge that are recognised in other comprehensive income
may be reclassified to profit or loss.
Example 6: Fair value through profit or loss financial assets

Grime Limited purchased 25 000 shares at a total cost of C25 000 on 1 November 20X5.
At the year-end (31 December 20X5) the fair value of the shares was C55 000.
Grime Limited purchased these shares with the intention to sell in the short term (i.e.
the shares are held for trading).
Initial directly attributable costs amounted to C 2 500.
Required: Show the necessary journal entries to record the change in fair value.
Solution 6: Fair value through profit or loss financial assets

Comment:
Since the shares were held for trading, the FV adjustments may not be recognised in other
comprehensive income and thus they will be recognised in profit or loss.
1 November 20X5 Debit Credit
Investment in shares (asset) Given 25 000
Bank 25 000
Purchase of shares – classified as ‘fair value through profit or loss’
Direct costs (expense) 2 500
Bank 2 500
Payment of direct costs
31 December 20X5
Investment in shares (asset) 55 000 – 25 000 30 000
Gain on financial asset held at fair value (P/L) 30 000
Re-measurement of shares (FVTPL) to FV at year-end (recog in P/L)
It was explained above, that fair value adjustments are normally recognised in profit or loss
but that there are two exceptions to this, where the fair value adjustments could be recognised
in other comprehensive income. One of these exceptions involved equity investments.
IFRS 9 BC5.25(c) explains that there is very little clarity on which equity investments should
have their movements shown in other comprehensive income. In trying to answer this
question, the IASB attempted to split equity investments between two classes, one being
‘strategic investments’ and the other ‘non-strategic investments’, where movements in
strategic investments would be recognised in other comprehensive income.
986 Chapter 22
The IASB was, however, not able to decide what the definition of a ‘strategic investment’
would be and, as a result and by the IASB’s own admission, there is still some mystery
regarding which instruments would qualify.
Example 7: Fair value through other comprehensive income
Stubborn Limited invested in the issued shares of Help-us Limited on 1 January 20X9.
On initial recognition the management of Stubborn Limited determined that the
equity investment qualified as a ‘strategic equity investment’ and elected to present
the fair value changes in other comprehensive income.
The initial investment was for C100 000 with broker fees of C8 000.
At 31 December 20X9 the investment had a fair value of C120 000.
Dividends of C1 000 were declared on 31 December 20X9.
Required: Prepare the journal entries for the year ended 31 December 20X9.
Solution 7: Fair value through other comprehensive income

Investment in Help-us (A) 100 000
Bank 100 000
Investment in financial asset
Investment in Help-us (A) 8 000
Bank 8 000
Brokers fees capitalised because the FA is classified as FV through OCI
31 December 20X9
Investment in Help-us (A) FV: 120 000 – CA: (100 000 + 8 000) 12 000
Gain on financial asset (OCI) 12000
Fair value change at year end
Dividends receivable (A) 1 000
Dividend income (P/L) 1 000
Dividends receivable for the year
3.5 Financial assets: de-recognition (IFRS 9.3.2.3 and 3.2.4)

An entity shall derecognise a financial asset when: Derecognition is defined
The contractual rights to the cash flows from the as
financial asset expire; or The removal of
It transfers the financial asset and the transfer qualifies a previously recognised FA or FL
for de-recognition. IFRS 9.3.2.3 from an entity’s statement of
financial position IFRS 9 Appendix A
An entity has transferred its financial asset if:
It transfers the contractual right to receive cash flows of the financial asset; or
It retains the contractual right to receive the cash flows of the financial asset, but assumes
the contractual obligation to pay the cash flows to one or more entities (‘the eventual
recipients’) in an arrangement that meets the following three conditions:
- The entity has no obligation to pay amounts to the eventual recipients unless it
collects equivalent amounts from the original asset;
- The entity is prohibited by the terms of the transfer contract from selling or pledging
the original asset other than as security to the eventual recipients for the obligation to
pay them the cash flows;
- The entity has an obligation to remit (pay) any cash flows that it collects on behalf of
the eventual recipients without material delay. In addition, the arrangement must not
allow the entity to reinvest such cash flows except for investments in cash or cash
equivalents during the short settlement period from the collection date to the date of
required remittance to the eventual recipients, in which case the arrangement must
require that the interest earned on such investments be passed to the eventual
recipients). IFRS 9.3.2.4 and 3.2.5
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3.5.1 Financial assets: treatment of cumulative gains and losses on derecognition
Gains or losses on financial assets that are recognised in other comprehensive income may or
may not be reclassified to profit or loss at a later date. Reclassification adjustments may arise
on derecognition of an asset or if the asset itself is reclassified (e.g. from fair value through
other comprehensive income to fair value through profit or loss).
We need to recall that two types of financial assets may be held at fair value through other
The first type is made up of financial assets that must be measured at fair value through
other comprehensive income due to the business model test (i.e. compulsory
classification) See IFRS 9.4.1.2A.
The second type of financial assets that may be held at fair value through other
comprehensive income are equity instruments that are not held for trading.
Generally, equity instruments do not pass the business model test for classification as
financial assets through other comprehensive income and are consequently held at fair value
through profit or loss. However – an entity is able to elect that the qualifying equity
instruments be subsequently measured at fair value through other comprehensive income (i.e.
optional classification) See IFRS 9.4.1.4.
On derecognition of financial assets held at fair value through other comprehensive income,
the treatment of cumulative gains and losses depends on whether the classification of the
financial assets was compulsory or optional.
Compulsory classification: the cumulative gains or losses in other comprehensive income
may be reclassified to profit/loss when the financial assets are derecognised;
Optional classification: (note: an election is irrevocable See IFRS 9.4.1.4): the cumulative gains
or losses in other comprehensive income may not be reclassified to profit/loss when the
financial assets are derecognised, but may be transferred directly within equity instead See
IFRS 9.B5.7.1
4. Financial Liabilities
4.1 Financial liabilities: identification (IAS 32.11)

An item would be identified as a financial liability if it meets the definition of a financial
liability, which is as follows:
a contractual obligation to deliver cash or another financial asset to another entity; or
a contractual obligation to exchange financial assets or financial liabilities with another
entity under conditions that are potentially unfavourable to the entity; or
a contract that will or may be settled in the entity’s own equity instruments and is:
- a non-derivative for which the entity is or may be A financial liability is
obliged to deliver a variable number of the defined as
entity’s own equity instruments; or Contractual obligation to deliver
- a derivative that will or may be settled other than cash or another financial asset to
by the exchange of a fixed amount of cash or another entity; or
another financial asset for a fixed number of the Contract to be settled in equity
entity’s own equity instruments. instruments IAS 32.11(Reworded)
Example 8: Financial liabilities

Discuss whether any of the following are financial liabilities:
a. Creditors
b. Compulsory redeemable preference shares
c. Warranty obligations
d. Bank loans
e. Current tax payable
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Solution 8: Financial liabilities

a. Yes, the entity is contractually obligated to settle the creditor with cash.
b. Yes, the entity must, in the future, redeem the preference shares with cash.
c. If the entity has to pay the warranty obligation in cash, it is a financial liability. If the entity
merely has to repair the goods, then, since there is no obligation to pay cash or any other
financial instrument, it is not a financial liability.
d. Yes, there is a contractual obligation to repay the bank for the amount of cash received plus
interest.
e. No, a contractual obligation does not exist, only a statutory obligation exists.
4.2 Financial liabilities: classification (IFRS 9.4.2 - 9.4.4)

4.2.1 Overview
There are two main classifications of financial liabilities: Financial liabilities are
liabilities at amortised cost (using the effective classified as follows -
interest rate method); or fair value through profit or loss
liabilities at fair value through profit or loss. IFRS 9.4.2.1 at amortised cost
These two classifications relate to the measurement of the financial liability.
There are three exceptions to these two main classifications, where the measurement does not
follow the normal rules of fair value or amortised cost:
financial liabilities that arise when a transfer of a financial asset does not qualify for de-
recognition or when the continuing involvement approach applies;
financial guarantee contracts;
commitments to provide a loan at a below-market interest rate. IFRS 9.4.2.1
These exceptions are not covered in this chapter.
Once the financial liability is classified, it may never be reclassified. IFRS 9.4.4.2
4.2.2 Financial liabilities classified at fair value through profit or loss (IFRS 9.4.2.2)
Financial liabilities at fair value through profit or loss are defined as those financial liabilities
that: IFRS 9 Appendix A Financial liabilities at fair
meet the definition of held for trading, where the value through profit and
definition of held for trading requires that the liability: loss are defined as -
is acquired or incurred principally for the purpose liabilities held for trading
of selling or repurchasing it in the near term; financial liabilities that are
designated as fair value through
is a derivative (except for a derivative that is a profit or loss on initial recognition
financial guarantee contract or is a designated and IFRS 9 Appendix A
effective hedging instrument); or

on initial recognition, is part of a portfolio of identified financial instruments that are
managed together and for which there is evidence of a recent actual pattern of short-
term profit-taking; or
are designated by the entity as fair value through profit or loss upon initial recognition.
The designation of a financial liability through profit or loss is only allowed if it provides
more relevant information:
through eliminating measurement or recognition inconsistency, or
because the financial liability is part of a group of financial liabilities (or liabilities and
assets) that is managed and evaluated by the entity’s key management personnel (e.g.
board of directors) on a fair value basis in accordance with its documented risk
management or investment strategy. IFRS 9.4.2.2
Chapter 22 989
The designation of fair value through profit or loss is not allowed if:
it is a contract that contains an embedded derivative/s; and
the host is not an asset within the scope of IFRS 9; and
the embedded derivatives either:
do not significantly change the cash flows otherwise required by the contract, or
the separation of the embedded derivative is not allowed. IFRS 9.4.3.5
4.2.3 Financial liabilities classified at amortised cost (IFRS 9.4.2.1)

Financial liabilities at amortised cost are essentially Financial liabilities at
liabilities that: amortised cost are -
not held for trading; and
are not held for trading, and
not designated at FV though
are not otherwise designated as fair value through profit P/L on initial recognition.
or loss on initial recognition.
4.3 Financial liabilities: recognition (IFRS 9.3.1)
As with financial assets, financial liabilities are recognised when and only when the entity
becomes party to the contractual provisions of the instrument.
4.4 Financial liabilities: measurement at amortised cost (IFRS 9.5.1)

Financial liabilities that are measured at amortised cost are:
Financial liabilities at
Initially measured at fair value less transaction costs ; amortised cost are
IFRS 9.5.1.1 measured as follows -
e.g. if debentures were issued for C100 000, with Initially measured at FV less
transaction costs
C1 000 transaction costs, the entity would have received
Subsequently measured at
a net amount of C99 000 and therefore the debentures amortised cost using the
would be recognised at C99 000 in the statement of effective interest rate
financial position; and
Subsequently measured at amortised cost using the effective interest rate method. IFRS 9.4.2.1
The amortisation process will result in gains and losses being recognised in profit or loss over
the life of the liability.
Example 9: Other financial liabilities

Tempo Limited issued 200 000 0% debentures on 1 January 20X5:
The debentures are issued at C7 each.
The debentures are compulsorily redeemable on 31 December 20X7 for C10 (i.e. at a
premium).
Required:
Calculate the finance costs and carrying amount of the debentures for each affected year.
Solution 9: Other financial liabilities

The effective interest rate is calculated using a financial calculator as 12.6248%
PV = 7 FV= -10 N= 3 COMP i
PV = 1 400 000 FV= -2 000 000 N = 3 COMP i
Date Finance Costs @ 12,6248% Carrying Amount

1 Jan 20X5 1 400 000 200 000 x C7
31 Dec 20X5 176 747 1 576 747
31 Dec 20X6 199 061 1 775 808
31 Dec 20X7 224 192 2 000 000
Redemption (2 000 000)
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4.5 Financial liabilities: measurement at fair value through profit or loss
Financial liabilities that are measured at fair value are:

initially measured at fair value (transaction Financial liabilities at fair value
costs are expensed); IFRS 9.5.1.1 and are measured as follows -
subsequently measured at fair value. IFRS 9.4.2.1 Initially measured at fair value.
Transaction costs are expensed
The fair value gains and losses are recognised in Subsequently measured at fair value
profit or loss IFRS 9.4.2.2 unless:
the liability is part of a cash flow hedge (hedges are covered in the chapter on forward
exchange contracts); or
the liability was designated as at fair value through profit or loss, in which case the:
- amount of the fair value adjustments that are attributable to changes in credit risk of
that liability must be presented in other comprehensive income; and
- rest of the fair value adjustment must be presented in profit or loss IFRS 9.5.7.1 & 9.5.7.7
unless the recognition in other comprehensive income of fair value adjustments relating to
credit risk creates or enlarges an accounting mismatch in profit or loss, in which case:
- all fair value adjustments are presented in profit or loss. IFRS 9.5.7.7 & 9.5.7.8
When measuring the amount that relates to changes in credit risk, follow these steps:
Compute the liabilities internal rate of return at the start of the period using the observed
market price of the liability and the liability’s contractual cash flows at the start of the
period.
Deduct from the internal rate of return the observed market interest rate at the start of the
period to arrive at the instrument-specific component of the internal rate of return.
Calculate the present value of the cash flows associated with the liability at the end of the
period using a discount rate equal to the sum of the interest rate at the end of the period
and the instrument-specific component of the internal rate of return previously calculated.
The difference between the fair value of the liability at the end of the period and the
amount determined above is the change in fair value that is not attributable to changes in
the observed interest rate.
IFRS 9-B5.7.16-18
This is the amount to be presented in other comprehensive income.
Fair value gains or losses recognised in other comprehensive income may not be reclassified
to profit or loss. However, the entity may transfer the cumulative gains or losses to another
equity account. IFRS 9.B5.7.9
Example 10: Fair value through profit or loss

Mousse Limited issued 100 000 debentures on 1 January 20X5, proceeds totalling
C200 000.
On 31 December 20X5 the debentures had a fair value of C300 000.
Mousse Limited designated these debentures to be held at ‘fair value through profit or
loss’.
Transaction costs incurred by Mousse Limited came to a total of C1 000.
Required:
Provide the necessary journals to show how Mousse Limited should account for the change in the fair
value of the debentures.
Chapter 22 991
Solution 10: Fair value through profit or loss

Transaction costs expense 1 000
Bank 1 000
Transaction costs on the issue of debentures
Bank 200 000
Debentures (liability) 200 000
Issue of debentures
31 December 20X5
Fair value adjustment on financial liabilities (P/L) 100 000
Debentures (liability) 100 000
Re-measurement of debentures at year-end
Example 11: Fair value through profit or loss with change in credit risk
Same information as above except that:
there was a favourable change in the credit risk component, measured at a gain of
C20 000; and
there is no accounting mismatch.
Required:
Provide the necessary journals to show how Mousse Limited would account for the change in the fair
value of the debentures.
Solution 11: Fair value through profit or loss with change in credit risk

Transaction cost expense 1 000
Bank 1 000
Transaction costs on the issue of debentures
Bank 200 000
Debenture (liability) 200 000
Issue of debentures
FV adjustment - financial liabilities (P/L) (100 000 + 20 000) 120 000
Debenture (liability) (300 000 – 200 000) 100 000
FV adjustment - financial liabilities (OCI) (Given) 20 000
Re-measurement of debenture, separately recognising the change in FV
due to a change in the credit risk in OCI with the balance of the FV
adjustment recognised in P/L
4.6 Financial liabilities: derecognition (IFRS 9.3.3.1-3, IFRIC 19)
An entity must remove a financial liability from its statement of financial position (i.e.
derecognise it) when it is extinguished.
An extinguishment occurs when the obligation specified in the contract is discharged,

cancelled or expires.
An extinguishment could result in the de-recognition of the original financial liability and the
recognition of a new financial liability in its place. This occurs, for example, when:
there is an exchange between an existing borrower and lender of debt instruments that
involves substantially different terms;
the terms of an existing financial liability or part thereof are substantially changed.
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When derecognising a financial liability, any resulting gain or loss is recognised in profit or
loss. This gain or loss is calculated as the difference between:
the carrying amount of the financial liability (or part of financial liability) extinguished or
transferred to another party; and
the consideration paid, including any non-cash assets transferred or liabilities assumed.
IFRIC 19 explains the consequences of a:

debtor extinguishing a financial liability,
by issuing its equity instruments to the creditor,
when the terms of the financial liability are renegotiated.
The consensus provided in IFRIC 19 is that the equity instruments should be considered
‘consideration paid’ and, as a result:
the issue of the equity instruments to the creditor should be recognised and measured at
their fair value;
the liability should be reduced by the carrying amount of the financial liability that is
settled through this issue of equity instruments; and
any difference between the fair value of the equity instruments and the carrying amount of
the liability extinguished is recognised in profit or loss.
If the fair value of the equity instruments cannot be reliably measured, then the equity
instruments must be measured at the fair value of the financial liability extinguished.
If only part of the financial liability is extinguished, the entity must assess whether:
some of the consideration paid relates to a modification of the terms of the liability
outstanding, in which case the entity will need to allocate the consideration paid between
the part of the liability extinguished and the part of the liability outstanding; and
the terms of the remaining outstanding liability have been substantially modified, in
which case the entity must account for an extinguishment of the original liability and the
recognition of a new liability.
It is important to note that this interpretation does not apply where:

extinguishing the financial liability by issuing equity shares is in accordance with the
original terms of the financial liability,
the creditor is a direct or indirect shareholder and is acting in its capacity as a direct or
indirect existing shareholder; or
the creditor and the entity are controlled by the same party before and after the transaction
and the substance of the transaction includes an equity distribution by, or contribution to,
the entity.
IFRIC 19 also only explains how the debtor accounts for the issue of its equity instruments in
settlement of a liability. It does not explain how the creditor would account for the receipt of
these equity instruments.
5. Reclassification of Financial Instruments (IFRS 9.4.4 ; 9.5.6 and B4.4.1 – B4.4.3)
5.1 Reclassifications overview
Financial liabilities may never be reclassified whereas financial assets may be reclassified.
Chapter 22 993
Although financial assets may be reclassified, reclassification is only allowed when:

the entity changes its business model for managing those specific assets; and
this change in the business model’s objective has already been put into effect. IFRS 9 B4.4.2
The following are not changes in business model: IFRS 9 B4.4.3

a) a change in intention related to particular financial assets (even in circumstances of
significant changes in market conditions).
b) the temporary disappearance of a particular market for financial assets.
c) a transfer of financial assets between parts of the entity with different business models.
The reclassification date is the first day of the first reporting period following the change in
business model that results in the entity reclassifying financial assets.
Example 12: Reclassification date (adapted from B4.4.2)

Faith decides to shut down its retail mortgage division:
The decision to shut it down is made on 1 November 20X7; but
It continues operating this division (i.e. continues to create loan assets) whilst looking
for a purchaser for the division.
Three potential purchasers are found during February 20X8 and the division formally
ceases to acquire new retail mortgage business from 1 March 20X8.
Faith has a 31 December financial year-end.
Required: Explain when the reclassification date would be.
Solution 12: Reclassification date

Although on 1 November 20X7 the business model objective is changed from one where the
intention is to collect contractual cash flows to one where the intention is to sell the asset, this
change in objective is not yet put into effect until 1 March 20X8.
Both the objective must have changed and also have been put into effect before it can be said that
the business model has changed.
The business model is therefore said to have changed on 1 March 20X8.
The reclassification date is the first day of the financial period following the change in the business
model and therefore the reclassification date is 1 January 20X9.
If the business model for managing a group of financial assets changes, all the affected
financial assets must be reclassified. IFRS 9.4.4.1
However, when an entity sells a financial asset which it was holding to receive contractual
cash flows, it does not automatically mean that the entire portfolio should be reclassified.
All reclassifications are accounted for prospectively and no gains, losses or interest previously
recognised shall be restated. IFRS 9.5.6.1
5.2 Reclassifying from amortised cost to fair value through profit or loss (IFRS 9.5.6.2)
If reclassifying a financial asset from the amortised cost model to the fair value model:
the fair value is determined on reclassification date;
the difference between the carrying amount of the financial instrument carried at
amortised cost and the fair value on reclassification date is recognised in profit or loss.
IFRS 9 is silent on how to account for any income accrued on this financial asset. It is
therefore submitted that, although the asset must be re-measured to fair value on
reclassification date and every reporting date thereafter, income on the asset would continue
to be recognised and measured using the effective interest rate method.
994 Chapter 22
Essentially, this means that the asset is re-measured to fair value after accruing for interest on
the effective interest rate method.
This requires that a new effective interest rate is calculated at the start of each year using the
latest fair value as the present value of the asset.
Example 13: Reclassification of financial asset from amortised cost to fair value
On 1 January 20X7 ABC Limited invested C500 000 in a government bond.
The bond would mature in 10 years time and pay out C550 000.
Interest is paid each year in arrears at 8%.
The bond was being held to receive the contractual cash flows.
The effective interest rate is 8.6887%.
On 30 June 20X9, management decided that they would sell the bond in the near future and
consequently changed the business model.
The fair values were as follows:
30 June 20X9: was C540 000
1 January 20Y0: C530 000
31 December 20Y0: C550 000
Required: Provide the journal entries for the year ended 31 December 20X9 and 31 December Y0.
Solution 13: Reclassification of financial asset from amortised cost to fair value
W1: Effective interest rate table
Date Effective interest Amount received Balance
A×8.6887% A×8% A
1 January 20X7 500 000
31 December 20X7 43 444 (40 000) 503 444
31 December 20X8 43 743 (40 000) 507 187
31 December 20X9 44 068 (40 000) 511 255

Government bond :amortised cost (A) W1 44 068
Interest for the full year under the amortised cost method
Bank 500 000×8% 40 000
Government bond (A) 40 000
Coupon payment received for the year ended 31 December 20X9
1 January 20Y0
Government bond: fair value (A) FV: 530 000 – CA: 511 255 (W1) 530 000
Government bond: amortised cost (A) W1 511 255
Gain on bond (P/L) 18 745
Measuring asset at fair value (beginning of year after change in
business model)
31 December 20Y0
Government bond (A) FV at beg of year: 530 000 x new EIR: 7.97% 42 243
Interest income (P/L) 42 243
Interest recognised using amortised cost, at a new EIR of 7.97% (PV:
530 000, n = 7; FV = 550 000, PMT = 40 000)
Bank 500 000×8% 40 000
Government bond (A) 40 000
Coupon payment received for the year ended 31 December 20Y0
Government bond (A) FV at year-end: 550 000 - CA before re- 17 757
Gain on bond (P/L) measurement: (530 000+ 42 243- 40 000) 17 757
Gain on re-measuring to fair value at year-end
Comment: Notice how even though the business model changed from 30 June 20X9, the new
measurement model is only applied from the first day of the year after the business model changes.
Chapter 22 995
5.3 Reclassifying from fair value to amortised cost (IFRS 9.5.6.3)
Where an asset is reclassified such that it is now measured at amortised cost, the fair value on
the date of reclassification becomes the new carrying amount of the financial asset.
Example 14: Reclassification of financial asset from fair value to amortised

cost
Change Limited purchased debentures in Leverage Limited a few years ago. The
debentures did not meet the criteria to be classified as amortised cost since they were held
for trading in the near future
The face value of the debentures is C500 000 and interest is paid annually in arrears
at 10% per annum and will be redeemed at a premium of C100 000.
With the recent change in market interest rates, the return on the debentures
improved relative to other market investments. As a consequence, at a meeting on 1
July 20X9, when the maturity date was 6 years away, Change Limited’s board of
directors passed a resolution that the debentures would now be held until maturity.
The relevant fair values are:
1 July 20X9 C570 000
31 December 20X9 and 1 January 20Y0 C590 000
Required: Provide the journal entries for the year ended 31 December 20X9 and 31 December 20Y0
Solution 14: Reclassification of financial asset from fair value to amortised cost

Debenture: FV through PL (A) 590 000-545 000 45 000
Gain on debentures (P/L) 45 000
Gain on debentures on reclassification date
Debenture: Amortised cost (A) At latest FV 590 000
Debenture: FV through PL (A) 590 000
Reclassification of debentures from FVTPL to Amortised cost *
31 December 20Y0
Debenture (asset) Balancing 1 490
Interest income W2 51 490
Bank C500 000 x 10% 50 000
Interest at year end- at amortised cost
*: Since the asset is now classified at amortised cost, we will need to recognise an allowance for credit
losses – this allowance account is explained in section 9 and is thus beyond the scope of this question.
Comment: Notice how the fair value at the end of the financial year for 20Y0 is not adjusted to fair
value since the financial instrument is now carried at amortised cost.
W1: Effective interest rate:

n=5.5 PV=-590 000 PMT=50 000 FV=600 000 COMP IR=8.7271% (rounding error)
W2: Effective interest rate table

Effective interest Interest received Amount
@8.7271%
31 December 20X9 590 000
31 December 20Y0 51 490 (50 000) 591 490
31 December 20Y1 51 620 (50 000) 593 110
31 December 20Y2 51 761 (50 000) 594 871
31 December 20Y3 51 915 (50 000) 596 786
31 December 20Y4 52 082 (50 000) 598 868
(a)
30 June 20Y5 26 132 (25 000) 600 000
285 000 (275 000)
(a) 598 868 x 8.7271% x 6/12
996 Chapter 22
6. Compound Financial Instruments (IAS 32.28 - .32)
Some financial instruments have both equity and liability portions. These are referred to as
compound (hybrid) instruments. These instruments must be split into the two separate
elements based on the definition of ‘equity instrument’ and ‘financial liability’ (thus reflecting
substance over form).
The difference between equity and liabilities is that:

liabilities involve a contractual obligation to deliver cash or exchange financial
instruments with another entity under conditions that are potentially unfavourable and the
issuer of a financial liability does not have an unconditional right to avoid delivering cash
or another financial asset, whereas
An equity instrument
equity involves no such obligation. is defined as –
Any contract that evidences
The method used to split a compound financial instrument is:
a residual interest in the
first: find the value of the liability portion; and assets of an entity after
then: balance back to the equity portion (the total value – deducting all of its liabilities
IAS 32.11
the value of the liability).
In many cases, the subsequent measurement of the liability portion of the compound
instrument is determined by the effective interest method.
Remember that the classification of an instrument in the statement of financial position affects
other components of the financial statements too: if, for example, a financial instrument such
as a preference share is treated as partly equity and partly liability, then:
any portion of the preference dividend that relates to the part considered to be equity will
be recognised as a dividend in the statement of changes in equity, and
the portion of the dividend that relates to the part considered to be liability will be
recognised as interest (finance costs) in the statement of comprehensive income.
A summary of the various terms of preference shares and debentures and the resulting
accounting treatment is outlined in the table below:
Terms Accounting Treatment

Preference Shares
Non-cumulative and non-redeemable Pure equity
Cumulative and compulsory redeemable Pure liability
Non-cumulative and redeemable at option Pure equity
of issuer
Convertible into ordinary shares (optional in Compound instrument (Liability = PV of dividends and
hands of issuer or holder) possible redemption if not converted)
Compound instrument (Liability = PV of dividends
Compulsory convertible into ordinary shares
only)
Debentures
Compulsory redeemable Pure liability
Convertible into ordinary shares (optional in Compound instrument (Liability = PV of interest and
hands of issuer or holder) possible redemption if not converted)
Compulsory convertible into ordinary shares Compound instrument (Liability = PV of interest only)
Redeemable at option of issuer or holder Compound instrument (Liability = PV of interest and
during a period possible redemption)
It is worth noting that debenture interest is always payable (a cumulative obligation), thus the
distinction between cumulative and non-cumulative is not required.
Chapter 22 997
Example 15: Splitting of compound financial instruments

Barmy Limited issued 100 000 cumulative, 10% preference shares on 1 January 20X5 at an
issue price of C5 each:
These preference shares are convertible on the 31 December 20X7 into ordinary
shares at the option of the holder.
If they are not converted they will be redeemed on this date at C5 each.
The market interest rate is 15%.
The preference shares are not held for trading nor were they designated at fair value
on initial recognition.
Required: Split the compound financial instrument into its equity and liability portions.
Solution 15: Splitting of compound financial instruments

Comment:
The preference shares that we issued are convertible into ordinary shares. The conversion is at the option
of the shareholder: in order to be prudent, we assume the worst from a cash flow point of view and
therefore assume that all the shareholders will choose to the redemption instead of the conversion.
The potential liability that we have is therefore (1) the interest that we know we will have to pay each year
for three years plus (2) the possible redemption (repayment) of capital after three years. The liability is
measured at the present value of these two cash outflows.
The difference between the amount we receive and the amount we recognise as a liability (measured at its
present value) is recognised as equity.
Step 1: Calculate the liability portion
1.1 Annuity
Interest payment each year for 3 years (100 000 x C5 x 10%) 50 000
Discount factor for 3 years (based on 15%) (15% for a 3-year annuity) * 2.2832
Liability portion 114 160
1.2 Redemption
Lump sum payment after 3 years (100 000 x C5 x 100%) 500 000
Discount factor after 3 years (based on
15%) (15% after 3-years) * 0.6575
* Discount factor at 15% for a 3-year annuity:

1/ 1.15 0.8696
0.870/ 1.15 0.7561
0.756/ 1.15 0.6575
2.2832
1.3 Total liability
Present value of the 3 interest payments W1.1 114 160
Present value of the lump-sum payment W1.2 328 750
Step 2: Calculate the equity portion
Total cash received 100 000 x C5 500 000

Less recognised as a liability W1.3 442 910
Recognise as equity Balancing 57 090
998 Chapter 22
Example 16: Compulsorily convertible preference shares

On 2 January 20X4 Crazee Limited issued 500 000 cumulative 20% preference shares at C15
each.
The preference shares are compulsorily convertible into ordinary shares (1 ordinary
share for every 5 preference shares) on 31 December 20X6.
The appropriate adjusted market dividend rate for ‘pure’ redeemable preference shares is
25%.
The preference shares are not held for trading nor were they designated at fair value on
initial recognition.
Required:
Prepare journals to record the financial instrument over its three-year life in the accounting records of
Crazee Limited. You may ignore the journal entry for its conversion on 31 December 20X6.
Solution 16: Compulsorily convertible preference shares
Comment:
The preference shares that we issued are convertible into ordinary shares. The conversion is
compulsory. This means that there is no way that we will have to repay any of the cash received.
The potential liability that we have is therefore only the interest that we know we will have to pay
each year for three years. The liability is measured at the present value of these cash outflows.
The difference between the amount we receive and the amount we recognise as a liability (measured
at its present value) is recognised as equity.
Journals:
Debit Credit
2 January 20X4
Bank 7 500 000
Preference share liability 2 928 000
Preference share equity 4 572 000
Issue of convertible preference shares
31 December 20X4
Finance costs 732 000
Preference share liability (balancing) 768 000
Bank 1 500 000
Payment of preference dividend
31 December 20X5
Preference share liability (balancing) 960 000
Bank 1 500 000
31 December 20X6
Preference share liability (balancing) 1 200 000
Bank 1 500 000
Workings:
Step 1: Calculate the liability portion
Interest payment each year for 3 years (500 000 x C15 x 20%) 1 500 000
Discount factor for 3 years (based on 25%) (25% for a 3-year annuity) * 1.952
Liability portion 2 928 000
Chapter 22 999

* Discount factor at 25% for a 3-year annuity
1/ 1.25 0.800
0.8/ 1.25 0.640
0.64/ 1.25 0.512
1.952
Step 2: Calculate the equity portion
Total cash received (500 000 x C15) 7 500 000

Less recognised as a liability Step 1 2 928 000
Therefore equity portion Balancing 4 572 000
Step 3: Loan amortisation table Interest Bank Liability

25%
2 Jan 20X4 2 928 000 (2 928 000)
31 Dec 20X4 732 000 (1 500 000) (2 160 000)
31 Dec 20X5 540 000 (1 500 000) (1 200 000)
31 Dec 20X6 300 000 (1 500 000) 0
1 572 000 (1 572 000)
Example 17: Redeemable debentures issued at a discount

On 2 January 20X4, Redvers Limited issued 10 000 debentures, at a discount of C100 off their
face value of C500, details of which are as follows:
These debentures are compulsorily redeemable at a premium of 10% over face value,
4 years later.
The debentures bear interest at 15% per annum payable in arrears.
The effective interest rate on the debentures is 25.23262%.
The preference shares are not held for trading nor were they designated at fair value on initial
recognition.
Required: Prepare journals for Redvers to record the financial instrument over its four-year life.
Solution 17: Redeemable debentures issued at a discount

Comment:
The preference shares that we issued are redeemable. There is no possibility of conversion and
therefore there is definitely no equity component.
The liability that we have is therefore:
(1) the interest that we know we will have to pay each year for four years plus
(2) the definite redemption (repayment) of capital after four years.
The liability is measured at the present value of these two cash outflows.
Remember that the difference between the amount we receive and the amount we recognise as a
liability (measured at present value) would be recognised as equity: this will work out to zero in this
example since the issue price will have been worked out based on our rate of return combined with
the 15% interest cost and the 10% premium.

Bank 4 000 000
Debenture liability 10 000 x (500 – 100) 4 000 000
Issue of redeemable debentures s
31 December 20X4
Finance costs W3 1 009 305
Debenture liability Balancing 259 305
Bank 10 000 x C500 x 15% 750 000
Finance costs on debentures
1000 Chapter 22

Bank 10 000 x C500 x 15% 750 000
31 December 20X6
Bank 10 000 x C500 x 15% 750 000
31 December 20X7
Debenture liability Balancing 4 990 713
Bank 750 000 + 5 500 000 6 250 000
Workings:
W1: Calculate the liability portion
W1.1 Annuity
Interest payment each year for 4 years (10 000 x C500 x 15%) 750 000
Discount factor for 4 years (for 25.23262%) (25.23262% for a 4-year annuity)* 2.3518567
Liability portion Note: rounding error 1 763 890
W1.2 Annuity
Lump sum payment after 4 years (10 000 x C500 x 110%) 5 500 000
Discount factor after 4 years (for 25.23262%) (15% after 4-years) * 0.4065654
* Discount factor at 25.2326% for a 4-year annuity
1/ 1.252326 0.7985141
0.7985/ 1.252326 0.6376248
0.6376/ 1.252326 0.5091524
0.5092/ 1.252326 0.4065654
2.3518567
W1.3 Total liability
Present value of the 4 interest payments W1.1 1 763 890
Present value of the lump-sum payment W1.2 2 236 110
W2: Calculate the equity portion

This was not required since there can be no equity because these are compulsorily redeemable
Total cash received 10 000 x C400 (issue value) 4 000 000
Less recognised as a liability W1.3 4 000 000
Recognise as equity Balancing 0
W3: Loan amortisation table Interest Bank Liability

25.23262%
2 Jan 20X4 4 000 000 4 000 000
31 Dec 20X4 1 009 305 (750 000) 4 259 305
31 Dec 20X5 1 074 734 (750 000) 4 584 039
31 Dec 20X6 1 156 673 (750 000) 4 990 712
31 Dec 20X7 1 259 287 (750 000) 5 500 000
(5 500 000)
4 500 000 (4 500 000)
Chapter 22 1001
7. Settlement in Entity’s Own Equity Instruments (IAS 32.21-24 and AG 27)
A contract that will be settled by delivering a fixed number of its own equity instruments (shares) in
exchange for a fixed amount of cash or another financial asset is an equity instrument.
A contract that will be settled in a variable number of the entity’s own equity instruments (shares)
whose value equals a fixed amount or an amount based on changes in an underlying variable (eg. a
commodity price) is a financial liability.
Example 18: Settlement in entity’s own equity instruments

Us Ltd buys a machine worth C600 000 on 1 August 20X5 from Me Ltd.
Us Ltd shares had a market price of C4 on 1 August 20X5 and C6 on 31 December 20X5.
Required: Prepare journals in the accounting records of Us Ltd for each of the following scenario:
A. Us Ltd issues 120 000 of its shares to Me Ltd on 31/12/20X5 in exchange for the machine.
B. Us Ltd issues C600 000 worth of its shares to Me Ltd on 31/12/20X5 in exchange for the machine.
Solution 18A: Settlement in entity’s own equity instruments

Comment:
Notice that the number of shares to be issued is fixed and therefore we regard this as an equity
instrument from the outset.
Also notice that since we have to issue 120 000 shares on 31 December 20X5 to settle a liability of
C600 000, the issue price is effectively C5 per share (600 000 / 120 000 shares), which happens to
be less than the market price on this date.

Machine: cost 600 000
Stated capital – deferred shares (equity) 600 000
Purchase of a machine for a fixed number of shares on 31 Dec X5
31 December 20X5
Stated capital – deferred shares (equity) 600 000
Stated capital (equity) 600 000
Issue of 120 000 shares: 600 000 / 6 = 100 000
Solution 18B: Settlement in entity’s own equity instruments

Comment:
Since the value of the shares to be issued by the machine is fixed at C600 000, but the market price on
the date of the future issue is not known on the date the machine is bought, the number of future shares
to be issued on 31 December 20X5 is variable: thus we initially record this as a financial liability.
Machine: cost 600 000
Debenture liability (liability) 600 000
Purchase of a machine for a variable number of shares
31 December 20X5
Debenture liability (liability) 600 000
Stated capital (equity) 600 000
Issue of 100 000 shares: 600 000 / 6 = 100 000
8. Derivatives
8.1 Overview
Financial instruments are either primary or derivative. If you were to ask a man on the street
what he understood the word derivative to mean, he would say it is a spin-off, an off-shoot or
by-product. A derivative in financial terms is much the same. A derivative is simply a
financial instrument whose value is derived (got) from the value of something else.
1002 Chapter 22
A derivative is defined as:

A financial instrument or other contract within the scope of this Standard with all three of the
following characteristics.
a) its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable, provided in the case of a non-financial variable that the variable is not
specific to a party to the contract (sometimes called the ‘underlying’).
b) it requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors.
c) it is settled at a future date.
The derivative definition

If one simplifies this definition of a derivative, a derivative can be summarised as a
is simply an instrument whose value is derived from financial instrument
another specified variable, requires little or no investment whose value changes in response to
and will be settled in the future. There are many types of another specified variable (e.g. a
derivatives of which we will discuss a few: specified interest rate or foreign
options, exchange rate);
swaps, and that requires little or no initial net
investment or one that is lower than
futures. expected
is settled at a future date
8.2 Options IFRS 9 Appendix A (reworded)
An option gives the holder the right (but not the obligation) to buy or sell a financial
instrument on a future date at a specified price. The most common option that we see
involves options to buy shares on a future date at a specific price (strike price). These are
often granted to directors or employees of companies. Another example is an option to
purchase currency on a future date at a specific exchange rate. Options may be used to limit
risks (as the exercise price of an option is always specified) or they may be used for
speculative purposes (i.e. to trade with).
8.3 Swaps
A swap is when two entities agree to exchange their future cash flows relating to their
financial instruments with one another. A common such agreement is an ‘interest rate swap’.
For example, one entity (A) has a fixed-rate loan and another entity (B) has a variable-rate
loan. The two entities may agree to exchange their interest rates if A would prefer a variable
rate and B would prefer a fixed rate.
Example 19: Swaps
Company A and Company B agree to swap their interest rates.
Company A has a loan of C100 000 with a fixed interest rate of 10% per annum.
Company B has a loan of C100 000 with a variable interest rate, which was 10% p.a.
in 20X1.
The variable rate changed to 12% in year 2 and to 8% in year 3.
Required: Journalise the receipts/ payments of cash in Company A’s books for year 2 and year 3.
Solution 19: Swaps
Year 2 Debit Credit

Finance cost (expense) 100 000 x 10% 10 000
Bank 10 000
Interest on fixed rate loan paid to lender
Finance cost (expense) 100 000 x (12% - 10%) 2 000
Bank 2 000
Difference between variable and fixed rate loan paid to Company B
Chapter 22 1003

Year 3 Debit Credit
Finance cost (expense) 100 000 x 10% 10 000
Bank 10 000
Interest on fixed rate loan paid to lender
Bank 100 000 x (10% - 8%) 2 000
Difference between variable and fixed rate loan received from
Company B
8.4 Futures and forwards
A future is an agreement to buy or sell a specified type and quantity of a financial instrument
on a specified future date at a specified price. For example, if A does not have the cash to
purchase shares immediately but believes that they are a worthwhile investment, it may enter
into a futures contract with another entity (B) whereby A commits to buying them on a future
date. The difference between a future and an option is that a future commits (i.e. obligates)
the entity whereas an option does not.
A forward contract is identical to a futures contract except for the standard of the contract:
A futures contract is a standard contract drawn up by a financial services company that
operates an exchange
A forward contract is based on a non-standard contract written up by the parties
themselves.
8.5 Embedded derivatives (IFRS 9.4.3)
An embedded derivative is simply a:

derivative that is rooted in a combined instrument,
where the combined instrument is created through a non-derivative host contract,
where some of the cash flows of the combined instrument vary in the same way as had
they come from an individual derivative,
where the embedded derivative may not be contractually transferred separately from and
does not have a different counterparty to the other financial instruments.
It may sound complicated but is not really complex at all. Essentially, there is a contract that
combines a number of instruments where one or more of these instruments is a derivative.
For this derivative to be embedded, it must be unable to be transferred (e.g. sold) separately
from the host contract and must not have a separate counterparty to the counterparties of the
other financial instruments in the contract.
The entire hybrid contract, provided the host contract meets the requirements in IFRS 9, is
accounted for collectively either as fair value through profit or loss or amortised cost based on
the normal classification criteria.
9. Impairment of Financial Assets (IFRS 9.5.5)
9.1 Overview
For the purposes of impairment in IFRS 9, the financial assets are classified into two broad
categories – fair value through profit or loss and the others which include fair value through
other comprehensive income and amortised cost. If an asset is measured at fair value through
profit or loss there is obviously no need for an impairment test because all changes in the
value of the financial asset are automatically accounted for and recorded in profit or loss.
1004 Chapter 22
If a financial asset is not measured at fair value through profit or loss, the entity must apply
the expected credit loss model. This model applies to the
following assets: A loss allowance is defined
Financial assets at amortised cost, as the
Financial assets at fair value through other allowance for expected credit losses
comprehensive income, on financial assets measured at
Lease receivables (see IAS 17 Leases), amortised cost, lease receivables &
Contract assets (see IFRS 15 Revenue from contract assets and
Contracts with Customers), accumulated impairment amount for
Loan commitment and financial guarantee contracts. financial assets measured at FV
through OCI
The expected credit loss model kicks in from the first provision for expected credit losses
on loan commitments and guarantee
day the financial asset is recognised in the financial IFRS 9 Appendix A
contracts)
statements. In other words, it is not necessary for an
impairment event or trigger to be evident before the loss allowance is accounted for – we
account for credit losses based on expectations – we do not wait for them to occur. Therefore
at initial recognition there are two primary transactions to be accounted for namely the initial
recognition of the financial asset and the creation of a loss allowance account.
Under expected credit loss model, an entity recognises a loss allowance for expected credit
losses on the initial recognition of a financial asset at amortised cost and a corresponding
impairment loss adjustment, recognised in profit or loss. The loss allowance account is a
measurement account that effectively reduces the carrying amount of the financial asset (what
we refer to in this book as a ‘negative asset’). The journal would thus be as follows:
Initial recognition of loss allowance Debit Credit
Impairment loss (P/L: E) xxx
Financial asset: loss allowance (-A) xxx
Recognising loss allowance on a FA at amortised cost
However, in the case of debt instruments at fair value through other comprehensive income,
although the impairment loss on initial recognition is recognised in profit or loss, no loss
allowance account is recognised. Instead, the credit entry is recognised in the same OCI
account in which the asset’s fair value gains and losses are recognised.
Initial recognition of loss allowance Debit Credit
Impairment loss (P/L: E) xxx
Impairment loss on financial asset (OCI) xxx
Recognising loss allowance on a FA at FV through OCI
There is a general approach to the expected credit loss model and a simplified approach. The
simplified credit loss model must be used when dealing with trade receivables, lease
receivables and contract assets (see section 9.3).
9.2 Expected credit loss model – the general approach (IFRS 9.5.5.1)
9.2.1 Overview of the general approach
Under the general approach, the loss allowance account to be created on initial recognition
(i.e. day 1) is measured based on the credit losses expected during the 12 months following its
reporting date.
Then, after initial recognition, we re-assess the credit risk Expected credit losses
are defined as –
of the financial asset and, depending on this credit risk
assessment, the loss allowance is either: The weighted average of
maintained at the 12-month expected credit losses: credit losses with
- if the credit risk has not increased significantly, or the respective risks of a default
adjusted to reflect lifetime expected credit losses if: occurring as the weights IFRS 9 App A
- there has been a significant increase in the credit
risk or
- there is objective evidence that the financial asset is credit-impaired.
Chapter 22 1005
Summary: Subsequent measurement of loss allowances under the general approach

The FA’s credit risk did not The FA’s credit risk The FA is credit-impaired
increase significantly increased significantly
Measurement of expected losses: Measurement of expected losses: Measurement of expected losses:
12-month expected credit losses lifetime expected credit losses lifetime expected credit losses
Effect of accounting for expected losses on the subsequent measurement of assets at Amortised Cost:
Measurement of interest income: Measurement of interest income: Measurement of interest income:
EIR x GCA EIR x GCA EIR x (GCA – Loss allowance)
Gross carrying amount is defined as the amortised cost of a FA, before adjusting for any loss allowance *
Effect of accounting for expected losses on the subsequent measurement of assets at FV through OCI:
There is no effect on the subsequent measurement of the actual asset at FV through OCI: the asset account
continues to be adjusted to the latest FVs. This is because the expected losses are accounted for entirely
separately (debited to P/L and credited to OCI – they are not credited to a loss allowance account).
An exception to this general approach relates to financial assets that were already credit-
impaired at initial recognition. If an entity has such financial assets, then the loss allowance is
always equal to the lifetime expected credit losses from initial recognition and at each
reporting date. See IFRS 9.5.5.13
If the financial assets are not credit-impaired at initial recognition but subsequently become
credit-impaired, the lifetime expected credit losses are measured as the difference between
the gross carrying amount of the financial asset and the present value of the estimated future
cash flows discounted using the original effective interest rate.
For subsequent periods, the interest income on a credit-impaired financial asset is no longer
measured using the original effective interest rate and the financial asset’s gross carrying
amount but will now be measured using the original effective interest rate and the financial
asset’s amortised cost (gross carrying amount less the loss allowance).
A financial asset is considered to be credit-impaired once an event has actually occurred, that
has caused a decrease in the asset’s estimated future net cash inflows.
A credit-impaired financial asset is a FA whose estimated future cash flows have been
detrimentally affected by an event that has already occurred.
The following events may indicate that a financial asset has been credit-impaired:
significant financial difficulty of the issuer or the borrower,
a breach of contract such as a default or ‘past due’ event,
the lender/s of the borrower, for economic or contractual reasons relating to the borrower’s financial
difficulty, having granted to the borrower a concession/s that the lender/s would not otherwise consider,
when it becomes probable that the borrower will enter bankruptcy or other financial reorganisation,
the disappearance of an active market for that financial asset because of financial difficulties, or
the purchase of origination of a financial asset at a deep discount (below market prices for instruments of
a similar profile) that reflects incurred credit losses. IFRS 9 Appendix A (Reworded).
9.2.2 Assessment of credit risk (IFRS 9.5.5.4 – 11)

At each reporting date, the entity needs to assess whether
the credit risk on the financial asset has increased Credit risk is defined as –
significantly since initial recognition. IFRS 9.5.5.9.
The risk that one party to a
The assessment of whether there has been an increase in financial instrument
credit risk needs to consider all reasonable and will cause a financial loss for the
supportable information, including information that is other party
by failing to discharge an
forward looking. IFRS 9.5.5.4 (reworded) obligation IFRS 7 Appendix A
In order to assess whether there has been a significant increase in the credit risk of a financial
instrument, the entity shall focus on the change in the risk of default (also called probability of
default: PD) over the life of the financial instrument rather than focusing on the change in the
amount of expected credit losses. In other words, the change in the amount of expected credit
losses is not in itself an indication that there has been a significant increase in the credit risk
of the financial instrument. IFRS 9.5.5.9
1006 Chapter 22
If a financial instrument is regarded as having a low risk of default at the reporting date then
the entity may assume that there has not been any significant increase in credit risk since
initial recognition. IFRS 9.5.10
If the contractual terms of a financial asset are renegotiated or modified, the basis for
assessing the change in credit risk is simply a comparison between the risk of default at the
reporting date (using the modified contractual terms) and the risk of default at initial
recognition (based on original terms). IFRS 9.5.5.12
9.2.3 If no significant increase in credit risk (IFRS 9.5.5.3)
If there is no evidence of a significant deterioration in credit risk (i.e. no evidence of an

increase in credit risk) since initial recognition, the entity shall continue to measure the loss
allowance for that financial instrument at an amount equal to 12-month expected credit losses.
Example 20: Expected credit loss - no significant increase in credit risk

(IFRS 9IG Example 8 – Adapted)
On 2 January 20X4, Joyous Limited provides a loan to Sadness Limited for C100 000. The
interest rate on the loan is 12% per annum and is due in 5 years.
The loan is classified as a financial asset at amortised cost.
At initial recognition, Joyous estimates that the loan has a probability of default of 0.05% for the next
12 months and estimates that if the loan defaults over the 5-year period, then an estimated 20% of the
gross carrying amount will be lost.
Required: Discuss how Joyous Limited should account for the expected credit losses on the financial
instrument for the year ended 31 December 20X4
Solution 20: Expected credit loss measurement - no significant increase in credit risk
By estimating that there is a 0.05% probability of a default occurring within the first 12 months, Joyous
is implicitly stating that there is a 99.5% probability that there will be no default in the first 12 months.
The total expected losses over the term of the loan (i.e. loss given the probability that a default might
occur) is 20%. In other words the ‘loss given default’ (LGD) is equal to C100 000 x 20% = C20 000.
This represents expected lifetime credit losses (if there is a default in the next 12 months, then we
expect to lose a total of C20 000 over the life of the asset). However, our loss allowance must only
equal the expected credit losses over the next 12 month period.
At initial recognition: Joyous must recognise a loss allowance equal to the 12-month expected
credit losses: C20 000 x 0.5% = C1 000 (Lifetime Expected Credit Losses [LGD] x Probability of
default over 12 months [PD])
Therefore, at initial recognition, Joyous recognises the financial asset and also recognises an
allowance for credit losses equal to C1 000.
After initial recognition: Since there has been no significant increase in the credit risk of Sadness
up to the reporting date, the allowance for credit losses will remain at C1 000 at the reporting date.
9.2.4 Significant increase in credit risk (IFRS 9.5.5.9)
If there is evidence of a significant deterioration in credit risk (i.e. evidence of an increase in

credit risk) since initial recognition, the entity must re-measure the loss allowance to reflect
the lifetime expected credit losses.
Example 21: Expected credit loss – significant increase in credit risk

On 2 January 20X4, Joyous Limited provides a loan to Sadness Limited for C100 000. The
interest rate on the loan is 12% per annum and is due in 5 years. The loan is classified as a financial
asset at amortised cost. At initial recognition, Joyous estimates that the loan has a probability of default
of 0.05% for the next 12 months and estimates that if the loan defaults over the 5-year period, then 20%
of the gross carrying amount will be lost.
Chapter 22 1007
At the end of the reporting period, Joyous becomes aware that Sadness is considering filing for
protection from its creditors as it is facing bankruptcy. This is assessed by the directors of Joyous to be
an objective indicator that Sadness will not be able to discharge all its financial obligations.
Required: Explain how Joyous Limited should account for the expected credit losses on the financial
instrument for the year ended 31 December 20X4.
Solution 21: Expected credit loss measurement – significant increase in credit risk
By estimating that there is a 0.05% probability of a default occurring in the first 12 months, Joyous is
implicitly stating that there is a 99.5% probability that there will be no default in the first 12 months.
The sum of expected losses over the term of the loan (i.e. loss given the probability that a default might
occur) is 20%. In other words the loss given default (LGD) is equal to C100 000 x 20% = C20 000.
This represents expected lifetime credit losses (if there is a default in the next 12 months, then we
expect to lose a total of C20 000 over the life of the asset). However, our loss allowance must only
equal the expected credit losses over the next 12 month period.
At initial recognition: Joyous must recognise a loss allowance equal to the 12-month expected
credit losses: C20 000 x 0.5% = C1 000 (Lifetime Expected Credit Losses [LGD] x Probability of
default over 12 months [PD])
Therefore, at initial recognition, Joyous recognises the financial asset and also recognises an
allowance for credit losses equal to C1 000.
Initial recognition and measurement of loan Debit Credit
Loan asset (A) 100 000
Bank (A) 100 000
Loan: loss allowance (-A) 1 000
Recognising loan granted to Sadness and related loss allowance
At the reporting date, there has been a significant increase in the credit risk of Sadness Limited,
therefore the allowance for credit losses will now be the lifetime expected credit losses of C20 000.
We therefore need to account for an additional allowance of C19 000.
Subsequent measurement of loan at reporting date Debit Credit
Loan: loss allowance (-A) 19 000
Remeasurement of loss allowance due to significant increase in
credit risk: measurement now = lifetime expected credit losses
Where the financial asset is measured at amortised cost, the related interest income that is
recognised continues to be measured at the effective interest rate method using the original
interest rate and multiplying this by the gross carrying amount of the financial asset (i.e.
before deducting the loss allowance).
Example 22: Expected credit loss – significant increase in credit risk
On 2 January 20X4, Joyous Limited invested in 5 000 debentures that were issued by
Ecstatic Limited. The debentures had the following terms –
Nominal value – C100
Coupon rate – 9% (payable annually on 31 December)
Issue price – C98 per debenture (equal to fair value on the issue date)
Issue date – 2 January 20X4
Maturity date – 31 December 20X7
Transaction costs – C2 500
Joyous classified the investment in debentures as a financial asset at amortised cost.
The effective interest rate on the debentures is 9.47%.
This rate was calculated as follows (PV = -((5 000 x C98) + C2 500) = -C492 500; N = 4; PMT = (5 000 x C100 x
9%) = C45 000; FV = (5 000 x C100) = C500 000; Comp I = ???).
On initial recognition, Joyous Limited estimates that the lifetime expected credit losses (‘Loss Given
1008 Chapter 22
Default’ (LGD)) are C17 500 and the 12-month expected credit losses (‘Probability of Default’ (PD))
are C3 125.
On 31 December 20X4, due to its high debt ratio and declining profit margins, Ecstatic issues a
warning to its creditors that it is undergoing a business restructuring process aimed at saving the
business from bankruptcy. As a result of this, the directors of Joyous determine that there has been a
significant increase in credit risk since the acquisition of the debentures issued by Ecstatic.
Required: Explain how Joyous should account for the expected credit losses on the debentures for the
year ended 31 December 20X4 and 31 December 20X5.
Solution 22: Expected credit loss – significant increase in credit risk

As this is a financial asset at amortised cost, the general approach applies at initial recognition. In other
words, Joyous Limited needs to recognise the investment in debentures as a financial asset and also
recognise a loss allowance for the financial asset. As the investment is not credit-impaired at initial
recognition the loss allowance is initially measured based on 12-month expected credit losses.
At the end of the reporting period, there is evidence of an increase in the credit risk of the financial
asset and Joyous Limited must therefore account for lifetime expected credit losses.
Debentures: amortised cost (A) 5 000 x C98 490 000
Bank (A) 490 000
Purchase of debentures at fair value classified at amortised cost)
Debentures: amortised cost (A) 2 500
Bank (A) 2 500
Transaction costs capitalised
Debentures: loss allowance (-A) 3 125
Recognition of 12-month expected credit losses
31 December 20X4
Bank (A) 5 000 x C100 x 9% 45 000
Debentures: amortised cost (A) Balancing 1 640
Interest income (I) (490 000 + 2 500) x 9.47% 46 640
Recognition of coupon and interest income (effective interest rate)
Impairment loss E) 17 500 – 3 125 14 375
Remeasurement of loss allowance due to significant increase
in credit risk - measurement now based on lifetime expected credit losses
31 December 20X5
Bank (A) 5 000 x C100 x 9% 45 000
Debentures: amortised cost (A) Balancing 1 795
Interest income (I) (490 000 + 2 500 + 1 640) x 9.47% 46 795
9.2.5 If the asset becomes credit-impaired (IFRS 9.B5.5.33)
If an asset becomes credit-impaired, the lifetime expected credit losses must be accounted for.
The lifetime expected credit losses are measured as the difference between the gross carrying
amount of the financial asset and the present value of the estimated future cash flows
discounted using the original effective interest rate.
For subsequent periods, the interest income on a credit-impaired financial asset will no longer
be measured using the original effective interest rate and the financial asset’s gross carrying
amount but will now be measured using the original effective interest rate and the financial
asset’s amortised cost (gross carrying amount less the loss allowance).
Chapter 22 1009
Example 23: Expected credit loss – asset becomes credit-impaired

Repeat the previous example with the following adaptations:
On initial recognition, Joyous estimates that the 12-month expected credit losses are C3 125.
On 31 December 20X4, the directors of Joyous determine that the financial asset is credit-
impaired. It calculates that the present value of the related estimated future cash flows, calculated
using the original interest rate, as at 31 December 20X4 to be C476 640.
Required: Discuss how Joyous should account for the expected credit losses on the debentures for the
year ended 31 December 20X4 and 31 December 20X5.
Solution 23: Expected credit loss – asset becomes credit-impaired
The journals will be the same except for the following:

The impairment loss journal at 31 December 20X4: Although the amount of the journal is
the same as in the previous example, this is simply due to the design of the question.
What is important to notice is that this loss allowance is now calculated as the difference
between the gross carrying amount and the present value of the future cash flows.
Amortisation journal at 31 December 20X5: the interest is no longer calculated based on
the gross carrying amount, but is now calculated based on the amortised cost (i.e. gross
carrying amount less the loss allowance).
Impairment loss E) 17 500 – 3 125 14 375
Remeasurement of loss allowance due to significant increase
in credit risk - measurement now based on lifetime expected credit losses
31 December 20X5
Bank (A) 5 000 x C100 x 9% 45 000
Debentures: amortised cost (A) Balancing 138
Interest income (I) (490 000 + 2 500 + 1 640 – 3 125 – 14 375) x 9.47% 45 138
9.3 Expected credit loss model – the simplified approach (IFRS 9.5.5.15)
In terms of the general approach, a loss allowance for lifetime expected credit losses is
recognised for all qualifying financial assets if there has been a significant increase in credit
risk whilst the loss allowance for financial assets which do not indicate a significant increase
in credit risk is limited to the 12-month expected credit losses.
However – a simplified approach exists where an entity must simply always account for
lifetime expected credit losses. The approach is available for the following financial assets –
trade receivables or contract assets arising from contracts with customers (IFRS 15)
provided that such transactions contain an insignificant financing component.
trade receivables or contract assets arising from contracts with customers (IFRS 15) that
contain a significant financing component provided the entity has adopted the accounting
policy of measuring the loss allowance at an amount equal to lifetime expected credit
losses.
lease receivables within the scope of IAS 17, provided the entity has adopted the
accounting policy of measuring the loss allowance at an amount equal to lifetime
expected credit losses. IFRS 9.5.5.15 (extracts)
Example 24: Expected credit loss measurement – simplified approach
Joyous has a portfolio of trade receivables of C9 250 000 at 31 December 20X4. The trade
receivables do not have a significant financing component in terms of IFRS 15 Revenue from Contracts
with Customers.
1010 Chapter 22
Joyous Limited has constructed a reliable provision matrix to determine expected credit losses for the
portfolio.
This provision matrix, based on the expected default rates per ageing category, has been included in the
current age analysis of trade receivables as follows:
Gross carrying amount Provision matrix reflecting
expected default rates
Current C3 750 000 0.3%
1 – 30 days C3 500 000 1.75%
31 – 60 days C1 000 000 3.6%
61 – 90 days C750 000 5.75%
More than 90 days past due C250 000 9%
Grand total C9 250 000
Required: Provide the loss allowance journal that will be processed assuming that there was no
balance in this account at the beginning of the period.
Solution 24: Expected credit loss measurement – simplified approach

Since the financial asset is a receivable in terms of IFRS 15 and has no significant financing component,
the expected credit losses must be accounted for under the simplified approach: the loss allowance must
equal the lifetime expected credit losses on the portfolio of trade receivables.
Debit Credit
Impairment loss (E) W1 174 125
Receivables: loss allowance (-A) 174 125
Impairment of receivables based on lifetime expected credit losses
W1. Calculation of the loss allowance:

Lifetime expected credit loss
GCA Default rate
allowance
Current C3 750 000 0.3% C11 250
1 – 30 days C3 500 000 1.75% C61 250
31 – 60 days C1 000 000 3.6% C36 000
61 – 90 days C750 000 5.75% C43 125
More than 90 days past due C250 000 9% C22 500
Grand total C9 250 000 C174 125
9.4 Measurement of expected credit losses (IFRS 9.5.5.17 – 5.5.20)
When an entity measures expected credit losses on a financial instrument, it shall use
information that reflects the following:
probability-weighted amounts that consider a range of possible outcomes,
time value of money, and
readily available information that is reasonable and supportable and falls within the
contractual period over which the entity is exposed to credit risk. IFRS 9.5.5.17-19
This does not imply that every possible scenario will always be accounted for, however the
probability of credit losses occurring must be considered even if the possibility of the loss
occurring is deemed low. IFRS 9.5.5.18
For example, if an entity has a financial instrument that generates contractual cash flows and
such cash flows are subsequently amended or delayed, that information would be used in
computing the allowance credit losses as the cash shortfalls are credit losses whilst the delay
in payments indicates that the present value of expected cash flows is now different to the
present value of the cash flows initially expected. See IFRS 9.B5.5.28
Chapter 22 1011
10. Offsetting of Financial Assets and Liabilities

(IAS 32.42 - .50, AG38A-38F, IFRS 7.13C-13E)
Financial assets and liabilities may not be offset against one another unless:
the entity has a legally enforceable right to set-off the recognised asset and liability; and
the entity intends to realise the asset and settle the liability simultaneously or on a net
basis.
When an entity has the right to receive or pay a single net amount and intends to do so, it has,
in effect, only a single financial asset or financial liability. However, the existence of an
enforceable right, by itself is not a sufficient basis for offsetting. There has to be an intention
to exercise this right or to settle simultaneously. Conversely, an intention to settle on a net
basis without the legal right to do so is not sufficient to justify offsetting.
In order to have a legally enforceable right to set-off, the right of set-off;

must not be contingent upon a future event( ie the right is only exercisable on the
occurrence of some future event, such as default, insolvency or bankruptcy of one of the
counterparties
must be legally enforceable in all of the following circumstances:
- the normal course of business
- the event of default and
- the event of insolvency and bankruptcy of the entity and all of the counterparties.
It is important to note that offsetting a financial asset and financial liability and presenting the
net amount differs from the derecognition of a financial asset and financial liability since the
derecognition of a financial instrument not only results in the removal of the previously
recognised item in the statement of financial position but may also result in recognition of a
gain or loss in the statement of comprehensive income.
IFRS 7 requires the following disclosures regarding set-offs:

the gross amount of those recognised financial assets and financial liabilities
the net amounts presented in the statement of financial position
the amounts subject to an enforceable master netting arrangement or similar agreement
a description of the nature of the rights of set-off associated with the entity’s financial
assets and financial liabilities subject to enforceable master netting arrangements
11. Financial Risks (IFRS 7)
11.1 Overview
There are three categories of financial risks and they are:

market risk (affected by price risk, interest rate risk and currency risk);
credit risk; and
liquidity risk.
11.2 Market risk (IFRS 7: Appendix A)
Market risk is the risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises of:
interest rate risk;
currency risk; and
other price risk.
1012 Chapter 22
11.2.1 Interest rate risk
Interest rate risk is the risk that the fair value or the future cash flows of a financial instrument
will fluctuate with changes in the market interest rate. A typical example is a bond: a bond of
C100 earning a fixed interest of 10% (i.e. C10) would decrease in value if the market interest
rate changed to 20%, (theoretically, the value would halve to C50: C10/ 20%). If the bond
earned a variable interest rate instead, the value of the bond would not be affected by interest
rate fluctuations.
11.2.2 Currency risk
Currency risk is the risk that the value or the future cash flows of a financial instrument will
fluctuate because of changes in the foreign exchange rates. A typical example would be
where we have purchased an asset from a foreign supplier for $1 000 and at the date of order,
the exchange rate is $1: C10, but where the local currency weakens to $1: C15. The amount
owing to the foreign creditor has now grown in local currency to C15 000 (from C10 000).
11.2.3 Other price risk
Other price risk is the risk that the value or the future cash flows of the financial instrument
will fluctuate as because of changes in the market prices (other than those arising from
interest rate risk or currency risk).
For example: imagine that we committed ourselves to purchasing 1 000 shares on a certain
date in the future, when the share price was C10 on date of commitment. By making such a
commitment, we would be opening ourselves to the risk that the share price increases (e.g. if
the share price increased to C15, we would have to pay C15 000 instead of only C10 000).
11.3 Credit risk
This is the risk that the one party to a financial instrument will fail to discharge an obligation
and cause the other party to incur a financial loss. A typical example is a debtor, being a
financial asset to the entity, who may become insolvent and not pay the debt due (i.e. where a
debtor becomes a bad debt).
11.4 Liquidity risk
This is the risk that an entity will experience difficulty in meeting obligations associated with
financial liabilities. An example: the risk that we (the entity) find ourselves with insufficient
cash to pay our suppliers (i.e. where we risk becoming a bad debt to one of our creditors).
12. Disclosure (IFRS 7)
The following narrative disclosure is required (required by IFRS 7):

For credit risk:
- Amount of maximum exposure to credit risk
- Collateral held as security
- Other credit enhancements
- Credit quality of financial assets (neither past due, nor impaired)
- An analysis of financial assets past due/ impaired.
- The nature and carrying amount of financial and non-financial assets obtained during
the period by taking possession of collateral it holds as security or calling on other
credit enhancements, provided these meet the recognition criteria in the IFRSs.
For liquidity risk:
- Maturity analysis for derivative and non-derivative financial liabilities
- Description of how liquidity risk is managed.
Chapter 22 1013
For market risk

- Sensitivity analysis for each market risk
- Methods and assumptions used in the analysis
- Any changes in the above assumptions, together with reasons for the changes.
For each class of financial assets and liabilities:
- The criteria for recognition;
- Basis for measurement
- Methods and assumptions made to determine fair value
- Fair value of the financial instrument (or the reasons why it cannot be determined,
information about the related market and the range of possible fair values).
The following figures must be separately disclosed:

Finance costs from financial liabilities must be presented as a separate line item
The total change in fair value of the instruments reported in profit or loss
The changes in fair value that were taken directly to other comprehensive income (equity)
Any impairment loss reversal on a financial liability.
For reclassifications the following disclosures are required: IFRS 7.12

The date of reclassification
A detailed explanation of the change in business model and a qualitative description of
the effect on the financial statements
The amount reclassified into and out of each category
IAS 1 requires that on the face of the statement of comprehensive income, the movement in
other comprehensive income must be shown in total and must be split between:
Items that may be subsequently reclassified to profit of loss, and
Items that may never be subsequently reclassified to profit or loss
The following is a suggested disclosure layout that you may find useful.
Name of Company
Note 20X5 20X4
C C
EQUITY AND LIABILITIES or ASSETS
Loans/ debentures Xxx Xxx
Financial instruments 39 xxx xxx
Preference shares xxx xxx
Name of Company
Ordinary Retained Gains/ losses on Gains/ losses on Total
shares earnings financial assets cash flow hedge
at FV through
OCI
C C C C C
Balance: 1 January 20X5 xxx xxx xxx xxx Xxx
Ordinary shares issued xxx Xxx
Total comprehensive income xxx xxx xxx Xxx
Balance: 31 December 20X5 xxx xxx xxx xxx Xxx
1014 Chapter 22
Name of Company
Note 20X5 20X4
C C
Revenue xxx Xxx
Other income:
Fair value adjustment of financial asset through profit or loss xxx Xxx
Fair value gains/(losses) on reclassifications of financial
assets
Impairment losses (expected credit losses)
Distribution costs (xxx) (xxx)
Profit before finance costs xxx Xxx
Finance costs (xxx) (xxx)
Taxation expense xxx Xxx
Profit for the year xxx Xxx
Other comprehensive income for the year xxx Xxx

- Gain/(loss) on cash flow hedge, net of reclassification 23 xxx Xxx
adjustments and tax
- Gain/ loss on the portion of a financial liability 24 xxx Xxx
designated at fair value through profit or loss that relates
to the changes in fair value due to changing credit risk,
net of tax
- Gain/ loss on a financial asset that is an investment in 25 xxx Xxx
equity instruments elected to be measured at fair value
through other comprehensive income, net of tax
Total comprehensive income for the year xxx Xxx
Name of Company
1. Statement of compliance
2.1 Financial instruments
The following recognition criteria are used for financial instruments…
The fair values of the financial instruments are determined with reference to …
20X5 20X4
C C
23. Other comprehensive income: cash flow hedge, net of reclassifications and tax
Cash flow hedge gain / (loss) xxx (xxx)

Tax on gain / (loss) (xxx) Xxx
Reclassification of cash flow gain / (loss) (xxx) Xxx

Tax on reclassification of cash flow gain / (loss) xxx (xxx)
Cash flow hedge gain/ (loss), net of reclassification and tax xxx Xxx
Chapter 22 1015
Name of Company
24. Other comprehensive income: gain or loss on a financial liability designated at fair value
through profit or loss relating to credit risk, net of tax
Fair value gain / (loss) xxx Xxx

Tax on fair value gain / (loss) (xxx) (xxx)
Fair value adjustment of financial instrument, net of tax xxx Xxx
25. Other comprehensive income: gain or loss on a financial asset that is an investment in
equity instruments at fair value
Fair value gain / (loss) xxx Xxx

Tax on fair value gain / (loss) (xxx) (xxx)
Fair value adjustment of financial instrument, net of tax xxx Xxx
39. Financial instruments

The company uses … to manage Financial Risks.
Such risks and methods are:
We are exposed to Currency risk in … and Foreign Currency risk is managed by …
We are exposed to Interest rate risk in … and Interest rate risk is managed by …
We are exposed to Market risk in … and Market risk is managed by …
We are exposed to Credit risk in … and Credit risk is managed by …
We are exposed to Liquidity Risk in … and Liquidity Risk is managed by …
1016 Chapter 22
13. Summary
Financial risks
Market risk Credit risk Liquidity risk

Risk that the value of the Risk that one party to the Risk that the entity will
financial instrument will financial instrument will encounter difficulty in
fluctuate due to: default causing the other raising funds to meet its
Currency risk party to incur financial loss obligations associated
Interest rate risk (e.g. your debtor won’t pay with financial
Other Price risk you) instruments
Financial Assets: Classification Process
Consider the contractual cash flows (CCF):

Are the CCF solely payments of principal and interest
(SPPI) on specified dates (SD)? Is the FA an
No investment in equity No
FV through P/L
And And instruments?
Consider the business Consider the business
model (BM): model (BM):
Yes
Is BM to collect only: Is BM to collect both:
Elect to classify at No
CCF CCF + CF from sale of A
FV through OCI?
Yes Yes Yes
Will classification below cause accounting mismatch and, if Yes

so, do you wish to designate as FV through P/L?
No No
Amortised cost FV through OCI
Financial Assets: Measurement

Classification: Amortised cost FV through OCI FV through P/L
(For qualifying (Default option)
instruments)
Initial measurement: FV + transaction FV + transaction Fair value
costs costs
Expected credit losses 12-month expected 12-month expected Not applicable
at initial recognition: credit losses credit losses
Subsequent Amortised cost (using Fair value Fair value
measurement: the effective FV gains in OCI FV gains in P/L
interest method)
Financial Assets: Impairment Testing (general approach)

(does not apply to financial assets at FV through P/L)
We apply the expected credit loss model
- Recognise an IL allowance * on initial recognition of the FA – account for 12-month expected credit
losses
- For FAs that do not indicate a significant increase in credit risk – continue to account for 12-month
expected credit losses
- For FAs that indicate a significant increase in credit risk – account for lifetime expected credit losses
- For FAs that become credit impaired – account for lifetime expected credit losses
* We adjust an OCI a/c instead of recognising an IL allowance in the case of FAs at FV through OCI
Chapter 22 1017
Financial assets: Reclassifications - the permutations
Reclassification Treatment prior to reclassification Treatment after reclassification
Amortised cost to Initial recognition - Fair value plus Reclassification – previous gains/losses are
FV through P/L (5.6.2) transaction costs not restated.
Then: the loss allowance is created Reclassification journals –
on initial recognition based on the DR FA at FVPL
general approach (12-month CR FA at AmC
expected credit losses) CR Profit on reclassification (P/L)
FV through P/L to Initial recognition – Fair value. Reclassification – previous gains/losses are
Amortised Cost (5.6.3) Transaction costs are expensed not restated.
Subsequent – gains and losses in P/L
Reclassification journals –
As all movements go through P/L – DR FA at AmC
no impairments are necessary and CR FA at FVPL
hence no loss allowance account is
created
Amortised cost to Initial recognition - Fair value plus Measure fair value on reclassification date –
FV through OCI (5.6.4) transaction costs if there is a difference between the
A loss allowance is created on initial amortised cost and the fair value – the
recognition based on the general difference is in OCI
approach (12-month expected credit
losses) DR FA at FVOCI
CR FA at AmC
DR/CR Gain/loss on reclassification (OCI)
FV through OCI to Initial recognition – FV plus Reclassification – the fair value becomes
Amortised Cost (5.6.5) transaction costs the gross carrying amount
Subsequent – gains and losses in OCI However – cumulative gains in OCI are set
off against the asset
Loss allowance account created on Reclassification journals –
day 1 (using the general approach – DR FA at AmC
12-month expected credit losses) CR FA at OCI
Then
DR MTM Reserve (OCI)
CR FA at AmC
FV through P/L to Initial recognition – fair value. DR FV through OCI
FV through OCI (5.6.6) Transaction costs are expensed CR FV through P/L
Subsequent – gains and losses in P/L Fair value remains the same.
However – FVOCI assets require a loss
As all movements go through P/L – allowance account to be created, the fair
no impairments are necessary and value on reclassification date is used as the
hence no loss allowance account is basis for calculating the expected credit
created losses
FV through OCI to Initial recognition – FV plus Reclassification –
FV through PL (5.6.7) transaction costs Cumulative gains/losses are reclassified to
Subsequent – gains and losses in OCI P/L.
Loss allowance account created on This excludes instruments subject to the

day 1 (using the general approach – irrevocable election simply because their
12-month expected credit losses) irrevocable nature makes it impossible for
them to be reclassified under para 5.6.7
Financial liabilities: Measurement

Classification: Amortised cost Fair value
(By default) (Subject to specific requirements)
Initial Fair value less transaction costs Fair value
measurement: (Transaction costs expensed)
Subsequent Amortised cost (using the effective Fair value
measurement: interest rate method) Gains/losses related to credit
risk – OCI
Other gains/losses – P/L
1018 Chapter 22
Gripping GAAP Share capital: equity instruments and financial liabilities
Chapter 23
Share Capital: Equity Instruments and Financial Liabilities
Reference: Companies Act of 2008, Companies Regulations of 2011, IFRS 7, IFRS 9, IAS 32
(including amendments to 31 December 2014)
Contents: Page
1. Introduction 1020
2. Ordinary shares and preference shares 1020
2.1 Ordinary dividends and preference dividends 1020
Example 1: Preference dividend 1021
2.2 Cumulative and non-cumulative preference shares 1021
2.3 Participating and non-participating preference shares 1021
Example 2: Participating dividend 1022
2.4 Redeemable and non-redeemable preference shares 1022
Example 3: Issue of non-redeemable preference shares: equity 1022
Example 4: Issue of redeemable preference shares: liability 1024
3. Changes to share capital 1027
3.1 Issues of ordinary shares 1027
Example 5: Issue at par value and above par value 1028
Example 6: Issue of ordinary shares 1028
Example 7: Share issue costs and preliminary costs 1029
3.2 Conversion of shares 1029
Example 8: Converting ordinary shares into preference shares 1030
3.3 Rights issue 1030
Example 9: Rights issue 1030
3.4 Share splits 1031
Example 10: Share split 1031
3.5 Share consolidations (Reverse share split) 1031
Example 11: Share consolidation 1031
3.6 Capitalisation issue 1031
Example 12: Capitalisation issue 1032
3.7 Share buy-backs (treasury shares) (s48) and other distributions made by the
company (s46) and the solvency and liquidity test (s4) 1032
Example 13: Share buy-back 1034
3.8 Redemption of preference shares 1035
3.8.1 Overview 1035
3.8.2 Financing of the redemption 1035
Example 14: Redemption at issue price – share issue is financing of last resort 1035
Example 15: Redemption at issue price – share issue is financing of first resort 1036
3.8.3 Redemption at a premium 1037
Example 16: Redemption at a premium - shares were recognised as equity 1037
Example 17: Redemption at a premium - shares were recognised as a liability 1038
4. Summary 1041
Chapter 23 1019
1. Introduction
A business entity requires funds to start and continue running a business. These funds can be
obtained from any of the following:
Raising funds from owners (shares);
Making profits (an internal source); and
Borrowing through loans or debentures (an external source).
In the case of a partnership, the owners would be referred to as partners. In the case of a close
corporation, the owners would be referred to as members (please note that close corporations
still exist but are being phased out since the introduction of the new Companies Act of 2008).
In the case of companies, the owners would be referred to as shareholders. This chapter
concentrates on the acquisition of funds by a company through its shareholders.
A share issued by an entity to a shareholder is:

an equity instrument to the entity (or, in some cases, a financial liability); and
a financial asset to the shareholder.
An equity instrument is a contract in which the holder has a residual An equity

interest in the assets of the entity after deducting its liabilities (i.e. E = instrument is
A – L; the accounting equation). When issuing a share, the bank defined as:
increases (i.e. an increase in assets) and since there is no obligation to any contract
return the funds to the shareholder (i.e. there is no increase in that evidences a
liabilities), equity increases, thus making it an equity instrument. residual interest in
the assets of an
entity
This chapter looks at shares from the perspective of the entity that
after deducting all of
issued the shares. Share capital from the perspective of the investor is its liabilities. IAS32.11
explained in the financial instruments chapter.
There are two basic classes of shares that a company may issue:
ordinary shares (also called common stock); and
preference shares (also called preferred stock).
Each class of shares must be authorised in terms of the Companies Act Shares must
S36
, being the maximum number of shares the company may issue. be authorised before
Only authorised shares can be issued to shareholders. See Companies Act S38 they can be issued
2. Ordinary Shares and Preference Shares
2.1 Ordinary dividends and preference dividends
Preference shareholders have preference over the ordinary shareholders in the case of the
company being liquidated. Ordinary shares are therefore riskier from an investor perspective
than preference shares but they usually outperform preference shares on the stock markets.
Ordinary shareholders are not guaranteed to receive dividends because ordinary dividends are
dependent on both the profitability of the company and its cash flow. It should be noted that
an interim ordinary dividend is often declared during the year with a final ordinary dividend
declared at year-end or shortly thereafter. A dividend should only be recognised once the
company has a present obligation to pay the dividend. This obligation arises when the
dividends are declared (e.g. a final ordinary dividend for the year ended 31 December 20X2
that is declared in January 20X3, should be recorded in the financial statements for the year
ended 31 December 20X3, since there was no obligation before the date of the declaration).
Preference shareholders generally receive a fixed preference dividend annually. The dividend
is based on the coupon rate.
1020 Chapter 23
Example 1: Preference dividend

A company has 1 000 12% preference shares in issue (all issued at C2 each).
Required: Calculate the preference dividend for the year.
Solution 1: Preference dividend

1 000 x C2 x 12% (coupon rate) = C240
Below is a summary of the differences between ordinary and preference shares.

Ordinary vs. preference share capital
Ordinary shares Preference shares
Element: equity Dividend

Redemption Element Dividends
recognition
Dividend:
equity distribution non- equity must pay out
equity cumulative
redeemable distribution first
if unpaid,
at option of equity non- need not be
equity
company distribution cumulative paid next
year
pay fixed and
compulsory liability finance charge participating variable
dividend
only pay
at option of non-
liability finance charge fixed
shareholder participating
dividend
2.2 Cumulative and non-cumulative preference shares

‘Cumulative’ or ‘non-cumulative’ preference shares refer to the status of the dividends:
‘non-cumulative’ preference dividends are not recorded if they are not declared in any
one year since the entity has no obligation to pay the dividend; whereas
‘cumulative’ preference dividends are dividends which must be paid and therefore if the
company is unable to pay the dividend in any one year, this dividend accrues to the
preference shareholder until it is paid. No ordinary dividend may be paid until all
cumulative preference dividends have been paid.
Interestingly, when a company issues ‘cumulative preference shares’ Cumulative pref
it commits itself to the payment of preference dividends until either shares result in:
the company is wound up or the preference shares are redeemed. a liability being created
This means that the company creates a present obligation on the date for future pref dividends
of issue: a liability equal to all the future preference dividends.
It also stands to reason that if the share issue is to be recorded as a liability, the preference
dividends payable thereon would be recognised – for accounting purposes – as finance
charges (and not as preference dividends – i.e. not as an equity distribution) and disclosed in
the statement of comprehensive income (and not in the statement of changes in equity).
You may assume, for the rest of this chapter, that all preference shares are non-cumulative
(i.e. equity in nature and not liability) unless the question indicates otherwise.
2.3 Participating and non-participating preference shares
Non-participating preference shares are those where the shareholder Participating pref
does not participate in profits except to the extent of the fixed annual shares result in:
dividend, which is based on the coupon rate. Participating preference the preference
shares are those where the shareholders receive, in addition to the shareholder also earning
fixed annual dividend, a fluctuating dividend, which fluctuates in a variable dividend from
accordance with the ordinary dividend. profits generated
Chapter 23 1021
Example 2: Participating dividend

A company has 1 000 12% non-cumulative preference shares in issue (all issued at C2
each). These preference shares participate to the extent of 1/5 of the ordinary dividend per
share. The ordinary dividend declared is C0,10 per share. There are 1 000 ordinary shares in issue.
Required:
Journalise the ordinary and preference dividends.
Solution 2: Participating dividend

Debit Credit
Ordinary dividends 1 000 x C0,10 100
Ordinary shareholders for dividends (L) 100
Ordinary dividends declared
Preference dividends 1 000 x C2 x 12% 240
Preference shareholders for dividends (L) 240
Fixed preference dividend owing
Preference dividends 1 000 x C0,10 x 1/ 5 20
Preference shareholders for dividends (L) 20
Participating preference dividend owing
Please note: the ordinary dividend and the preference dividend (assuming that the latter related to preference
shares that were non-cumulative and non-redeemable and thus were recognised as pure equity) would appear in
the statement of changes in equity as a distribution to equity participants.
2.4 Redeemable and non-redeemable preference shares

Redeeming a preference share means returning the capital to the To redeem
preference shareholder. Therefore, when issuing a preference share that is means:
redeemable at some date in future, the company immediately commits
itself to a future outflow of economic benefits. This issue of shares would to return capital
then be recognised as a liability. The recognition and measurement of the liability would
depend on many factors, inter alia:
whether the redemption of the preference share is at the option of the company, option of
the shareholder or is compulsory on a specific date;
whether the redemption is to be made at a premium (profit to the shareholder) or discount
(loss to the shareholder); and
whether the coupon rate of the share is greater or less than the market-related interest rate.
If the preference shares are compulsorily redeemable, or are redeemable at the option of the
shareholder, the company has, through the issue of such shares, created a present obligation,
the settlement of which is likely to result in an outflow of future economic benefits – and thus
created a liability.
If, on the other hand, the preference shares are either non-redeemable or are redeemable at the
option of the company, the shares do not result in a present obligation and therefore the shares
are not a liability. These shares must therefore be recognised as equity.
Example 3: Issue of non-redeemable preference shares recognised as equity
On 1 January 20X1 (date of incorporation) a company issued:
100 000 ordinary shares at C3,50 each.
50 000 10% non-cumulative, non-redeemable preference at C2 each.
Half of the authorised ordinary and preference shares have been issued. All preference dividends were
declared and paid before year-end with the exception of 20X6, when the preference dividend was
declared but not yet paid at 31 December 20X6.
Required:
A. Provide all journal entries from the date of issue of the preference shares to 31 December 20X6.
B. Disclose the ordinary and preference shares in the financial statements for all years affected
including 20X6. Show the statement of changes in equity for 20X6 only (with no comparatives).
1022 Chapter 23
Solution 3A: Issue of non-redeemable preference shares recognised as equity

Bank(A) 50 000 x C2 100 000
Preference share capital (Eq) 100 000
Issue of 50 000 10% non-redeemable preference shares at C2 each
31/12/20X1 – 31/12/20X6 *
Preference dividends (distribution to equity participants) * 10 000
Preference shareholders for dividends (L) * 10 000
Preference dividends: 50 000 x C2 x 10%*
* The above journal would be repeated on 31/12/20X2; 31/12/20X3;
31/12/20X4, 31/12/20X5 and 31/12/20X6.
31/12/20X1 – 31/12/20X5 **
Preference shareholders for dividends (L) ** 10 000
Bank ** 10 000
Payment of preference dividend: 50 000 x C2 x 10%**
** The above journal would be repeated on 31/12/20X2; 31/12/20X3;
31/12/20X4 and 31/12/20X5 but not on 31/12/20X6, since the
dividends were not paid in 20X6 (presented as a current liability)
Solution 3B: Issue of non-redeemable preference shares recognised as equity

Company name
At 31 December 20X6
Note 20X6 20X5 20X4 20X3 20X2 20X1
Equity and Liabilities C C C C C C
Issued share capital and reserves
Ordinary share capital 3 350 000 350 000 350 000 350 000 350 000 350 000
Preference share capital 4 100 000 100 000 100 000 100 000 100 000 100 000
Current liabilities
Preference shareholders for dividends 10 000 0 0 0 0 0
Company name
For the year ended 31 Dec 20X6
Ordinary Preference Retained Total
share capital share capital earnings
C C C C
Opening balance 350 000 (1) 100 000 (2) xxx xxx
Ordinary dividends declared (xxx) (xxx)
Preference dividends declared (10 000) (10 000)
Closing balance 350 000 100 000 xxx xxx
(1) ordinary shares: 100 000 shares x C3,50 each

(2) preference shares: 50 000 x C2
Company name
3. Ordinary share capital 20X6 20X5 20X4 20X3 20X2 20X1
Number Number Number Number Number Number
Authorised:
Ordinary shares of no par value NOTE 200 000 200 000 200 000 200 000 200 000 200 000
Chapter 23 1023
Solution 3B: continued …

Company name
Notes to the financial statements continued…
3. Ordinary share capital cont… 20X6 20X5 20X4 20X3 20X2 20X1
Issued:
Shares in issue: opening balance 100 000 100 000 100 000 100 000 100 000 0
Issued during the year 0 0 0 0 0 100 000
Shares in issue: closing balance 100 000 100 000 100 000 100 000 100 000 100 000
4. Preference share capital 20X6 20X5 20X4 20X3 20X2 20X1

Authorised:
10% non-redeemable non-cumulative 100 000 100 000 100 000 100 000 100 000 100 000
preference shares of no par value NOTE
Issued:
Shares in issue: opening balance 50 000 50 000 50 000 50 000 50 000 0
Issued during the year 0 0 0 0 0 50 000
Shares in issue: closing balance 50 000 50 000 50 000 50 000 50 000 50 000
NOTE: Since all shares in future will have no par value (see 3.1), it may seem odd to disclose this fact in the
share capital notes. However, IAS 1 requires disclosure of whether the shares have a par value or not, and thus
this disclosure is required even though the option of par value shares is not available in South Africa any
longer.
Example 4: Issue of redeemable preference shares recognised as a liability

On 1 January 20X1, date of incorporation, a company issued:
100 000 ordinary shares, issued at C3,50 each;
50 000 10% cumulative, redeemable preference shares, issued at C2 each.
The preference shares must be redeemed on 31 December 20X6 at a premium of C0,20 per share.
The effective rate of interest paid is calculated to be 11,25563551%.
There are a total of 120 000 authorised ordinary shares (unchanged since incorporation).
Half of the authorised preference shares have been issued.
Retained earnings on 1 January 20X5 was C150 000.

Total comprehensive income (after taking into account the above information) was C80 000 in 20X5.
An ordinary dividend of C10 000 was declared in 20X5.
Required:
A. Calculate and show all journal entries from the date of issue to the date of redemption (excluding
the redemption).
B. Disclose the ordinary and preference shares in the financial statements for all years affected
excluding 20X6 (the year of redemption). Show the statement of changes in equity for 20X5 only.
Solution 4A: Issue of redeemable preference shares recognised as a liability

Preference share liability: Effective interest rate = 11,25563551% (given – or calculated as the
internal rate of return using a financial calculator):
PV = 100 000 FV = -110 000 (C2,20 x 50 000) PMT = -10 000 (50 000 x C2 x 10%) n=6
COMP i = 11.25563551%
1024 Chapter 23

W1: Effective interest rate table: Interest Bank Liability balance
1/1/20X1 100 000 (100 000)
31/12/20X1 11 256 (10 000) (101 256)
31/12/20X2 11 397 (10 000) (102 653)
31/12/20X3 11 554 (10 000) (104 207)
31/12/20X4 11 729 (10 000) (105 936)
31/12/20X5 11 924 (10 000) (107 860)
31/12/20X6 12 140 (10 000) (110 000)
31/12/20X6 (110 000) 110 000
70 000 (70 000) 0
Notice that the total interest of C70 000 equals:

dividends of C60 000 (C10 000 x 6 years) + premium on redemption of C10 000 (50 000 x C0.20)

Bank (A) 50 000 x C2 100 000
Preference share liability (L) 100 000
Issue of 50 000 10% redeemable preference shares at C2 each
31/12/20X1
Interest expense (E) 100 000 x 11.25563551% 11 256
Interest on preference shares incurred
Preference share liability (L) 50 000 x C2 x 10% 10 000
Bank (A) / Preference shareholders for dividends (L) 10 000
Payment of preference dividend (or recognising it as a L if unpaid)
Interest on preference shares
31/12/20X3
31/12/20X4
31/12/20X5
Chapter 23 1025

31/12/20X6
Solution 4B: Issue of redeemable preference shares recognised as a liability

Company name
Note 20X5 20X4 20X3 20X2 20X1
C C C C C
Profit before finance charges xxx xxx xxx xxx xxx
Finance charges 11 924 11 729 11 554 11 397 11 256
Profit before tax xxx xxx xxx xxx xxx
Tax xxx xxx xxx xxx xxx
Profit for the year xxx xxx xxx xxx xxx
Other comprehensive income for the year xxx xxx xxx xxx xxx
Total comprehensive income for the year 80 000 xxx xxx xxx xxx
Company name
Ordinary share capital Retained earnings Total
C C C
Opening balance – 20X5 350 000 150 000 500 000
Ordinary dividends declared (10 000) (10 000)
Closing balance 350 000 220 000 570 000
Note: These preference shares are not in the statement of changes in equity since they are included as a liability in
the statement of financial position. Similarly, the preference dividends are not in the statement of changes in
equity since they are included as finance charges in the statement of comprehensive income.
Company name
Note 20X5 20X4 20X3 20X2 20X1
Equity and liabilities C C C C C
Issued share capital and reserves 570 000 500 000 xxx xxx xxx
Ordinary share capital 3 350 000 350 000 350 000 350 000 350 000
Retained earnings 220 000 150 000 xxx xxx xxx
Redeemable preference shares 4 0 105 936 104 207 102 653 101 256
Current liabilities
Redeemable preference shares 4 107 860 0 0 0 0
Note: If the dividend was declared before year-end but only paid after year-end, the dividends on the ‘preference
shareholders’ account at year-end would be disclosed in the statement of financial position as ‘preference
shareholders for dividends’ under the heading of ‘current liabilities’.
1026 Chapter 23

Company name
2.8 Preference shares
Redeemable preference shares that are redeemable on a specific date or at the option of the
shareholder are recognised as liabilities, as the substance thereof is ‘borrowings’. The dividends on
such preference shares are recognised in the statement of comprehensive income as finance charges
using the effective interest rate method.
3. Ordinary share capital 20X5 20X4 20X3 20X2 20X1
Number Number Number Number Number
Authorised:
Ordinary shares of no par value 120 000 120 000 120 000 120 000 120 000
Issued:
Shares in issue: opening balance 100 000 100 000 100 000 100 000 0
Issued during the year 0 0 0 0 100 000
Shares in issue: closing balance 100 000 100 000 100 000 100 000 100 000
4. Redeemable preference share liability 20X5 20X4 20X3 20X2 20X1

Number Number Number Number Number
Authorised:
10% redeemable preference shares 100 000 100 000 100 000 100 000 100 000
Issued:
Shares in issue: opening balance 50 000 50 000 50 000 50 000 0
Issued during the year 0 0 0 0 50 000
Shares in issue: closing balance 50 000 50 000 50 000 50 000 50 000
The redeemable preference shares, of no par value, are compulsorily redeemable on 31 December
20X6 at a premium of C0,20 per share. The 10% preference dividends are cumulative. The effective
interest rate is 11,25563551%.
3. Changes to Share Capital
3.1 Issues of ordinary shares

Under the previous South African Companies Act, each class of shares either had a par value
or had no par value. This situation changed with the introduction of the Companies Act of
2008 (‘the Companies Act’). This new Act states that shares may no longer have a nominal or
par value see s35 Companies Act. The Regulations explain that, with the exception of banks,
companies that had par value shares in existence at effective date must deal with their par
value shares as follows:
If the company had authorised par value shares, none of which had been issued by
effective date or all had been issued but all these had since been re-acquired by the
company by effective date (i.e. all treasury shares at effective date), these shares may not
be issued until they have been converted into ‘no par value’ shares; Regulations 31 (3) reworded
If the company had authorised par value shares, only some of which had been issued at
effective date (i.e. outstanding issued shares), the company may continue to issue the
unissued authorised par value shares until the company publishes a proposal to convert
these shares into no par value shares, but it may not increase the number of these
authorised shares. Regulations 31 (5) reworded
Chapter 23 1027
Since the intention is that all shares in future be ‘no par value With the new
shares’, this text focuses on no par value shares. However, since par Co’s Act:
value shares still exist in South Africa and in many countries only no par value shares
around the world, a brief explanation and example is included to can be issued; but
show how par value shares are accounted for (see example 5). par value shares still exist
Shares with a par value (in countries where par value shares are issuable) may be issued:
at their par value (in which case there would be no share premium);
above their par value (in which case there would be a share premium); or
below their par value (subject to the conditions laid down in s81 of the Companies Act).
Example 5: Issues at par value and above par value
X Ltd issued 100 ordinary shares with a par value of C1 each at an issue price of C1 each.
Required:
A. Journalise this share issue if the shares are issued at C1 each (i.e. issued at par value).
B. Journalise this share issue if the shares are issued at C1,10 each (i.e. issued above par value) and
show how this would be reflected in the statement of changes in equity.
Solution 5A: Issued at par value

Debit Credit
Bank (A) 100 x C1 100
Ordinary share capital (Eq) 100
Issue of C1 par value ordinary shares for C1
Solution 5B: Issued above par value

Debit Credit
Bank (A) 110
Ordinary share capital (Eq) 100 x C1 100
Share premium (Eq) 100 x C0,10 10
Issue of C1 par value ordinary shares for C1.10
Please note: the amount paid in excess of the par value is recorded separately as a ‘share premium’. Both the
‘share capital account’ and the ‘share premium account’ are classified as ‘owners’ equity’.
X Limited
Ordinary shares Share premium Retained earnings Total
C C C C
Opening balance 0 0 xxx xxx
Ordinary shares issued 100 10 110
Closing balance 100 10 xxx xxx
Note: the entire amount of cash received is recognised as equity.
The following examples all refer to no par value shares.
Example 6: Issue of ordinary shares

On 1 January 20X1, Wallington Limited issued 100 ordinary no par value shares at C1 each.
Required: Journalise this share issue.
Solution 6: Issue of ordinary shares

Debit Credit
Bank (A) 100
Ordinary share capital (Eq) 100 x C1 100
Issue of ordinary shares for C1
1028 Chapter 23
The previous Companies Act (of 1973) contained provisions regarding certain items (such as
preliminary costs and share issue costs) which could be written off against the various share
capital accounts. These provisions no longer apply as a result of the 2008 Act being signed
into law, and thus all such costs are to be accounted for in terms of IFRSs:
share issue costs (also referred to as transaction costs): must be set-off against the equity
account, unless the issue of shares is abandoned, in which case the share issue costs will
be expensed in profit or loss; see IAS 32.37 whereas
preliminary costs (also called start-up costs): must be expensed in profit or loss see IAS 38.69.
Example 7: Share issue costs and preliminary costs

Wacko Limited was incorporated during 20X1:
Preliminary costs (legal costs incurred in connection with the start-up of the company)
of C10 000 were paid on 2 January 20X1.
2 000 ordinary no par value shares were issued at C100 each on 5 January 20X1.
Share issue costs of C2 000 were paid on 5 January 20X1.
The draft statement of comprehensive income for 20X1, before processing any
adjustments for the above transactions, reflected total comprehensive income for 20X1
of C120 000 (components of other comprehensive income: C0).
Required:
A. Process journals to account for the preliminary costs, share issue and the related share issue costs.
B. Disclose this in the statement of changes in equity for the year ended 31 December 20X1.
Solution 7A: Share issue costs and preliminary costs

Preliminary costs (E) Given 10 000
Bank (A) 10 000
Preliminary costs paid are expensed
5 January 20X1
Bank (A) 200 000
Ordinary share capital (Eq) 2 000 x C100 200 000
Issue of 2 000 ordinary shares at C100 each
Ordinary share capital (Eq) Given 2 000
Bank (A) 2 000
Share issue costs paid deducted from equity
Solution 7B: Share issue costs and preliminary costs

Wallington Limited
C C C
Opening balance 0 0 0
Ordinary shares issued 200 000 0 200 000
Share issue costs set-off (2 000) 0 (2 000)
Total comprehensive income* 118 000 118 000
Closing balance 198 000 118 000 316 000
*Calculation:
Corrected total comprehensive income = Given: C120 000 – preliminary costs expensed: C2 000 = C118 000
3.2 Conversion of shares
Shares of one class may be converted into shares of another class (for example, preference
shares may be converted into ordinary shares, or vice versa).
Chapter 23 1029
Example 8: Converting ordinary shares into preference shares

Craig Limited had 1 000 ordinary shares in issue (having been issued at C1,20).
On 1 January 20X2, 500 of these shares were converted into 12% preference share equity.
Required:
A. Journalise this conversion.
B. Disclose this in the statement of changes in equity for the year ended 31 December 20X2.
Solution 8A: Converting ordinary shares into preference shares

Ordinary share capital (Eq) 500 x C1,20 600
Preference share capital (Eq) 600
Conversion of ordinary shares into preference shares
Solution 8B: Converting ordinary shares into preference shares

Craig Limited
share share earnings
capital capital C C
C C
Opening balance 1 200 0 xxx xxx
Conversion of ordinary shares to preference shares (600) 600 0
Notice that the net balance on these equity accounts remains at C1 200 and total equity is not affected. Also note
that such a change in the company’s share capital has no impact on cash reserves.
3.3 Rights issue

Rights issues are the offering of a certain number of shares to existing shareholders in
proportion to their existing shareholding at an issue price that is lower than the market price.
The lower price provides an incentive to invest capital in the company. Note that shareholders
are not obliged to purchase the shares offered.
Example 9: Rights issue
A company has 1 000 ordinary shares in issue, each issued at C2,50. The company wishes
to offer its shareholders 1 share for every 4 shares held at an issue price of C3.
The current market price immediately before this issue is C4.
All the shareholders had accepted the offer by the last day of the offer.
Required:
A. Journalise this issue.
B. Disclose this in the statement of changes in equity.
Solution 9A: Rights issue
W1: Calculations
Number of shares issued 1 000/ 4 x 1 250
Proceeds received 250 x C3 C750
Journal: Debit Credit
Bank (A) W1 750
Shares issued to existing shareholders (1:4) at C3 each (market price: C4)
1030 Chapter 23
Solution 9B: Rights issue

Company name
C C C
Opening balance 1 000 x 2.50 2 500 xxx xxx
Issue of shares in terms of a rights issue 750 750
3.4 Share splits
A share split involves the company splitting its authorised and issued share capital into more
shares. This generally has the effect of reducing the market value per share, since there are
suddenly more shares on the market, while the net asset value of the company has not
changed. Thus, a company may perform a share split if it feels that its share price is too high,
as a lower price may attract new investors and increase market capitalisation.
Example 10: Share split
A company has 1 000 shares, issued at C2 each, which it converts into 2 000 shares.
Required: Journalise the conversion.
Solution 10: Share split

Although the number of the authorised and issued share capital will change in the notes, there is no
journal entry since there is no change in either the share capital or cash resources:
Previously: 1 000 shares at C2 each = C2 000
Now: 2 000 shares at C1^ each = C2 000
^C2 000 / 2 000
3.5 Share consolidations (Reverse share split)

This is the opposite of a share split and is often implemented when the company believes its
share price is too low: the company reduces the number of authorised and issued shares. This
should increase the market value per share, as there are now fewer shares on the market, yet
the company’s net asset value remains the same.
Example 11: Share consolidation
A company has 1 000 shares, issued at C2 each, which it converts into 500 shares.
Required: Journalise the conversion.
Solution 11: Share consolidation

Although the number of the authorised and issued share capital will change in the notes, there is no
journal entry since there is no change in either the share capital or cash resources:
Previously: 1 000 shares at C2 each = C2 000
Now: 500 shares at C4^ each = C2 000
^C2 000/ 500
3.6 Capitalisation issue
A company may issue shares to existing shareholders entirely for free, A capitalisation
and may even issue shares of one class to shareholders of another issue is defined
class. These capitalisation shares are often referred to as ‘fully paid up’ as:
shares meaning that the shareholder will not pay anything for them. a free issue of shares
to shareholders
Chapter 23 1031
A capitalisation issue is often made in order to make use of the company’s reserves –
converting idle reserves into capital or instead of a dividend payment due to a possible
shortage of cash. It is also referred to as a scrip issue or bonus issue.
The Companies Act S40 requires authorised shares (including capitalisation issues) to be
issued for “adequate consideration.” In this text it is assumed that the market price of a share
is “adequate consideration” for the purposes of measuring a capitalisation issue.
In order for a capitalisation issue to take place, S46 of the Companies Act must be adhered to.
This is the same section that has to be applied to before declaring dividends. This section
requires that the solvency and liquidity test must be satisfied immediately after the
capitalisation issue takes place (see 3.7 for a more detailed discussion about S46 and the
solvency and liquidity test).
Example 12: Capitalisation issue

At the beginning of the year, a company has 1 000 ordinary shares in issue (issued at C1,50
each).
The company issued a further 600 fully paid-up shares to its existing shareholders in proportion to
their existing shareholding at the current market price of C1 each.
The company had retained earnings of C800 at the beginning of the year and total comprehensive
income of C150 for the year.
Required:
A. Journalise the issue.
B. Disclose the issue in the statement of changes in equity.
Solution 12A: Capitalisation issue

Debit Credit
Retained earnings (Eq) C1 x 600 600
Capitalisation issue of 600 ordinary shares to existing shareholders
Solution 12B: Capitalisation issue

Company name
C C C
Opening balance 1 500 800 2 300
Capitalisation issue 600 (600) 0
Closing balance 2 100 350 2 450
Note: there is no change in either the equity or the cash resources of the company.
3.7 Share buy-backs (treasury shares) (s48) and other distributions made by the
company (s46) and the solvency and liquidity test (s4)
A company may, under certain circumstances and for various Treasury shares:
reasons, buy-back its own shares from its own shareholders. are an entity’s shares
The reason that a company may decide to buy back its own that it has bought back
have no voting rights or dividends
shares could be, for example, in an effort to increase the
share price (remember: the laws of supply and demand are no longer outstanding
suggest that if the supply of an item is lower than the demand must be separately disclosed.
for it, the price of the item will increase) or even to prevent a hostile takeover. Interestingly,
it may also be used as a device to increase the earnings per share that must be disclosed in
terms of IAS 33 Earnings per share (see chapter 24) because a share buy-back reduces the
number of shares in issue (thus increasing the earnings per share).
1032 Chapter 23
Shares that are bought back by the entity are called treasury shares. Treasury shares have no
rights attached to them, which means that the holder of a treasury share (i.e. the entity itself)
will have no voting rights and will not receive dividends. A company buying back its own
shares can signal to the market that management (who know the real value of their company)
believes the share is under-priced.
IAS 1 requires that when an entity holds its own shares, that these shares must be separately
disclosed. This disclosure could be made on the face of the statement of financial position,
statement of changes in equity or in the notes to the financial statements.
Treasury shares, being shares that an entity holds in itself, are commonly described as ‘issued
shares that are not outstanding shares’. The term outstanding shares is the term used to
describe shares that have been issued to investors (as opposed to shares now held by the
issuing entity itself). However, in South Africa, the Companies Act states that shares that
have been bought-back by a company should be considered to be authorised but not issued.
Thus, in South Africa, a treasury share would be described as a share that is held by the entity
itself but is ‘neither issued nor outstanding’. Treasury shares may be re-issued at a later date.
In South Africa, a company may buy-back its shares only on condition that the requirements
of Companies Act 2008 are met:
The buy-back must satisfy the requirements of section 46;
After the buy-back, there must be shares in existence other than:
- shares that are owned by one or more of its subsidiaries; or
- convertible or redeemable shares. See Companies Act
Section 46 of the Companies Act states that a company may not make any proposed
distribution to shareholders (such as a dividend payment, a redemption of preference shares or
a buy-back of ordinary shares) unless:
the distribution is:
- pursuant to an existing legal obligation of the company, or
- pursuant to a court order; or
- the board of the company, by resolution, has authorised the distribution; and
It reasonably appears that the company will satisfy the solvency and liquidity test
immediately after completing the proposed distribution; and
The board of the company, by resolution, has acknowledged that it has applied the
solvency and liquidity test, and concluded that the company will satisfy the solvency and
liquidity test immediately after completing the proposed distribution. See Companies Act s46
The solvency and liquidity test will be satisfied at a given time A S&L test means
if, considering all reasonably foreseeable financial information: satisfying test of:
The assets of the company, fairly valued, equal or exceed its solvency = A(FV) ≥ L(FV)
liabilities, fairly valued; and liquidity = ability to pay
It appears that the company will be able to pay its debts as current debts as and when
they become due in the ordinary course of business for a they fall due
period of 12 months after the date on which the test is considered or, in the case of a
distribution, 12 months following that distribution. Companies Act s4 slightly reworded
The reason for these restrictions is that both the cash reserves The S&L test helps
and the capital base of the company are diminished through a to protect the
share buy-back – thus putting other shareholders and creditors at financial interests of
risk. Thus the solvency and liquidity test helps to protect their shareholders with smaller
financial interests in the entity. shareholdings and creditors
IAS 32 explains that, when buying-back shares, the consideration paid for these shares must
be debited directly to equity and no gain or loss may be recognised in profit or loss. See IAS 32.33
Although IAS 32 requires that the buy-back of shares must be debited to equity, it does not
specify which equity accounts should be debited.
Chapter 23 1033
It is suggested that, if the entity pays more for a share than it was issued at (or more than the
average share issue price where the share capital of an entity constitutes shares issued at
various different share prices), then the amount that is debited to the share capital account (or
in the case of no par value shares, the amount that is debited to the share capital and share
premium accounts), should be limited to the average share issue price. If we don’t limit it to
the original average issue price of the shares, then the share capital account/s could end up
with a debit balance! Any difference between the total amount paid for the share and this
average share issue price should be processed as an adjustment directly to retained earnings
(the adjustment may not be made to profit or loss because IAS 32 expressly prohibits a gain
or loss from being recognised on such a transaction). See IAS 32.33
Example 13: Share buy-back

A company has 1 000 authorised unissued ordinary no par value shares and 750 issued
ordinary no par value shares (issued over a number of years at varying issue prices).
The total balance on the share capital account for this class of shares is C1 500.
The company buys-back 250 of these shares at their market price of C3 per share.
Required:
A. Journalise the share buy-back.
B. Disclose the ordinary shares note and the statement of changes in equity.
Solution 13A: Share buy-back

Debit Credit
Ordinary share capital (Eq) C1 500/ 750 shares = C2 average price/share x 250 shares 500
Retained earnings (Eq) Balancing: C750 paid – C500 average issue price 250
Bank (A) C3 per share x 250 shares 750
Buy-back of 250 shares in terms of s48: excess over average price debited to RE
Solution 13B: Share buy-back

Company name
Statement of changes in equity (extract)
Ordinary Retained Total
share capital earnings
C C C
Acquisition of shares by the company (s48): treasury shares (500) (250) (750)
Company name
3. Ordinary share capital
Number of authorised shares: Number
Ordinary shares of no par value 1 750
Number of outstanding shares:
Shares outstanding at the beginning of the year 750
Acquisition of shares by the company in terms of s48: treasury shares (250)
Shares outstanding at year-end 500
Please note: the total authorised shares that are available to be issued has now increased by 250 shares to 1 250
shares, (as 250 shares have been bought back):
There were 1 000 shares available for issue (Authorised: 1 750 – Issued & outstanding: 750); but
There are now 1 250 shares available for issue (Authorised: 1 750 – Issued & outstanding: 500).
1034 Chapter 23
Summary: Movements in issued shares
Increase in number Decrease in number
Share splits Share issue Share consolidation Share buy-back

existing shares for value: mkt price existing shares reduce share
split into more for free: cap issue combined into capital a/c
shares fewer shares dr SC, cr Bank &
no journal combo: rights issue no journal dr/cr RE
3.8 Redemption of preference shares (s4, s46 of The Companies Act)

3.8.1 Overview
The redemption of a preference share entails the company paying out the preference
shareholder for the preference share. This redemption could be compulsory, at the option of
the company or at the option of the shareholder:
If when the preference shares were originally issued, the Redeemable pref
company knew that the future redemption of these shares shares can be liability/
would occur or that the redemption would not be at the equity depending on
option of the company, then at the time of the issue, the the terms of the
redemption:
company had created an obligation for itself. The issue of
compulsory/at option of
such shares is thus recorded as a liability, and not equity. shareholder: liability
If, on the other hand, the preference shares could be at option of company: equity
redeemed in the future but such redemption would be at the
option of the company, then there is no obligation at the time of issue and therefore such
preference shares are recognised as equity.
The S&L test
Although redeemable preference shares are recognised as a liability in must again be
satisfied before
the financial records, they are legally still considered to be shares. preference shares
are redeemed!
When redeeming shares, both the capital and the company’s cash
reserves are reduced, thus possibly putting the other remaining shareholders and creditors at
risk. To counter this risk, the Companies Act requires that the provisions of section 46
(discussed in section 3.7 above) be complied with before the redemption takes place.
3.8.2 Financing of the redemption

How the payment is made is referred to as the ‘financing of the redemption’. A company may
finance the redemption of shares by, for example, issuing new shares, issuing debentures,
raising a loan or an overdraft or raising the cash through any combination thereof.
Example 14: Redemption at issue price – share issue is financing of last resort
A company is to redeem all of its preference shares at their original issue price of C2.
It prefers not to have to issue any further ordinary shares unless absolutely necessary
but if such an issue is necessary, these ordinary shares will be issued at C6 each.
The company has C80 000 in the bank but the directors feel that only C30 000 of this
should be used for the redemption.
Any further cash required should be acquired via an issue of a maximum of 10 000
debentures at C1 each (redeemable after 3 years at C1 each).
If further cash is still required, a bank loan of up to C40 000 (repayable after 4 years)
may be raised.
There is a balance of C150 000 in the retained earnings account.
Required: For each of the scenarios listed below:
A. Calculate the number of ordinary shares that would need to be issued to finance the redemption.
B. Show all related journal entries.
Scenario (i): there are 10 000 preference shares to be redeemed
Scenario (ii): there are 35 000 preference shares to be redeemed
Scenario (iii): there are 70 000 preference shares to be redeemed
Chapter 23 1035
Solution 14A: Calculating the financing plan

Scenarios
(i): 10 000 (ii): 35 000 (iii): 70 000
pref shares pref shares pref shares
Cash needed for the (i): 10 000 x 2; (ii): 35 000 x 2 20 000 70 000 140 000
preference share redemption (iii): 70 000 x 2
Cash available through:
- cash in bank Given (30 000) (30 000) (30 000)
- new debenture issue 10 000 x 1 (0) (10 000) (10 000)
- new bank loan Balancing up to 40 000 (0) (30 000) (40 000)
- new share issue Balancing (0) (0) (60 000)
Cash shortage/ (surplus) (10 000) 0 0
Shares to be issued (i) & (ii): 0/ 6; (iii) = 60 000/ 6 0 0 10 000

Scenario (i) Scenario (ii) Scenario (iii)
Debit Credit Debit Credit Debit Credit
Preference shares (non-current liability) 20 000 70 000 140 000
Preference shareholders (current liability) 20 000 70 000 140 000
Preference shares to be redeemed
(i): 10 000 x 2; (ii): 35 000 x 2; (iii): 70 000 x 2
Bank (A) N/A 10 000 10 000
Debentures liability (L) N/A 10 000 10 000
Issue of debentures
(i): N/A; (ii): 10 000 x 1; (iii): 10 000 x 1
Bank (A) N/A 30 000 40 000
Loan liability (L) N/A 30 000 40 000
Loan raised
Bank (A) N/A N/A 60 000
Ordinary share capital (Eq) N/A N/A 60 000
Issue of ordinary shares (10 000 x C6)
Preference shareholders (current liability) 20 000 70 000 140 000
Bank (A) 20 000 70 000 140 000
Preference shares redeemed
Example 15: Redemption at issue price: share issue is finance of first resort
A company is to redeem all of its 20 000 preference shares at their issue price of C2 each.
In order to finance this redemption, the company issues 10 000 ordinary shares.
Any further cash required for this redemption will be funded by raising a bank loan.
Required: For each of the scenarios listed below:
A. Calculate the cash required to finance the redemption.
Scenario (i): the ordinary shares are to be issued at C4 each
Scenario (ii): the ordinary shares are to be issued at C3 each
Solution 15A: Calculation of the financing plan

Scenario (i) Scenario (ii)
Issue price C4 Issue price C3
Cash needed for preference 20 000 x C2 40 000 40 000
share redemption
- new share issue (i): 10 000 x C4; (ii): 10 000 x C3 (40 000) (30 000)
- new bank loan needed Balancing (0) (10 000)
Cash shortage/ (surplus) 0 0
1036 Chapter 23

Debit Credit Debit Credit
Preference shares (non-current liability) 40 000 40 000
Preference shareholders (current liability) 40 000 40 000
Preference shares to be redeemed: 20 000 x C2
Bank (A) (i): 10 000 x C4 = 40 000 40 000 30 000
Ordinary share capital (Eq) (ii): 10 000 x C3 = 30 000 40 000 30 000
Issue of ordinary shares
Bank (A) N/A 10 000
Loan liability (L) N/A 10 000
Loan raised
Bank (A) 40 000 40 000
3.8.3 Redemption at a premium

A redemption that requires a company to pay the preference shareholder an amount in excess
of its issue price is referred to as a redemption at a premium. The premium is usually offset
against a distributable reserve such as retained earnings.
Example 16: Redemption at a premium–preference shares recognised as equity
A company is to redeem all of its 20 000 preference shares (having an issue price of C2) at
C3 each (i.e. at a premium over the original issue price).
The company will fund this out of a new share issue of 10 000 ordinary shares.
The rest of the redemption payment must be funded by raising a bank loan.
These preference shares were being redeemed at the option of the company and had therefore been
recognised as equity.
Required:
For each of the scenarios listed below:
A. Calculate the cash required to finance the redemption.
Scenario (i): the ordinary shares are to be issued at C4 each
Scenario (ii): the ordinary shares are to be issued at C3 each
Solution 16A: Calculation of the financing plan

Issue price C4 Issue price C3
Need to redeem preference shares 20 000 x 3 60 000 60 000
- new share issue (i): 10 000 x 4; (ii): 10 000 x 3 (40 000) (30 000)
- new bank loan needed Balancing (20 000) (30 000)
Cash shortage/ (surplus) 0 0

Preference share capital (Eq) 20 000 x 2 40 000 40 000
Retained earnings (Eq) 20 000 x 1 20 000 20 000
Preference shares to be redeemed
Chapter 23 1037

Bank (A) (i): 10 000 x 4; 40 000 30 000
Ordinary share capital (Eq) (ii): 10 000 x 3. 40 000 30 000
Issue of ordinary shares:
Bank (A) See Sol 16A 20 000 30 000
Loan (L) 20 000 30 000
Loan raised
Bank (A) 60 000 60 000
Example 17: Redemption at a premium – preference shares were recognised as

a liability
On 1 January 20X1 (date of incorporation) a company issued:
100 000 ordinary shares at C3,50 each; and
50 000 10% cumulative, redeemable preference shares at C2 each.
These preference shares must be redeemed on 31 December 20X6, at a premium of C0,20
per share.
The effective rate of interest paid is calculated to be 11,25563551%.
The authorised share capital consists of:
120 000 authorised ordinary shares; and
100 000 authorised preference shares.
Required:
A. Calculate and show the journal entries in respect of the redemption. Assume that the company
issues the rest of the authorised ordinary shares at C4 each to facilitate the financing of the payment.
The balance of the retained earnings is C200 000 immediately before the redemption. Any balance
of the payment still requiring financing after taking into account the proceeds on the share issue,
will be paid for via C20 000 currently available cash in bank and lastly via the raising of a bank
overdraft. The premium on redemption is to be set-off against profits.
B. Disclose the shares in the financial statements for the year ended 31 December 20X6 (the year of
redemption). The statement of changes in equity is only required for 20X6.
Solution 17A: Redemption at a premium – shares were recognised as a liability

Please note: Detailed calculations of the balance on the ‘redeemable preference share’ account over
the years are shown in example 4.
W1: Calculation of the financing plan C
Cash needed for the redemption of 50 000 x (issue price C2 + premium C0,20) 110 000
preference shares
- new share issue (Authorised 120 000 - already issued 100 000) x 4 (80 000)
- cash in bank Given (20 000)
- bank overdraft utilised Balancing (10 000)
Cash shortage/ (surplus) 0
Journal entries Debit Credit

Bank (A) 80 000
Ordinary share capital (Eq) (20 000 x C4) 80 000
Issue of 20 000 ordinary shares at an issue price of C4 each
1038 Chapter 23

Journal entries continued ... Debit Credit
Preference share liability (non-current liability) (50 000 x C2.20) 110 000
Preference shareholders (current liability) 110 000
Preference shares to be redeemed (see workings in example 4)
Preference shareholders (current liability) 110 000
Bank (A) (20 000 + 80 000 cash raised through the issue) 100 000
Bank overdraft (L) 10 000
Redemption of shares - payment to preference shareholders
Comment:
The company has chosen to set the premium payable on redemption off against the retained earnings: but no
journal entry is required to set the premium off against retained earnings.
This is because the preference shares were recognised as a liability with the result that both the premium
payable on redemption and the preference dividends have already been included in finance charges (an
expense) over the life of the preference shares.
The premium has therefore already reduced the profits.
Solution 17B: Redemption at a premium –shares were recognised as a liability

Company name
As at 31 December 20X6 Note 20X6 20X5 20X4 20X3 20X2 20X1
C C C C C C
Equity and liabilities
Issued share capital and reserves
Ordinary share capital 3 430 000 350 000 350 000 350 000 350 000 350 000
Redeemable preference shares 4 0 0 105 936 104 207 102 653 101 256
Current liabilities
Redeemable preference shares 4 0 107 860 0 0 0 0
Please note: The 20X1 – 20X4 figures are not required and are given for explanatory purposes only.
Did you notice? Did you notice how the redeemable preference share liability:
gradually increases over the years until the date of redemption arrives; and then
on the date of redemption, the balance of the ‘redeemable preference share liability’ account has grown to
C110 000 (the amount to be redeemed); and then
after redemption, the balance on the account is reduced to zero.
Movement on the preference share liability account C
Opening balance – 20X6 107 860
Premium accrued (see example 4) (Interest: 12 140 - Coupon payment: 10 000) 2 140
Balance immediately before redemption 110 000
Redemption (debit preference shares and credit bank) (110 000)
0
Detailed calculations of the ‘redeemable preference share’ account over the years are in example 4.
Company name
20X6 20X5 20X4 20X3 20X2 20X1
C C C C C C
Profit before finance charges xxx xxx xxx xxx xxx xxx
Finance charges 12 140 11 924 11 729 11 554 11 397 11 256
Profit before tax xxx xxx xxx xxx xxx xxx
Tax expense xxx xxx xxx xxx xxx xxx
Profit for the year xxx xxx xxx xxx xxx xxx
Other comprehensive income xxx xxx xxx xxx xxx xxx
Total comprehensive income xxx xxx xxx xxx xxx xxx
Chapter 23 1039
Company name
C C C
Ordinary shares issued 80 000 80 000
Please note that the preference shares and the redemption thereof do not appear in the statement of changes in
equity since they appear in the statement of financial position as a liability instead.
Company name
2.5 Preference shares
Redeemable preference shares, which are redeemable on a specific date or at the option of the
shareholder are recognised as liabilities, as the substance thereof is ‘borrowings’. The dividends
on such preference shares are recognised in the statement of comprehensive income as finance
charges using the effective interest rate method.
20X6 20X5
3. Ordinary share capital Number Number
Authorised:
Ordinary shares of no par value 120 000 120 000
Issued:
Shares in issue: opening balance 100 000 100 000
Issued during the year 20 000 0
Shares in issue at year-end 120 000 100 000
20X6 20X5
4. Redeemable preference share liability Number Number
Authorised:
10% redeemable preference shares of no par value 100 000 100 000
Issued:
50 000 10% redeemable preference shares in issue 50 000 50 000
Redeemed during the year (50 000) 0
Balance at year-end 0 50 000
The redeemable preference shares were compulsorily redeemable on 31 December 20X6 at a
premium of C0,20 per share. The 10% preference dividends were cumulative. The effective interest
rate is 11,25563551%.
1040 Chapter 23
4. Summary
Ordinary vs. preference share capital
Ordinary shares Preference shares
Element: equity Dividend

Redemption Element Dividends
recognition
Dividend:
Non- equity equity Cumulative: must pay out
equity distribution
Redeemable: distribution first
equity Non- if unpaid, need
At option of equity
cumulative: not be paid next
company: distribution
year
liability Participating: pay variable and
Compulsory: finance charge
fixed dividend
At option of liability Non- only pay fixed
finance charge
shareholder: participating: dividend
Movements in issued shares
Increase in number Decrease in number
Share
Share splits Share issue Share buy-back
consolidation
existing shares for value: mkt existing shares reduce share
split into more price combined into less capital a/c
shares for free: cap issue shares dr SC, cr Bank &
no journal combo: rights issue no journal dr/cr RE
Chapter 23 1041
Gripping GAAP Earnings per share
Chapter 24
Earnings per Share
Reference:
IAS 33; Circular 2/2013 (including any amendments to 10 December 2014)
Contents: Page
2. Types of Shareholders 1044

2.1 Ordinary shareholders 1044
2.2 Preference shareholders 1045
3. Basic Earnings Per Share 1046

3.1 Overview 1046
3.2 Basic earnings (the numerator) 1046
3.2.1 The basic calculation 1046
3.2.2 Where there are only ordinary shares 1047
Example 1: Ordinary shares only 1047
3.2.3 Where there are ordinary and preference shares 1047
Example 2: Ordinary and non-participating preference shares 1047
Example 3: Preference shares and preference dividends – equity versus
liability 1048
3.2.4 Where there are ordinary shares and participating preference shares 1048
Example 4: Ordinary and participating preference shares 1049
3.3 Basic number of shares (the denominator) 1050
3.3.1 Overview 1050
3.3.2 Issue for value 1051
3.3.2.1 Issues at the beginning of the current year 1051
Example 5: Issue for value at the beginning of the year 1051
3.3.2.2 Issues at the end of the year or during the year 1052
Example 6: Issue for value at the end of the year 1052
Example 7: Issue for value during the year 1052
3.3.3 Issue for no value 1053
Example 8: Issue for no value 1053
Example 9: Issue for no value after an issue for value 1054
3.3.4 Combination issues 1055
Example 10: Rights issue 1055
Example 11: Various issues over three years 1056
3.3.5 Contingently issuable shares 1058
Example 12: Contingently issuable shares 1058
Example 13: Deferred shares 1059
3.3.6 Share buy-back 1060
Example 14: Share buy-back 1060
3.3.7 Reverse share split (share consolidation) 1060
Example 15: Reverse share split (share consolidation) 1060
1042 Chapter 24
4. Headline Earnings Per Share 1061

4.1 Overview 1061
4.2 Measurement of the headline earnings per share 1063
4.2.1 Headline earnings (the numerator) 1063
Example 16: Conversion: basic earnings to headline earnings 1064
4.2.2 Number of shares (the denominator) 1064
Example 17: Headline earnings per share 1065
4.3 Disclosure of the headline earnings per share 1065
Example 18: Headline earnings per share - disclosure 1065
5. Diluted Earnings Per Share 1066

5.1 Overview 1066
Example 19: Diluted earnings per share: simple example 1066
5.2 Potential shares 1067
5.2.1 Options 1068
Example 20: Options to acquire shares 1068
5.2.2 Convertible instruments 1069
Example 21: Convertible debentures 1070
Example 22: Convertible preference shares 1070
5.2.3 Contingent shares 1071
5.2.3.1 Where time is the only condition 1071
5.2.3.2 Where there are multiple conditions including time 1071
Example 23: Contingent shares 1072
5.3 Multiple dilutive instruments 1072
Example 24: Multiple dilutive instruments 1073
6. Presentation and Disclosure 1074

6.1 Overview 1074
6.1.1 Statement of comprehensive income 1075
6.1.2 Notes to the financial statements 1075
6.1.3 Sample note disclosure involving earnings per share 1075
6.2 Disclosure of further variations of earnings per share 1076
Example 25: Disclosure of rights issue, basic and headline earnings per share 1077
Example 26: Disclosure involving multiple dilutive instruments 1078
7. Summary 1080
Chapter 24 1043
1. Introduction
‘Earnings per share’ is essentially a ratio used in the financial analysis of a set of financial
statements and therefore falls under the chapter on financial analysis as well. It takes into
account the number of shares in issue, and is thus a comparable, relative measure. This ratio
is, however, so useful and popular that the standard, IAS 33, had to be developed to control
the method of calculation thereof. This standard sets out how to calculate:
the numerator: earnings; and
the denominator: the number of shares
for each class of equity share (where each class has a varying right to receive dividends).
Although IAS 33 states that earnings per share must

An ordinary share is defined
be calculated for all ordinary shares, it is possible as:
for there to be more than one class of ordinary share
(i.e. where the entity has shares that share in an equity instrument
dividends at different rates). In this case, the that is subordinate
earnings per share would need to be disclosed for to all other classes of equity instruments.
IAS33.5
each class of ordinary share.
IAS 33 refers to two different types of earnings per share: basic earnings per share and diluted
earnings per share. It allows other variations of earnings per share to be presented as well
(although these other per share figures may not be presented on the face of the statement of
comprehensive income, but may only be presented in the notes). In South Africa, companies
wishing to be/ remain listed on the JSE Exchange must comply with the JSE Listing
Requirements which requires that headline earnings per share be presented. The various
earnings per share figures can be summarised as follows:
Earnings per share:

A summary of the different types
Basic Diluted Headline Other variations

(IAS 33) (IAS 33) (Circular 02/13) (IAS 33)
Required by IFRS Required by IFRS if the Not required by IFRSs; Allowed if given in
entity had dilutive but is required for all SA addition to the
potential ordinary companies wishing to list/ BEPS (and DEPS
shares be listed on the JSE (a where applicable)
JSE Listing Requirement)
The ‘basic earnings per share’ figure may be extremely volatile since all items of income and
expenses are included in the calculation thereof. In order to compensate for this volatility, the
calculation of ‘headline earnings per share’ has been introduced, which excludes income and
expenses of a capital nature and those that are ‘highly abnormal’. Headline earnings are
therefore a better indicator of ‘maintainable earnings’. ‘Diluted earnings per share’ is also
covered by IAS 33. This is covered later in this chapter.
2. Types of Shareholders
2.1 Ordinary shareholders

Ordinary shareholders buy a share in a company to earn dividends and for capital growth.
These dividends fluctuate annually depending on profits and available cash reserves etc. As
the terms ‘ordinary’ and ‘preference’ implies, the ordinary shareholders have fewer rights
than the preference shareholders. For example, assuming a company with both preference and
ordinary shareholders is liquidated: the preference shareholders will have their capital
returned first and only if there are sufficient funds left over, will the ordinary shareholders
have their capital paid out.
1044 Chapter 24
2.2 Preference shareholders

The following diagram summarises the various issues that can affect preference shares.
Issues affecting preference shares
Participating & non-

Dividends Redemption Dividend recognition
participating shares
Cumulative: must Redeemable: the Participating: the Interest (SOCI): if
pay out arrear divs capital is returned to shareholder gets a the share is a liability
before paying the shareholder fixed dividend & a Dividend (SOCIE): if
ordinary divs share in the profits the share is equity
Non –cumulative: if Non-redeemable: Non-participating: Part interest, part
not paid, need not the capital is not the shareholder dividend: if the
be paid in next year returned to the gets a fixed share is a hybrid
shareholder dividend only equity instrument
Preference shareholders have more rights than ordinary shareholders – as mentioned above.
Not only do they have preference on liquidation, but they also have a fixed amount paid out
each year in dividends (as opposed to ordinary shareholders whose dividends are at the
discretion of the entity and are largely dependent on profits and available cash reserves). The
rate of dividends paid out is based on the share’s coupon rate (e.g. 10%). A shareholder
owning 1 000 preference shares issued at C2 each and a coupon rate of 10% will expect
dividends of C200 per year (C2 x 1 000 x 10%). The shareholders’ rights to dividends depend
on whether their shares are:
cumulative; or
non-cumulative.
Cumulative shares indicate that if a dividend was not paid out in a particular year, (perhaps
due to insufficient funds), these arrear dividends must be paid first before paying any
dividend to the ordinary shareholders. Therefore, no dividend may be paid out to ordinary
shareholders until the arrear preference dividends have been paid. Non-cumulative shares are
those where, if a dividend is not paid out in a year, these unpaid dividends need never be paid.
Irrespective of whether dividends are considered to be cumulative or non-cumulative,
dividends that are not declared may not be recognised until they are declared. IAS 10.12 and IAS 18.30
There is another variation with regard to preference shares; the shares may be:
redeemable; or
non-redeemable.
Redemption of a share involves the company returning the capital invested by the shareholder
to this shareholder at some stage in the future. This repayment could be set at a premium
(profit to the shareholder) or at a discount (loss to the shareholder). It could also be
compulsory or at the discretion of the company or the shareholder. Shares that are redeemable
(especially if the redemption is either compulsory or at the discretion of the shareholder) and/
or cumulative, may be classified fully or partly as a liability instead of as equity. In this case,
part or all of the related dividends will be recognised as ‘finance charges’ in the statement of
comprehensive income instead of as ‘dividends’ in the statement of changes in equity (see the
chapters on share capital and financial instruments for more on this).
There is a further variation relating to preference shares: the shares may be termed:
participating; or
non-participating.
Most preference shares are non-participating, meaning that the shareholders do not participate
in the profits except to the extent of a fixed dividend. In rare circumstances, however, a
preference shareholder may have a right to share (participate) in a certain percentage of the
profits in addition to their fixed preference dividend and will thus be termed a ‘participating
preference shareholder’. This will be dealt with later on in this chapter. (See example 4).
Chapter 24 1045
As mentioned already, some preference shares are recognised as pure liabilities rather than as
equity and their dividends are recognised as finance charges instead of as dividends. In these
instances, even if the dividend has not yet been declared as at the end of the reporting period,
the dividend will be recognised as a finance charge.
For the purposes of this chapter, we will restrict our examples (with the exception of
example 3) to non-cumulative, non-redeemable preference shares (thus pure equity shares)
whose dividends are considered to be pure dividends (and not interest). Dividends declared in
relation to these shares are recognised as distributions of equity and are therefore presented in
the statement of changes in equity.
3. Basic Earnings Per Share (IAS 33.9 - .29)
3.1 Overview
The objective of basic earnings per share is to provide a measure of the interests of each
ordinary share of an entity in the performance of the entity over the reporting period IAS33.11.
Basic earnings per share is calculated by dividing earnings Earnings

attributable to the ordinary shareholders by the weighted BEPS:
Number of shares
average number of ordinary shares in issue during the year.
In the event that the entity reports a loss instead of a profit, the earnings per share will be
reported as a loss per share instead.
3.2 Basic earnings (the numerator) (IAS 33.12 - .18)
3.2.1 The basic calculation
In order to calculate the earnings attributable to the ordinary shareholders, one should start
with the ‘profit for the period’ per the statement of comprehensive income and deduct the
profits attributable to the preference shareholders.
Basic Earnings C
Profit (or loss) for the period (after tax) xxx
Less fixed preference dividends (based on the coupon rate) NOTE 1 (below) (xxx)
Less share of profits belonging to participating preference shareholders (xxx)
= Earnings attributable to ordinary shareholders xxx
NOTE 1:
Preference dividends are, in fact, not always deducted. Deciding whether or not to
deduct the preference dividends depends on whether the shares are cumulative or non-
cumulative. The following guidelines should be helpful when dealing with pure equity
preference shares:
in respect of non-cumulative preference shares, deduct only the preference dividends that
are declared in respect of that period; and
in respect of cumulative preference shares, deduct the total required preference dividends
for the period (in accordance with the preference share’s coupon rate), regardless of
whether or not these dividends have been declared.
It should be borne in mind that where the preference shares are classified as a liability, their
dividends would be wholly or partly treated as finance costs.
If the preference dividends have been recognised as a finance cost, they will have already
been deducted in the calculation of ‘profit or loss for the period’ and thus they must not be
deducted again when calculating ‘earnings attributable to the ordinary shareholders’.
1046 Chapter 24
Deducting preference dividends in the BE calculation: the fixed preference

dividends deducted in the BE calculation should:
only be those relating to preference shares classified as equity (not those classified as liabilities); and
be the dividend actually declared if the preference share is non-cumulative
be the required dividend (i.e. the full dividend even if it was not declared) if the preference share is
cumulative. See example 3.
3.2.2 Where there are only ordinary shares
If there are only ordinary shareholders, it stands to reason that the entire profit or loss of the
company belongs to the ordinary shareholders (owners).
Example 1: Ordinary shares only

A company has 10 000 ordinary shares in issue throughout 20X1.
The company earns a profit after tax of C100 000.
Required: Calculate the basic earnings per ordinary share.
Solution 1: Ordinary shares only

Basic earnings per share = C10 per ordinary share (W1&W2)
W1: Earnings belonging to ordinary shareholders: C

Profit (or loss) for the year (per the statement of comprehensive income) 100 000
Less fixed preference dividends (0)
Less share of profits belonging to participating preference shareholders (0)
Earnings belonging to ordinary shareholders 100 000
W2: Earnings per ordinary share:

Earnings belonging to ordinary shareholders C100 000
= = = C10 per ordinary share
Number of ordinary shares 10 000
3.2.3 Where there are ordinary and preference shares
If there are both ordinary and preference shareholders, some of the profit for the year must
first be set aside for the preference shareholders’ preference dividends.
Example 2: Ordinary and non-participating preference shares

A company has the following shares in issue throughout 20X1: 10 000 ordinary shares and
10 000 non-cumulative, non-redeemable 10% preference shares (the preference shares were
all issued at C2 each). The company earns a profit after tax of C100 000. The company declared the
full 20X1 dividends owing to the preference shareholders.
Required: Calculate the basic earnings per ordinary share.
Solution 2: Ordinary and non-participating preference shares

Basic earnings per share = C9,80 per ordinary share (W1&W2)

Profit (or loss) for the year 100 000
Less fixed preference dividends declared (10 000 x C2 x 10%) (2 000)
Less share of profits belonging to participating preference shareholders (0)
W2: Earnings per ordinary share:

= = = C9,80 per ordinary share
Chapter 24 1047
Example 3: Preference shares and preference dividends – equity versus

liability
A company has 10 000 ordinary shares and 10 000 10% C2 preference shares in issue throughout
20X2. The profit after tax was C100 000 in 20X2.
Required: Calculate the basic earnings in 20X2, assuming that the preference shares are:
A non-cumulative and non-redeemable (i.e. equity) and the dividend is declared.
B non-cumulative and non-redeemable (i.e. equity) and the dividend is not declared.
C cumulative and non-redeemable (i.e. equity) and the dividend is not declared.
D cumulative and redeemable (i.e. liability) and the dividend is declared.
E cumulative and redeemable (i.e. liability) and the dividend is not declared.
Solution 3: Preference shares (equity) and declared dividends
W1: Earnings belonging to ordinary Ex3A Ex3B Ex3C Ex3D Ex3E

shareholders C C C C C
Profit (or loss) for the year 100 000 100 000 100 000 100 000 100 000
Less preference dividends (see comments) (2 000) (0) (2 000) (0) (0)
Earnings belonging to ordinary 98 000 100 000 98 000 100 000 100 000
shareholders
Comment:
3A: These preference shares are recognised as equity, thus the dividends will only be deducted from
retained earnings in the statement of changes in equity if they are declared. Thus, since the
dividends were declared, they must be deducted from the profit for the period to determine how
much of the profit belongs to the ordinary shareholders: 10 000 x C2 x 10% = C2 000.
3B: These preference shares are recognised as equity, and thus declared dividends are deducted in the
statement of changes in equity, but since the dividend is not declared, there is no obligation to pay
it and thus it will not be recognised in the financial statements at all. Since the undeclared
dividends are non-cumulative, no adjustment is made to the profit for the period when
calculating basic earnings: all the profit belongs to the ordinary shareholders.
3C: These preference shares are recognised as equity and thus declared dividends are deducted in the
statement of changes in equity. Since the dividend is not declared, there is no obligation to pay it
and thus it is not recognised in the financial statements. Since the undeclared dividends are non-
cumulative we must deduct them from the profit for the period when calculating basic earnings.
3D: Preference shares that are redeemable are recognised as liabilities. The cumulative declared
dividends on these preference shares are thus recognised as interest using the effective interest rate
method. This dividend has thus already been deducted in calculating the profit of C100 000.
3E: Preference shares that are redeemable are recognised as liabilities. The cumulative dividends are
also recognised as interest using the effective interest rate method, even though undeclared. This
dividend has thus already been deducted in calculating the profit for the period of C100 000.
3.2.4 Where there are ordinary shares and participating preference shares
In the event that there are participating preference shares in issue during the year, there would
effectively be two equity share types in issue. This means that the profits, after paying
preference shareholders their fixed dividend, need to be shared between two different types of
shareholders: ordinary shareholders and participating preference shareholders.
The portion of the net profit for the year that belongs to a participating preference shareholder
may be divided into two parts:
a fixed component (based on the coupon rate – 10% in the previous examples); and
a variable component (dependent on the proportion in which the preference shareholder
shares in profits with the ordinary shareholder).
1048 Chapter 24
Although there are two equity share types in issue, please remember that earnings per share is
only disclosed in respect of the ordinary shares.
Example 4: Ordinary and participating preference shares

A company has the following shares in issue throughout 20X1:
10 000 ordinary shares, and
10 000 participating non-cumulative, non-redeemable 10% preference shares (issued at C2 each).
The company earns a profit after tax of C100 000.
The company declared the full 20X1 dividends owing to the preference shareholders. The preference
shares participate to the extent of ¼ of the dividends declared to ordinary shareholders. The total
ordinary dividend declared for 20X1 was C4 000.
Required: Calculate the following:
A earnings per ordinary share and indicate if it is disclosable;
B earnings per participating preference share and indicate if it is disclosable;
C the total dividend belonging to the participating preference shareholders; and
D the total variable dividends in 20X1.
Ignore tax.
Solution 4: Ordinary and participating preference shares

A Earnings per ordinary share = C7,84 – this is disclosable (W1&W4)
B Earnings per participating share = C2,16 – this is not disclosable (W1-3&W5)
C Total dividend to participating shareholders = C3 000 (W6)
D Total variable dividends = C5 000 (W7)
Profit (or loss) for the year 100 000
Less preference dividends (fixed) declared (10 000 x C2 x 10%) (2 000)
Earnings to be shared 98 000
Less earnings attributable to participating preference shareholders (see W2) (19 600)
W2: Earnings belonging to participating preference shareholders: C
Earnings attributable to ordinary and participating preference shares 98 000
- portion belonging to ordinary shareholders (4/5 x C98 000: see W3) 78 400
- portion belonging to participating preference shareholders (1/5 x C98 000: see W3) 19 600
W3: The ratio in which to share earnings:
The ratio in which the earnings are to be shared (4/5 and 1/5) between the two equity share types is
calculated as follows:
Let X = the portion of the earnings belonging to the ordinary shareholders
Then ¼ X = the portion of the earnings belonging to the participating preference shareholders
And therefore:
X + ¼ X = total earnings to be shared
X + ¼ X = 98 000
5
/4 X = 98 000
X = 98 000 x 4/5
X = 78 400 (share belonging to ordinary shareholders)
Therefore:
¼ X = ¼ x 78 400 = 19 600 (share belonging to participating preference shares)
please note that the C19 600 may also be calculated as 98 000 x 1/5 or
98 000 – 78 400 = 19 600
W4: Earnings per ordinary share – this is disclosable:
= = = C7,84 per ordinary share
Chapter 24 1049
Solution 4: continued
W5: Earnings per participating preference share – this is not disclosable:
Earnings belonging to participating preference shareholders
=
Number of participating preference shares
C2 000 + C19 600
= = C2,16 per participating preference share
10 000
Comment:
Please note that the earnings belonging to the participating preference shareholders are made up of
both the fixed component (dividend based on the coupon rate: 10 000 x C2 x 10%) and the variable
component (share of the ‘after preference dividend profits’: 19 600 (W2)).
Please also note that this earnings per share of C2.16 is not disclosable as it is for preference
shareholders – the financial statements are produced for general users.
Also note that, as with the total earnings to be shared, the participating preference shareholders
participate in 1/5 of the ‘total variable’ dividends declared:
W6: Total dividends belonging to preference shareholders: C
Fixed dividend (10 000 x C2 x 10%) 2 000
Variable dividend (C4 000 x ¼ ) 1 000
Total dividend belonging to the participating preference shareholder 3 000
W7: Total variable dividends: C
Variable dividend declared to ordinary shareholders (given) 4 000
Variable dividend to participating preference shareholders: 1 000
(C4 000 x ¼ or C5 000 x 1/5)
Total variable dividends declared 5 000
3.3 Basic number of shares (the denominator) (IAS 33.19 - .29 and .64)
3.3.1 Overview
Thus far, we have dealt with the earnings figure in the earnings per share calculation (the
numerator). We will now move on to discussing the denominator of the earnings per share
calculation, being the number of shares. The number of shares used could be the actual
number, an adjusted number or a weighted average number of shares (as discussed below).
In the event that there was no movement of shares during the year, (i.e. the balance of shares
at the beginning of the year equals the balance of shares at year-end, say 10 000), then the
denominator in the earnings per share calculation is 10 000 shares.
If, however, there was movement in the number of shares during the year, then the number of
shares to be used in the calculation will need to be adjusted or weighted. The movement could
entail an increase (issue of shares) or a decrease in the number of shares.
There are five distinct types of issues that may have taken place during the year:
issue for value (e.g. shares issued at their market price);
issue for no value (e.g. shares given away);
combination issue (e.g. shares issued at less than their market value);
contingently issuable shares (e.g. shares issued on satisfaction of an event); and
deferred shares (e.g. shares issued after a period of time elapses and where time is the
only condition that must be satisfied).
Decreases in the number of shares could come in the form of:
share buy-backs: a for-value reduction; and
reverse share split (i.e. share consolidations): a not-for-value reduction.
Each of these types of movements will now be dealt with separately.
See the diagram that follows for a summary of what we have covered thus far (earnings) and
the main considerations that will be covered in this section (number of shares).
1050 Chapter 24
Basic earnings per share: Summary of calculation
Earnings No. of shares
Ordinary shares
Ordinary shares Issues Issues
and participating
only for value for no value
preference shares
Profit for the period Profit for the period Weight the current Adjust the number
less preference less preference year’s number of of shares so that
dividends on equity dividends shares based on the the ratio of ‘CY
portion of = time elapsed since shares: PY shares’
preference shares Earnings to be shared the share issue remains unchanged
Combination issue
3.3.2 Issue for value (IAS 33.19 - .23)
When shares are issued for value, we calculate the number of shares to include in the
denominator by weighting the number of shares from the date consideration is receivable. The
date on which consideration is receivable is generally the date of issue of the shares (although
some exceptions do apply). IAS 33.21
3.3.2.1 Issues at the beginning of the current year
When shares are issued for value, it means that there is no free (bonus) element in the share
issue: the shares are sold at their full market value. Since such an issue raises extra capital for
the entity, there is every chance that the increased capital has caused an increase in profits.
Since the increase in the denominator (shares) is expected to lead to a similar increase in the
numerator (earnings), the number of shares needs no adjustment.
Example 5: Issue for value at the beginning of the year
A company has 10 000 ordinary shares in issue during the previous year.
There was a share issue of 10 000 ordinary shares at market price on the first day of the
current year. The earnings in the previous year were C20 000, and thus the earnings per share in the
previous year was C2 per share (C20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances have occurred since the previous year,
explain what the user would expect the profits and earnings per share to be in the current year.
Solution 5: Issue for value at the beginning of the year

Since the capital base doubled, the user would expect the profits to double too. If the profits in the
current year did, in fact, double to C40 000, this would then mean that the earnings per share would
remain comparable at C2 per ordinary share (C40 000/ 20 000 shares).
Actual Current year Prior year
Number of shares (weighted)
(1)
Opening balance 10 000 10 000 10 000
(2)
Issue for value 10 000 10 000 0
Closing balance 20 000 20 000 10 000
(1)
Opening balance: 10 000 shares for 12 months (10 000 x 12/12) 10 000
(2)
New shares issued: 10 000 shares for 12 months (10 000 x 12/12) 10 000
Earnings per share: Current year Prior year
Earnings C40 000 C20 000
=
Number of shares 20 000 shares 10 000 shares
= C2 per share C2 per share
The earnings per share for the current year would then remain comparable at C2 per ordinary share.
Chapter 24 1051
3.3.2.2 Issues at the end of the year or during the year

When a company issues shares on a day other than at the beginning of the year, it must be
remembered that the earnings potential of the entity will only increase in the period after the
proceeds from the share issue have been received (the period in which the shares are in issue).
In order to ensure that the earnings per share in the current year is comparable to that of the
previous year, the number of shares is weighted based on time.
This weighting should ideally be performed based on the ‘number of days since the share
issue’ as a proportion of the ‘total number of days in the period’ (i.e. usually 365) although
months may also be used if considered a reasonable estimation. IAS33.20
Example 6: Issue for value at the end of the year
A company had 10 000 ordinary shares in issue during the previous year. There was a share
issue of 10 000 ordinary shares at market price on the last day of the current year.
The earnings in the previous year were C20 000, and thus the earnings per share in the previous year
was C2 per share (C20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances since the previous year, explain what the
user would expect the profits and the earnings per share to be in the current year.
Solution 6: Issue for value at the end of the year

Although the capital base doubled in the current year, the user would not expect the current year’s
profits to double since the extra capital was only received on the last day of the current year with the
result that this would not yet have had an effect on the entity’s earning potential (profits).
Thus assume the profits in the current year remained constant at C20 000 (i.e. equal to the prior year):
unless the number of shares (in the earnings per share calculation) is adjusted,
the current year’s earnings per share would incorrectly indicate that the efficiency of earnings halved
to C1 per share during the year (C20 000/ 20 000 shares),
when the reality is the company earned C2 for every one of the 10 000 shares in issue during the year.
Therefore, in order to ensure the comparability of the earnings per share calculation, the number of
shares in the current year should be weighted as follows:
Current year
Number of shares Actual Prior year
(weighted)
(1)
Opening balance 10 000 10 000 10 000
(2)
Issue for value 10 000 0 0
Closing balance 20 000 10 000 10 000
(1)
(2)
New shares issued: 10 000 shares for 0 months (10 000 x 0/12) 0
=
Number of shares 10 000 10 000
Example 7: Issue for value during the year

A company had 10 000 ordinary shares in issue during the previous year. There was a share
issue of 10 000 ordinary shares (at market price) 60 days before the end of the current year.
In the previous year:
earnings were C20 000, and
earnings per share was C2 per share (C20 000/ 10 000 shares).
1052 Chapter 24
Solution 7: Issue for value during the year

Although the capital base doubled, the user could not expect the annual profits to double since the extra
capital was only received 60 days before the end of the year with the result that this extra injection of
capital could only have had an effect on the profits earned during the last 60 days of the period.
The shareholder could only reasonably expect the earnings in the last 60 days to double.
He would thus hope that the earnings for the current year totals C23 288 (C20 000 + C20 000 x
60/365).
Assume that the profits in the current year did total the C23 288 that the shareholders hoped for:
Unless an adjustment is made to the earnings per share calculation, the current year’s earnings per
share would indicate that the efficiency of earnings decreased during the year (C23 288/ 20 000
shares) to 116,44c per share,
despite the reality that the company earned C2 for every one share in issue during the period, as
was achieved in the previous year.
Current year
Number of shares Actual Prior year
(weighted)
(1)
Opening balance 10 000 10 000 10 000
(2)
Closing balance 20 000 11 644 10 000
(1)
Opening balance: 10 000 shares for 365 days (10 000 x 365/365) 10 000
(2)
New shares issued: 10 000 shares for 60 days (10 000 x 60/365) 1 644
=
3.3.3 Issue for no value (IAS 33.26 - .28 and .64)
Issues for no value involve an entity effectively giving away shares. Examples of this include
capitalisation issues (bonus issues or stock dividends) and share splits. Capitalisation issues
frequently occur when a company has a shortage of cash with the result that shares are issued
instead of paying cash dividends to the shareholders.
Since there has been no increase in capital resources (there is no cash injection), a
corresponding increase in profits cannot be expected. If the earnings in the current year are
the same as the earnings in the prior year and there is an increase in the number of shares in
the current year, the earnings per share in the current year will, when compared with the
earnings per share in the prior year, indicate deterioration in the efficiency of earnings relative
to the available capital resources. Comparability would thus be jeopardised unless an
adjustment is made.
The adjustment made for an ‘issue for no value’ is made to the prior year and current year,
(note: an ‘issue for value’ is adjusted for in the current year only). This adjustment has the
effect that it appears that the shares issued in the current year had already been in issue in the
prior year. This adjustment is thus a retrospective adjustment.
Example 8: Issue for no value

A company had 10 000 ordinary shares in issue during the previous year.
There was a capitalisation issue of 10 000 ordinary shares during the current year.
The earnings in the previous year were C20 000, and thus the earnings per share in the previous year
was C2/ share (C20 000/ 10 000 shares).
Chapter 24 1053
Solution 8: Issue for no value

The number of shares doubled in the current year due to the capitalisation issue but there has been no
increase in resources and so the shareholders could not reasonably expect an increase in profits.
By way of explanation:
Assume that the profits in the current year did, in fact, remain constant at C20 000.
Without an adjustment to the earnings per share calculation, the earnings per share in the current
year would appear to halve, indicating to the user that the entity was in financial difficulty.
The reality, of course, is that the profitability has neither improved nor deteriorated since the
previous year and thus the earnings per share should reflect this stability.
The need for comparability between the earnings per share for the current year and the prior year
requires that the number of shares be adjusted. This is done by making an adjustment to the prior year’s
number of shares in such a way that it seems as if the share issue took place in the prior year.
This means that the prior year’s earnings per share has to be restated; and
the fact that the prior year’s earnings per share figure has been changed (restated) must be made
quite clear in the notes.
The earnings per share in the current year will be disclosed at C1 (C20 000/ 20 000 shares) and the
earnings per share in all prior periods presented will be restated: the prior period will be disclosed at
C1 (C20 000/ 20 000 shares).
Comment:
Please notice that the adjustment is not time-weighted.
Therefore ‘issues for no value’ made during the year, (as opposed to at the beginning or end of the
year), are all dealt with in the same way (by adjusting the prior year number of shares).
Example 9: Issue for no value after an issue for value

A company had 10 000 ordinary shares in issue during 20X1. On 1 April 20X2, 12 000
shares were issued at market value of C5 per share. On 1 June 20X2, there was a share split
where every 2 shares became 5 shares. The basic earnings were C150 000 (20X1) & C261 250 (20X2).
Required: Calculate the basic earnings per share for the years ended 31 December 20X1 and 20X2.
Solution 9: Issue for no value after an issue for value

Basic earnings per share (W1&W2): 20X1: C6 per share 20X2: C5,50 per share
W1: Number of shares Current year Prior year
Actual
(weighted) (adjusted)
(4)
Opening balance 10 000 10 000 10 000
(1)
(5) (5)
22 000 19 000 10 000
(3) (6) (7)
Issue for no value 33 000 28 500 15 000
(2) (8) (8)
Closing balance 55 000 47 500 25 000
P.S. Always start with the ‘actual’ column. The calculations thereafter are then:
(1)
New shares issued: 12 000 shares for 9 months (12 000 x 9/12) 9 000
(2)
Total shares after share split: 22 000 / 2 shares x 5 shares 55 000
(3)
Shares issued in terms of share split: 55 000 – 22 000 33 000
(4)
(5)
The ratio between the current and prior year is currently 19 000: 10 000 1,9: 1
(6)
Current year share split adjustment: 19 000 / 22 000 x 33 000 28 500
(7)
Prior year share split adjustment: 10 000 / 22 000 x 33 000 15 000
(8)
Check ratio the same: 47 500: 25 000 1,9: 1
W2: Earnings per share: 20X2 20X1
Earnings C261 250 C150 000
=
= C5,50 per share C6 per share
Comment: Where there is more than one movement during the year, it must be handled in
chronological order (i.e. in date order).
1054 Chapter 24
3.3.4 Combination issues

A combination issue occurs when shares are A combination issue is:
offered at less than market value: we treat part of
an issue of shares at less than market
the issue as an issue for value and part as an issue value, in effect combining an:
not for value. An example of a combination issue is issue for value (i.e. some shares are
a rights issue. A rights issue is an issue where assumed to have been sold at full market
shares are offered to existing shareholders at a value), and
specified price that is less than the market price. issue for no value (i.e. some of the shares
are assumed to have been given away).
There are two methods of calculating the number of
shares: one involves the use of a table (where the principles are those used in the previous
examples) and the other involves the use of formulae. Both give you the same final answer.
Take Note: Although share issues are always dealt with chronologically, when a combination issue
(or 2 issues on the same date) takes place, the share issue ‘for value’ is dealt with first.
Example 10: Rights issue

A company had 10 000 shares in issue at the beginning of the current year (20X2).
3 months before year-end, the company had a rights issue of 1 share for every 5 shares held.
The exercise (issue) price was C4 when the fair value immediately before the rights issue was C5 (i.e.
market value cum rights). All the shares offered in terms of this rights issue were taken up.
Required: Calculate the number of shares to be used as the denominator when calculating earnings per
share in the financial statements for the year ended 31 December 20X2.
Solution 10: Rights issue - using the ‘table approach’

The number of shares to be used in the calculation of EPS for 20X2 is 10 759 and for 20X1 is 10 345.
Workings:
The number of shares issued in terms of the rights issue: 10 000/5 x 1 share = 2 000 shares
The cash received from the rights issue: 2 000 shares x C4 = C8 000
The number of shares that are issued may be split into those shares that are effectively sold and
those that are effectively given away: Number
Shares sold (issue for value): proceeds/ market price cum rights = C8 000/ C5 1 600
Shares given away (issue for no value): total shares issued – shares sold = 400
2 000 shares – 1 600 shares or (2 000 x C5 – C8 000)/ C5
2 000
The weighted and adjusted average number of shares may then be calculated:
Number of shares Actual Current year Prior year
(weighted & adjusted) (weighted) (adjusted)
Balance: 1/1/20X2 10 000 10 000 10 000
Issue for value Note 1 (1 600 x 3/12) 1 600 400 0
11 600 10 400 10 000
Issue for no value Note 2 400 359 345
(CY: 400/ 11 600 x 10 400);
(PY: 400/ 11 600 x 10 000)
Balance: 31/12/20X2 12 000 10 759 10 345
Note 1: Please remember that issues for value during the year require weighting of the number of
shares to take into account how long the extra capital was available to the entity.
Note 2: Please note that an issue for no value will not cause an increase in the profits and therefore,
in order to ensure comparability, the prior year shares are adjusted as if the issue for no value had
occurred in the prior year. Please also note that the adjustment made should not change the ratio
between the number of shares in the current year and the prior year.
Note 3: The adjustment made should not change the ratio between the number of shares in the
current and prior year: to be sure you have not changed this ratio, check the ratios as follows:
Ratio between the number of shares in the current year and prior year:
Before issue for no value: 10 400/ 10 000 1,04
The issue for no value: 359/ 345 1,04
After the issue for no value: 10 759/ 10 345 1,04
It can therefore be seen that at no stage was this ratio altered .
Chapter 24 1055
Solution 10: Rights issue - using the ‘formula approach’ (IAS 33 Appendix A.2)
Theoretical ex-rights value per share:
(Fair value of all issued shares before the rights issue) + (the resources received from the rights issue)
Number of shares in issue after the rights issue
10 000 shares x C5 + 2 000 shares x C4 C58 000

= = = C4,833 per share
10 000 + 2 000 12 000
Adjustment factor:
Fair value per share prior to the exercise of the right C5
= = 1,0345
Theoretical ex-right value per share C4,833
Number of shares (rounded up):

= Current year (10 000 shares x 1,0345 x 9/12 + 12 000 x 3/12) 10 759
= Prior year (10 000 shares x 1,0345) 10 345
Comment: Notice that the current year calculation of the number of shares is weighted for the number
of months before the issue and after the issue, whereas the prior year is not weighted at all.
Example 11: Various issues over three years

Numbers Ltd has a profit of C100 000 for each of the years 20X3, 20X4 and 20X5.
There are no preference shares.
On 1 January 20X3, there were 1 000 ordinary shares in issue, all of which had been issued at C2 each,
after which, the following issues took place:
30 June 20X4: 1 000 ordinary shares were sold for C3,50 (their market price);
30 September 20X4: there was a capitalisation issue of 1 share for every 2 shares in issue on this
date, utilising the retained earnings account;
30 June 20X5: 2 000 ordinary shares were sold for C4,00 (their market price); and
31 August 20X5: there was a share split whereby every share in issue became 3 shares.
Required:
A Journalise the issues for the years ended 31 December 20X4 and 20X5.
B Calculate the basic earnings per share to be disclosed in the financial statements of Numbers
Limited for the year ended 31 December 20X5.
C Calculate the basic earnings per share as disclosed in the financial statements of Numbers Limited
for the year ended 31 December 20X4.

Bank (A) 3 500
Stated capital (Eq) 3 500
Issue of 1 000 ordinary shares at C3,50 (market price)
30/9/20X4
Retained earnings (Eq) (2 000/ 2 x 1) x Value per share [(SC:(C2 000 2 750
Stated capital (Eq) + C3 500)/ (number of shares in issue: 2 000)] 2 750
Capitalisation issue: 1 for 2 shares in issue: Transfer from RE
30/6/20X5
Bank (A) 2 000 x 4 8 000
Stated capital (Eq) 8 000
Issue of 2 000 ordinary shares at C4 (market price)
31/8/20X5
There is no journal for a share split (the authorised and issued number of shares are simply increased
accordingly)
1056 Chapter 24
Solution 11B: Calculations – 20X5 financial statements

W1: Numerator: earnings 20X5 20X4 20X3
C C C
Preference dividends (not applicable: no preference shares) 0 0 0
Basic earnings per share 100 000 100 000 100 000
W2: Denominator: number of Actual 20X5 20X4 20X3

shares
Balance: 1/1/20X3 1 000 N/A 1 000 1 000
Movement: none 0 0 0 0
Balance: 1/1/20X4 1 000 N/A 1 000 1 000
Issue for value: 30/6/20X4 1 000 N/A 500 0
(20X4: 1 000 x 6/12);
(20X3: 1 000 x 0/12)
Issue for no value: 30/9/20X4 2 000 N/A 1 500 1 000
(2 000 / 2 x 1); 1 000 N/A 750 500
(20X4: 1 000 x 1 500/ 2 000);
(20X3: 1 000 x 1 000/ 2 000)
Balance: 31/12/20X4 3 000 3 000 2 250 1 500
Issue for value: 30/6/20X5 2 000 1 000 0 0
(20X5: 2 000 x 6/12);
(20X4 & 20X3: 2 000 x 0/12)
Issue for no value: 31/8/20X5 5 000 4 000 2 250 1 500
(5 000 x 3 – 5 000); 10 000 8 000 4 500 3 000
(20X5: 10 000 x 4 000/ 5 000);
(20X4: 10 000 x 2 250/ 5 000);
(20X3: 10 000 x 1 500/ 5 000)
Balance: 31/12/20X5 15 000 12 000 6 750 4 500
W3: Earnings per share for the 20X5 financial statements

20X5 20X4 20X3
C C C
Restated Restated
Basic earnings C100 000 C100 000 C100 000
Weighted average number of shares 12 000 6 750 4 500
= Basic earnings per share in the 20X5 AFS C8.33 C14.81 C22.22
Solution 11C: Calculations – 20X4 financial statements
W1: Earnings per share for the 20X4 financial statements 20X3
20X4
C C
Restated
Basic earnings C100 000 C100 000
Weighted average number of shares 2 250 1 500
= Basic earnings per share in the 20X4 AFS C44.44 C66.67
Comment:
Look at 11C: When preparing the 20X4 financial statements, the denominators used (for the 20X4
and 20X3 years) are the number of shares calculated as at 31 December 20X4 (in W2). This is
because the share movements in 20X5 had not yet occurred.
Look at 11B: When preparing the 20X5 financial statements, the denominators used (for the 20X4
and 20X3 years) are not the same as those used for 20X4 and 20X3 to be presented in the 20X4
financial statements (in 11C) since these must now be adjusted for any issues for no value
occurring during 20X5.
Chapter 24 1057
3.3.5 Contingently issuable shares (IAS33.24)
These shares are included in the calculation of basic Contingently issuable

earnings per share when all the necessary conditions are shares are defined as
satisfied. See IAS 33.57 (b) and IAS 33.19&.26
shares that are issuable
for little or no consideration, &
The type of conditions that may be included in a contingent
only upon the satisfaction of
share agreement include, for example: specified conditions.IAS 33.5 Reworded
the maintenance of a specified level of earnings;
opening of specific number of retail stores; or
the future market price of an ordinary share.
The denominators in the comparative years are not restated for contingent shares.
Please note that shares that will be issued upon the expiry
Deferred shares are:
of a period of time (deferred shares) are not considered to
be contingently issuable shares since the passage of time is shares that will be issued
considered to be a certainty and not a condition that may or after a certain period of time.
may not be met. Deferred shares are considered issued from the date on which the decision is
taken to issue these shares – even though they are not yet in issue.
Example 12: Contingently issuable shares
Jamnas Ltd had 10 000 ordinary shares in issue during 20X2.
At the beginning of 20X3 it issued 1 000 shares to each of its 3 directors, conditional upon
company earnings being maintained at a minimum of C100 000 in each of 20X3 and 20X4.
If the conditions are met, the shares will be issued on 31 March 20X5.
Consider the two following scenarios: Scenario A Scenario B
Earnings Earnings
20X3 C100 000 C50 000
20X4 C110 000 C200 000
Required:
For each of the scenarios A and B, calculate the number of shares to be used when calculating BEPS
for disclosure in the year ended 31 December 20X5, where 2 comparative years are to be provided (i.e.
20X4 & 20X3).
Solution 12A: Contingently issuable shares

The condition upon which the issue is contingent was met in full (other than for a time delay) from
31 December 20X4 as the earnings in both 20X3 and 20X4 exceed the C100 000 minimum.
The denominator for the purposes basic earnings per share between 20X3 & 20X5 is therefore:
Denominator: number of shares Actual 20X5 20X4 20X3
Balance: 1 January 20X3 10 000 N/A N/A 10 000
20X3: contingent shares issued: 3 000 (1 000 x 3 directors) 3 000 N/A 0
N/A
contingent share issue: ignored note 1
Denominator: 31 December 20X3 13 000 N/A N/A 10 000
Balance: 1 January 20X4 10 000 N/A 10 000 10 000

20X4: contingent share issue (now deferred shares): note 2 3 000 N/A 3 000 0
conditions are satisfied (despite time delay)
Denominators: 31 December 20X4 13 000 N/A 13 000 10 000
Balance: 1 January 20X5 13 000 13 000 13 000 10 000

20X5: contingent/ deferred shares: reversed: (3 000) (3 000)
shares actually issued: 3 000 x 12/12 note 3 3 000 3 000 0 0
Denominators: 31 December 20X5 note 4 13 000 13 000 13 000 10 000
1058 Chapter 24

Notes:
1) At 31 December 20X3: Contingent shares ignored since conditions are not met.
2) At 31 December 20X4: Contingent shares are assumed to be actually issued since all conditions
(apart from time – the shares are only to be issued on a date in 20X5) are met, but the effect of
these shares is weighted based on the time from the date on which the conditions are met: since the
conditions are met on the last day of the year with the only remaining condition being a delay in
time, the contingent shares are no longer contingent but rather deferred shares (only condition
remaining is time). Deferred shares are taken into consideration in the basic earnings per share
calculation from the date that a decision was made to issue the shares. This ‘decision’ is
effectively made on 31 December 20X4 when the conditions (excluding time) were met. So,
although the shares are technically issued on 31 March 20X5, they are taken into consideration in
the basic earnings per share calculation at 31 December 20X4. IAS 33.24
3) At 31 December 20X5: From 31 December 20X4, all conditions were met with the exception of
time. The shares that were deferred shares in the first three months of the year are then issued on
31 December 20X5. The table above shows the deferred shares being reversed and replaced with
an actual issue. This detail in the table is not necessary since it does not change the answer in any
way but is shown for completeness.
4) The denominator in the basic earnings per share calculation for 20X5 is adjusted for the contingent
share issue (i.e. they are treated as already in issue from the date that the conditions are met) but
the denominator for the basic earnings per share for 20X3 remains 10 000 (i.e. it is not restated).
Solution 12B: Contingently issuable shares

Although the earnings in 20X4 (C200 000) exceed the C100 000 sub-minimum, the earnings in 20X3
(C50 000) failed to meet the sub-minimum and so the conditions fail to be met and the contingently
issuable shares will never be issued.
The number of shares to be used when calculating basic earnings per share in the financial statements
for the year ended 31 December 20X5 and for its 20X4 and 20X3 comparatives is 10 000 shares.
Example 13: Deferred shares

Balloon had 10 000 ordinary shares in issue at 31 December 20X2. On 1 January 20X3,
Balloon decides that it will issue 1 000 shares to each of its 3 directors at the end of 20X4.
Required: Calculate the number of shares to be used when calculating BEPS for disclosure in the year
ended 31 December 20X5, where 2 comparative years are to be provided (i.e. 20X4 & 20X3).
Solution 13: Deferred shares

This is not a contingent share issue but rather a deferred share issue as the passage of time (which is a
certainty) is the only condition that needs to be met. These 3 000 deferred shares will be included in
the calculation of the ‘weighted average number of shares in issue’ from the date that the decision has
been taken to issue these shares i.e. 1 January 20X3.
W1: Denominator: number of shares Actual 20X5 20X4 20X3
Balance: 1 January 20X3 10 000 N/A N/A 10 000
20X3: Deferred shares ‘issued’ (see note 1) 3 000 N/A N/A 3 000
(1 000 x 3 directors): 3 000 x 12/12
Denominator: 31 December 20X3 13 000 N/A 13 000 13 000
20X4: Further issues 0 N/A 0 0
Deferred shares reversed (3 000)
Shares actually issued 3 000
Denominator: 31 December 20X4 13 000 13 000 13 000 13 000
20X5: Further issues 0 N/A 0 0
Denominator: 31 December 20X5 13 000 13 000 13 000 13 000
Note 1: For the purposes of the BEPS calculation, deferred shares are assumed to be in issue from the
date the decision was taken to issue the deferred shares and is thus weighted for 12/12 months.
Chapter 24 1059
3.3.6 Share buy-back
A buy-back involves a reduction of the capital

A share buy-back is:
base (i.e. fewer issued shares will exist after
the buy-back) and a reduction in the money/ a decrease in the entity’s capital base,
resources of the entity (this is because the caused by
entity will be required to pay the shareholders - the entity repurchasing shares
for the shares). - from its own shareholders.
Since the entity pays the shareholders for their shares, the share buy-back is a for-value
reduction. The treatment of a for-value reduction is very similar to that of a for-value issue
with the exception that the number of shares involved is subtracted rather than added.
Example 14: Share buy-back
Bell Ltd had 10 000 ordinary shares in issue during 20X2 and had a share buy-back in 20X3:
of 5 000 ordinary shares (at market price)
60 days before the end of the current year (year-end: 31 December 20X3).
The basic earnings in 20X2 were C20 000 and were C17 000 in 20X3.
Required: Calculate the earnings per share in 20X3 and 20X2.
Solution 14: Share buy-back

Basic earnings per share (W1&W2): 20X3: C1,85 per share 20X2: C2,00 per share
W1: Denominator: number of shares Actual 20X3 20X2
Opening balance: 1/1/20X2 10 000 10 000 10 000
Reduction for value: 1/11/20X3 (5 000) (822) 0
(20X3: 5 000 x 60/ 365);
(20X2: 5 000 x 0/12)
5 000 9 178 10 000
W2: Earnings per share for inclusion in 20X3 financial statements
Basic earnings per share: 20X3 20X2
C1.85 C2.00
3.3.7 Reverse share split (share consolidation) (IAS 33.29)
An entity might perform a share split if they

believe that their share price is too low (by A reverse share split:
reducing the number of shares, the demand for
the share should push the market price up). is the combining of 2 or more shares into 1 share.
causes a reduction in shares.
As it can be seen, this transaction requires does not bring in cash and is thus treated as a
not-for-value reduction.
none of the entity’s resources and thus it is
treated as a not-for-value reduction.
The treatment of a not-for-value reduction is very similar to that of a not-for-value issue with
the exception that the number of shares involved is subtracted rather than added.
There is no journal entry to record a share consolidation.
Example 15: Reverse share split (share consolidation)
A company had 10 000 issued ordinary shares during 20X2. It then consolidated its shares in
20X3 such that every 2 shares were consolidated into 1 share, 60 days before the end of the
current year (year-end: 31 December 20X3). Basic earnings were C20 000 (20X2) & C17 000 (20X3).
Required: Calculate the earnings per share in 20X3 and 20X2.
1060 Chapter 24
Solution 15: Reverse share split (share consolidation)

Earnings per share (W1&W2): 20X3: C3,40 20x2: C4,00
W1: Denominator: number of shares Actual 20X3 20X2

Opening balance: 1/1/20X2 10 000 10 000 10 000
Reduction for no value: 1/11/20X3 (5 000) (5 000) (5 000)
(20X3: 5 000 x 10 000/ 10 000);
(20X2: 5 000 x 10 000/ 10 000)
5 000 5 000 5 000
W2: Earnings per share for inclusion in 20X3 financial statements
Basic earnings per share: 20X3 20X2
C3,40 C4,00*
* The 20X2 financial statements would have reflected an earnings per share figure of C2 (C20 000/ 10 000).
Comment: Since the share consolidation is not for value, the reduction is not weighted but is rather
retrospectively adjusted.
4. Headline Earnings Per Share (Circular 02/2013)
4.1 Overview
Headline earnings per share is not a requirement of IAS 33 but is a requirement for companies
wishing to be/ remain listed on the South African Johannesburg Securities Exchange (JSE).
The story behind the development of headline earnings per share, stems largely from:
the source of the basic earnings per share figure; and
the price-earnings ratio as a tool for analysing financial statements.
Since basic earnings are derived from the profit for the year, it may include the re-
measurement of assets and liabilities, some of which:
may relate to capital platform-related items (e.g. capital transactions), and some of which
may relate to operating activities (e.g. inventories).
The price-earnings ratio is a frequently used tool in the analysis of financial statements. The
need for a headline earnings developed largely from the belief that the share price is:
more likely to be driven by earnings from operations; and
less likely to be driven by earnings from re-measurements of certain non-current assets
making up the company’s capital-platform (e.g. property, plant and equipment).
The headline earnings per share therefore simply separates the basic earnings into:
The earnings that relates to operating/ trading activities (included in HEPS); and
The earnings that relates to the capital platform of the business (excluded from HEPS).
In short, South Africa felt it was necessary to develop an alternative earnings figure (headline
earnings) that reflects the entity’s operating performance.
Please remember that the headline earnings per share is not intended to represent maintainable
earnings, nor is it a means to depart from IAS 33 or to correct what may be considered
inappropriate accounting for the business. It is an additional disclosure and not a replacement
for the disclosure of basic earnings per share and diluted earnings per share.
The following are some of the core definitions essential to your understanding of headline
earnings per share. All of these have been extracted from Circular 2/2013 and are found in
paragraph 14 thereof.
Chapter 24 1061
Headline earnings is defined as: NOTE 1
an additional earnings number which is permitted by IAS 33. It is the basic earnings:
Adjusted for separately identifiable re-measurements, as defined (net of related tax and related
non-controlling interests), but
Not adjusted for included re-measurements, as defined.
NOTE 1: (Please see Circular 02/2013 for exact definition).
A re-measurement is defined as:
an amount recognised in profit or loss relating to any change (whether realised or unrealised) in the
carrying amount of an asset or liability that arose after the initial recognition of such asset or
liability…)
A re-measurement can, by definition, never be:
i) the initial recognition of an asset or liability at fair value; or
ii) the expensing of a cost which fails to meet the definition of an asset; or
iii) a gain recognised directly in equity, such as a revaluation surplus on PPE.
Included re-measurements are defined as:
re-measurements identified in circular 02/2013 (in the table in paragraph .21 of Section C) and
are to be included in headline earnings because:
iv) they have been determined as normally relating to the operating/trading activities of the entity;
v) they relate to the usage (as reflected by depreciation) of a non-current asset, which is an
operating/trading activity of the entity;
vi) they relate to current assets or current liabilities, and thus relate to the operating/trading
activities of the entity (other than current assets or liabilities as part of a disposal group) within
the measurement scope of IFRS 5 − Non-current Assets Held for Sale and Discontinued
Operations);
vii) they are foreign exchange movements on monetary assets and liabilities and thus relate to the
operating/trading activities of the entity, except for those relating to foreign operations that
were previously recognised in other comprehensive income and subsequently reclassified to
profit and loss. This exception also applies to the translation differences of loans or receivables
that form part of such net investment in a foreign operation;
viii) they are financial instrument adjustments arising from the application of IFRS 9 (whether the
result of revaluation, impairment or amortisation), except for all reclassified gains and losses
other than those detailed in (vi) below. For example, gains or losses on financial assets which are
reclassified to profit or loss on disposal or impairment of the financial asset are excluded from
headline earnings because the reclassified fair value gains and losses do not only reflect
performance in the current period; or
ix) they are reclassified items relating to IFRS 9 cash flow hedges because these amounts are
matched with those relating to the hedged item.
A reclassification (or reclassification adjustments) is defined as:
when a re-measurements in initially recorded in other comprehensive income (in accordance with the
relevant IFRS)
and is subsequently recycled or reclassified to profit and loss.
This is referred to as a “reclassified gain or loss item.”
Separately identifiable re-measurements are defined as:
those where the applicable IFRS explicitly requires separate disclosure of

the operating/trading and/or the platform re-measurement
in the separate or individual financial statements of the entity/company/subsidiary/associate/joint
venture or in the consolidated financial statements.
No adjustments would be permitted based on voluntary disclosure of gains or losses (or components
of these). For example, in the case of biological assets, even if the operating/trading portion and the
platform portion of the fair value gain on an apple orchard were voluntarily disclosed, no adjustments
to headline earnings would be permitted because this disclosure is not required by IFRS.
1062 Chapter 24
Operating/trading activities are defined as:
those activities that are carried out using the ‘platform’,

including the cost associated with financing those activities.
The platform is defined as:
the capital base of the entity.

Capital transactions reflect and affect the resources committed in producing operating performance
and are not the performance itself.
4.2 Measurement of the headline earnings per share

4.2.1 Headline earnings (the numerator)
Headline earnings reflect the entity’s operating performance. We calculate basic headline
earnings by taking the basic earnings figure (as per IAS 33) and adjusting it. See Circular 02/13.17
This basic earnings figure (calculated in terms of IAS 33) is :

Adjusted for any re-measurement of an asset or liability that constitutes part of the
platform of the business (e.g. re-measurement of property, plant and equipment): these are
excluded from the earnings figure; and conversely,
Not adjusted for any re-measurements of assets and liabilities related to the business
operations (e.g. re-measurement of inventories): these are included in headline earnings.
When calculating diluted headline earnings, we start with the basic diluted earnings figure
(per IAS33), and adjust it for the same headline earnings adjustments as above. Circular 02/13.23.
The following are examples of some items that would be excluded from earnings when
calculating ‘headline earnings’ per share:
Profits or losses on the sale of non-current assets NOTE 1
Profits or losses on the full or partial sale of a business (i.e. sale of disposal groups) NOTE 1
Impairments (and reversals thereof) of non-current assets or businesses NOTE 1
Foreign exchange loss on the translation of a net investment in a foreign operation NOTE 1
Gain on an available for sale financial asset that is reclassified on disposal (this type of
financial asset will not exist if the company has adopted IFRS 9) NOTE 2
The following are examples of some items that would not be excluded from earnings (i.e.
would be included in earnings) when calculating ‘headline earnings per share’:
Depreciation of plant NOTE 3
Amortisation of intangible assets NOTE 3
Write-down of inventory (remember that this relates to a current asset) NOTE 4
Increase in a deferred tax expense due to the effect of an increase in the tax rate on a
deferred tax liability NOTE 5
Foreign exchange loss due to the effect of the weakening of the local currency on an
amount payable by the entity NOTE 6
Gain on the initial recognition of a deferred tax asset NOTE 7
Note 1. excluded: re-measurement of an asset or liability that constitutes the business platform.
Note 2. excluded: re-measurement that falls outside of the definition of included measurements (v) –
this is a gain that does not only reflect the performance in the current year.
Note 3. included: relates to usage: see definition of included measurements (ii).
Note 4. included: relates to a current asset: see definition of included measurements (i) and (iii.)
Note 5. included: relates to operations: see definition of included measurements (i).
Note 6. included: relates to foreign exchange movements on a monetary liability: see definition of
included measurements (iv).
Note 7. included: this is not a re-measurement: see the definition of headline earnings where it is clear
that it is only re-measurements that are excluded.
Chapter 24 1063
Quick summary: Headline earnings per share (Circular 02/13)

HE = BE that are:
Adjusted for: ‘separately identifiable re-measurements’ as defined
Not adjusted for: ‘included re-measurements’ as defined
HEPS: Disclosed in the notes (never on the face!)
Example 16: Conversion: basic earnings to headline earnings

Would we adjust basic earnings for the following? Explain.
1. Depreciation or amortisation
2. Inventory write-down
3. Reversal of an impairment of property, plant and equipment
4. An impairment of goodwill
5. Increase in a doubtful debt allowance
6. Increase in deferred tax expense due to a rate change
7. Increase in deferred tax expense due to initial recognition of a deferred tax liability
8. Gain on financial asset at fair value through profit or loss
9. Gain on cash flow hedge in OCI reclassified to P/L over life of plant
10. Increase in deferred tax liability due to an increase in revaluation surplus on plant
11. Foreign exchange loss caused by increase in foreign creditor
12. Profit on sale of property, plant and equipment
13. Impairment of property, plant and equipment
14. Revaluation of property, plant and equipment
15. Fair value adjustment of investment property
Solution 16: Conversion: basic earnings to headline earnings

1. Depreciation or amortisation No IR (ii): usage of NCA
2. Inventory write-down No IR (i): operating and
IR (iii): current
3. Reversal of an impairment of property, plant and equipment Yes Re-measurement of A
4. An impairment of goodwill Yes Re-measurement of A
5. Increase in a doubtful debt allowance No IR (i): operating and
IR (iii): current
6. Increase in deferred tax expense due to rate change No IR (i): operating
7. Increase in deferred tax expense due to initial recognition of a No Not a re-measurement
deferred tax liability
8. Gain on financial asset at fair value through P/L No IR (v): IFRS 9 adj
9. Gain on cash flow hedge in OCI recycled to P/L over life of No IR (vi): reclassification re
imported plant CFH (for sake of
matching)
10. Increase in deferred tax liability due to an increase in No Not included in profit
revaluation surplus on plant
11. Foreign exchange loss on foreign creditor No IR (iv): forex and IR: (iii)
current liability
12. Profit on sale of property, plant and equipment Yes Re-measurement of A
13. Impairment of property, plant and equipment Yes Re-measurement of A
14. Revaluation of property, plant and equipment No If revaluation surplus: Not
included in profit; &
Yes If revaluation income:
Re-measurement of A
15. Fair value adjustment of investment property Yes Re-measurement of A
4.2.2 Number of shares (the denominator) Circular 02/13.24
The number of shares to be used in calculating the headline earnings per share must be the
same as the number used to calculate basic earnings per share in terms of IAS 33. Similarly,
the number used to calculate the diluted headline earnings per share must be the same as that
used to calculate diluted earnings per share.
1064 Chapter 24
Example 17: Headline earnings per share

The following information relates to Kin Limited’s year-ended 31 December 20X2:
The statement of comprehensive income shows profit for the year of C100 000. The calculation of this
profit included the following income and expenses:
Impairment of building: C35 000 (before tax: C50 000)
Profit on sale of plant: C22 400 (before tax: C32 000)
Inventory write-down: C10 000 (before tax: C15 000)
The statement of changes in equity reflected preference dividends of C2 000.
Required: Calculate the basic earnings and the headline earnings.
Solution 17: Headline earnings per share

Basic earnings C
Preference dividends (2 000)
Basic earnings 98 000
Headline earnings
Adjusted as follows:
Add impairment of building 35 000
Less profit on sale of plant (22 400)
Headline earnings 110 600
4.3 Disclosure of the headline earnings per share
Headline earnings per share must be disclosed with the same prominence as basic earnings
per share and diluted earnings per share (i.e. not with more prominence).
An earnings per share note needs to be included in the financial statements and must include:
the headline earnings per share
a reconciliation between the basic earnings and headline earnings
comparatives for all such disclosures. Circular 02/13.25
This reconciliation must be provided in a long-form, meaning that the amounts that have been
excluded from the basic earnings must be shown:
gross (before tax) and
net (after tax and after non-controlling interests). Circular 02/13.28
The gross and net must be provided in two columns.
Example 18: Headline earnings per share - disclosure
Use the same information as was provided in example 17 and that there were 10 000 shares
in issue throughout the year.
Required: Disclose headline earnings per share for the year-ended 31 December 20X2.
Solution 18: Headline earnings per share - disclosure

Company name
25. Earnings per share 20X2 20X1
Headline earnings per share HE: 110 000/ Shares: 10 000 C11 per share xxx
Headline earnings per share
The calculation of headline earnings per share is based on earnings of C 110 000 (20X4 C XXX) and
10 000 (20X4 xxx) ordinary shares outstanding during the year.
Chapter 24 1065

Reconciliation of earnings: Profit – basic earnings – headline earnings
20X2 20X1
Gross Net Gross Net
C C C C
Profit/(loss) for the period 100 000 xx
Preference dividend (2 000) (xx)
Basic earnings 98 000 xx
Add: back: Impairment of building 50 000 35 000 xx xx
Less: Profit on sale of plant (32 000) (22 400) xx xx
Headline earnings 110 600 xx
5. Diluted Earnings Per Share (IAS 33.30 - .63)
5.1 Overview
A dilution is defined as:
Dilution means to make thinner or less concentrated. IAS 33.5
With respect to earnings per share, dilution would occur A reduction in earnings per share, or
if the same earnings have to be shared amongst more An increase in loss per share
shareholders than are currently in existence. Resulting from the assumption that:
- convertible instruments are
Many entities at year-end have potential shares converted, or
outstanding, which, if converted into shares, would - options/ warrants are exercised, or
that
dilute the earnings per share. Diluted earnings per share
- ordinary shares are issued upon the
shows the lowest earnings per share possible assuming satisfaction of specified conditions.
that these potential ordinary shares are created. In other
words, the diluted earnings per share shows users the maximum potential dilution of their
earnings in the future (i.e. the worst case scenario) assuming the dilutive potential shares
currently in existence are converted into ordinary shares in the future. It logically follows that
diluted earnings per share can never be higher than basic earnings per share. Diluted earnings
per share is calculated for both basic and headline earnings per share.
Example 19: Diluted earnings per share: simple example
Family Limited had basic earnings for 20X5 of C500 000 . This basic earnings figure was
equal to its profit for the year. It had no components of other comprehensive income.
Family Limited had 1 200 000 ordinary shares in issue throughout 20X5 . There were 300 000 options
in issue at 31 December 20X5 (granted to the directors for no value).
Required:
A Calculate basic and diluted earnings per share for the year ended 31 December 20X5.
B Disclose basic and diluted earnings per share for the year ended 31 December 20X5.
Solution 19A: Diluted earnings per share - calculations

Basic earnings per share (W1): C0, 4167
Diluted earnings per share (W2): C0, 3333
W1: Basic earnings per share: 20X5
Basic earnings C500 000
Weighted average number of shares = 1 200 000
Basic earnings per share = C0,4167

W2: Diluted earnings per share: 20X5
Diluted earnings C500 000
Weighted average number of shares outstanding + potential shares = (1 200 000 + 300 000)
Diluted earnings per share = C0,3333
1066 Chapter 24
Solution 19B: Diluted earnings per share - disclosure

XYZ Limited
20X5 20X4
Note C C
Other comprehensive income 0 xxx
Total comprehensive income 500 000 xxx
Basic earnings per share 15 0,4167 x
Diluted earnings per share 15 0,3333 x
XYZ Limited
15. Earnings per Share
Basic earnings per share Basic earnings per share is based on earnings of C500 000
(20X4: CX) and a weighted average of 1 200 000 (20X4 X)
ordinary shares in issue during the year.
Dilutive earnings per share Dilutive earnings per share is based on dilutive earnings of
C500 000 (20X4 C X) and a weighted average of 1 500 000
(20X4 X) ordinary shares during the year.
5.2 Potential shares (IAS 33.36 - .63) A potential ordinary

share is defined as:
Potential shares are contracts that could potentially a financial instrument or
increase the number of shares in issue and thus possibly other contract
lead to a diluted (i.e. reduction) in the earnings per share. that may entitle its holder to
ordinary shares. IAS 33.5
There are many types of potential shares (dilutive Potential shares may cause a dilution in
instruments). Each has a different effect on diluted the EPS.
earnings (the numerator) and/ or the weighted number of shares outstanding (the
denominator). Examples include options, convertible instruments and contingently issuable
shares.
Potential ordinary shares are weighted for the period they are outstanding, meaning that:
those that are cancelled or allowed to lapse during the period are included in diluted
earnings per share only for the part of the period during which they were outstanding; and
those that are converted into ordinary shares during the period are included in diluted
earnings per share only up to the date of conversion.
Potential ordinary shares are included in the calculation of diluted earnings per share:
weighted from the beginning of the year, or
if the potential ordinary share was issued during the year, then from the date of the issue.
The basic number of shares is then increased from the date the options are exercised.
Diluted EPS: how potential shares affect the diluted EPS formula
Effect on EPS Convertible

Options Convertible Debentures
formula: Preference Shares
+ Finance costs saved + Dividends saved

Earnings: No effect: always zero
(net of tax) (if treated as finance costs)
+ number of possible
Number of + Number of possible + Number of possible
bonus/ not for value
shares: extra/new shares extra/new shares
shares
Chapter 24 1067
5.2.1 Options (IAS 33.45 - .48)
Options are granted to individuals allowing them to acquire a certain number of shares in the
company at a specified price per share (the strike price or exercise price) in the future. This is
usually lower than the average market price (fair value) of the share, which therefore
encourages the option holder to buy the share. When the date has been reached that the holder
is entitled to exercise the option, we say that the option has vested. It does not matter whether
the option has vested or not: the option is included in the calculation of diluted earnings per
share from the beginning of the year or, if later, from the date of issue of the option.
Options give the option-holder the right, not the obligation, to purchase shares at a future
date. The holder would only consider exercising the option (i.e. buy shares) if the strike price
is below the market price on the exercise date i.e. the option will only be exercised if it is ‘in
the money’.
Incidentally, if the strike price is greater than the market price (on the exercise date or during
an exercise period), the option is referred to as ‘out of the money’ and the option-holder would
not purchase the shares and the option would eventually lapse.
Options will affect the denominator for diluted earnings per share from the date of issue of
such options till the earlier of the date on which the options lapse or are exercised. The
notional shares to be included in the denominator for diluted earnings per share:
intrinsic value *
= Number of options X
average market price per share
where intrinsic value= average market price per share – strike
*
price per share
When the option is exercised it will result in both:

a ‘for value issue’ (relating to the cash received) and
a ‘not for value issue’ (relating to the bonus element, being the difference between what
should have been received based on the market price and what was received).
The two portions (for value and not for value) can be calculated as follows:
the total proceeds received when the options are exercised are divided by the market price
per share and the resultant number of shares is seen as a for value issue. This for value
issue requires no adjustment in diluted earnings per share; and
the total number of share options less the number of ‘for value’ shares calculated, is the
‘not for value’ portion. This ‘not for value’ portion has no effect on the numerator
(earnings) but the denominator must be increased accordingly.
Example 20: Options to acquire shares
20X5
Income tax expense (390 000)
There are 200 000 ordinary shares in issue (all issued at C2 each).
The company’s directors hold 100 000 options, at a strike price of C2 each.
Of these options, 80% vested on 1 July 20X5 and 20% have not yet vested.
During 20X5 the company’s shares had an average market value of C6.
Required: Calculate the earnings per share figures for 20X5 ascertainable from the information given.
Solution 20: Options to acquire shares

W1: Basic earnings per share 20X5
Basic earnings = C410 000 Given
Weighted number of shares outstanding 200 000 Given
Basic earnings per share = C2,05
1068 Chapter 24
Solution 20: continued

W2: Diluted earnings per share (20X5):
Diluted earnings C410 000 Given (dilution has no effect on earnings)
=
Weighted number of ordinary shares 266 667 W3
= C1,5375
W3: Weighted number of shares:
Basic number of shares 200 000
Notionally exercised options See W4 or calculate as follows: 66 667
(not for value portion): Bonus element: (market price – strike price):
(C6 – C2) ÷ Market price: C6 x Options: 100 000
Diluted number of shares 266 667
W4: Effect of options on number of shares:
Total proceeds
= Effective number of shares that would be sold
Market price
100 000 x C2
= 33 333 effectively sold (for value)
C6
100 000 – 33 333 = 66 667 effectively given away (not for value)
5.2.2 Convertible instruments (IAS 33.49 - .51)

Convertible instruments are instruments that may be converted into ordinary shares (known as
potential ordinary shares) at some time in the future (either on a specific date or at any time).
Examples of convertible instruments include:
convertible debentures; and
convertible preference shares.
Instruments may be convertible at the option of the holder or the issuer. It does not matter
who it is that decides whether to convert the instruments into ordinary shares or not: we
always assume the worst case scenario i.e. that the decision is made to convert the instrument
into ordinary shares.
The effect of a conversion will be:
an increase in the expected earnings (the numerator): increased by the after tax interest or
dividends saved by a conversion; and
an increase in the number of shares (the denominator): increased by the extra shares that
may be created by a conversion.
From a tax perspective: Please note that when we expect to save an interest expense we will
also expect our tax expense to increase. This is because interest expense is tax deductible and
thus by saving an interest expense, we lose a tax deduction (thus taxable profits and tax
expense increase). Thus when we adjust the earnings for an expected reduction in interest
expense, we adjust it for these savings after tax. Conversely, however, when we expect to
avoid a dividend distribution that is recognised as an interest expense, we do not expect our
tax expense to change. This is because, although it appears as an expected reduction in
interest, it is really a reduction in dividends and dividends would not have been tax-
deductible in the first place.
If the holder of the instrument is faced with more than one conversion option, the entity
(being the issuer of the instrument) must assume the most dilutive option in the diluted
earnings per share calculation. For example, if the holder of a debenture has the option to
convert the debenture into an ordinary share or to redeem it for cash, the entity must assume
that the holder will choose the ordinary shares since this will increase the number of shares
and therefore decrease dilutive earnings per share.
Chapter 24 1069
Example 21: Convertible debentures

Profit for the year ended 20X5 was C279 000, including finance costs on convertible
debentures of C30 000 (before tax). Tax is levied at 30%. There are:
z 100 000 ordinary shares in issue (all issued at C2 each)
z 200 000 convertible debentures in issue (the conversion rate is: 1 ordinary share for
each debenture; all were issued at C2 each).
Required: Calculate basic earnings and diluted earnings per share to be included in the statement of
comprehensive income for the year ended 31 December 20X5. Comparatives are not required.
Solution 21: Convertible debentures

W1: Basic earnings per share:
Basic earnings C279 000
= = C2,79
Weighted number of ordinary shares in issue 100 000
W2: Diluted earnings: C
Preference dividend 0
Adjustments
Finance costs avoided 30 000
Tax saving due to finance costs lost (30 000 x 30%) (9 000)
Diluted earnings 300 000
W3: Weighted number of ordinary shares:
Notionally converted ordinary shares 200 000
Diluted number of shares 300 000
W4: Diluted earnings per share:
Diluted earnings C300 000 (W2)
=
Weighted number of ordinary shares outstanding 300 000 (W3)
= C1,00
Example 22: Convertible preference shares

Engine Limited has provided the following extract from its statement of
comprehensive income for the year ended 31 December 20X5: 20X5
Profit from operations 465 000
Finance costs (60 000)
Tax @ 30% (121 500)
Engine Limited has the following shares in issue, all of which have been in issue for many years:
z 200 000 ordinary shares in issue (all issued at C2 each)
z 100 000 convertible 20% preference shares in issue:
The preference shares are convertible on 31 December 20X8 at the option of the preference
shareholders into ordinary shares at a rate of 1 ordinary share for every preference share.
A preference dividend of C40 000 was declared for 20X5.
Tax is levied at 30% on taxable profits.
Required: Calculate basic earnings and diluted earnings per share for presentation in the statement of
comprehensive income for the year ended 31 December 20X5 assuming the following 2 scenarios:
A The preference shares are correctly recognised as a liability and the dividend of C40 000 is
recognised as a finance cost of C45 000 using the effective interest rate method (i.e. the finance
costs of C60 000 refer to interest on a bank loan and interest on the preference shares).
B The preference shares are correctly recognised as equity (the C60 000 finance costs shown in the
extract from the statement of comprehensive income relate to a bank loan).
Comparatives are not required.
1070 Chapter 24
Solution 22: Convertible preference shares Ex 20A Ex 20B

(liability) (equity)
W1: Basic and diluted earnings:
Preference dividend (1) (2) 0 (40 000)
Basic earnings 283 500 243 500
Adjustments due to dilutions from potential shares:
Part A: Finance costs saved; or Interest: 45 000 x
31 500 40 000
Part B: Dividends saved 70%
Diluted earnings 315 000 283 500
(1) Ex 20A: If the shares are recognised as a liability, the preference dividend would be recognised as
an interest expense using the effective interest rate method (and would thus have already been
deducted in the calculation of profit for the year). Please note that the amount of the finance costs
are not necessarily the same as the actual dividend declared in any year.
(2) Ex 20B: If the shares are recognised as equity, the dividends to which the preference shareholders
are entitled have not been taken into account in determining the profit belonging to the ordinary
shareholders. These preference dividends must therefore still be deducted.
W2: Weighted number of ordinary shares:

Basic number of shares 200 000 200 000
Notionally converted ordinary shares 100 000 100 000
Diluted number of shares 300 000 300 000
W3: Basic earnings per share:

Basic earnings = C283 500 C243 500
Weighted number of ordinary shares in issue 200 000 200 000
Basic earnings per share = C1,4175 C1,2175
W4: Diluted earnings per share:

Diluted earnings C315 000 C283 500
=
Diluted number of shares 300 000 300 000
Diluted earnings per share = C1,05 C0,945
5.2.3 Contingent shares (IAS 33.52 -.57 and .24)

As already explained in section 3.3.5, contingent shares are those that will be issued in the
future if certain conditions (which are laid down in the share agreement) are met and these
shares will then be issued for little or no consideration (e.g. little or no cash).
5.2.3.1 Where time is the only condition
Where the passage of time is the only condition that needs to be met, the issue is not treated as
contingent shares but rather as deferred shares as the passage of time is considered a certainty.
The condition is thus satisfied and the shares are treated as outstanding from the date the grant
was issued (see Section 3.3.5 and example 13).
5.2.3.2 Where there are multiple conditions including time
Basic earnings per share

Only adjust the denominator when all the conditions, including time, are met.
Diluted earnings per share
If at the end of the reporting period all the conditions stated in the contingent share
agreement are satisfied (even if the time condition has not yet been met), then treat the
end of the reporting period as if it were the end of the contingency period and adjust the
denominator as if the contingent shares had already been issued.
Chapter 24 1071
Example 23: Contingent shares

At 1 January 20X5, Airways Limited had 1 million ordinary shares in issue, all having been
issued at C1 in 20X4.
On 2 January 20X5, Airways Limited bought 100% of Radio Limited, which it paid for through an
issue of a further 1 million ordinary shares.
Another 500 000 ordinary shares are contingently issuable upon Radio Limited generating total profits
of C100 million over 3 years.
Airways Limited’s profit for 20X5 is C500 million (20X4 C400 million).
Radio Limited earned C200 million in 20X5.
Required: Calculate Airway Ltd’s basic and diluted earnings per share for 20X4 and 20X5.
Solution 23: Contingent shares

20X5 20X4
C C
Basic earnings per share 20X5: C500 million ÷ 2 million shares 250,00 400,00
20X4: C400 million ÷ 1 million shares
Diluted earnings per share 20X5: C500 million ÷ 2,5 million shares 200,00 400,00
20X4 C400 million ÷ 1 million shares
Comment: The same rules do not apply to basic and diluted shares:
z Basic shares are not adjusted for these contingent shares because the contingency period is not yet
complete and it is not yet certain that the shares will be issued (a profit of C100 million must be
made over a 3-year period). Although a large profit in excess of C100 million has already been
made, this may reverse before the 3 years is up (e.g. if a large loss is made in 20X6 and 20X7, a
net profit of C100 million may not necessarily be made over the 3 years).
z (IAS33.53) Diluted shares must include the contingent shares that would be issued (500 000
shares) if the amount of the earnings at the end of the reporting period (20X5) were the amount of
earnings at the end of the contingency period (20X7). In other words, we pretend that 20X5 (the
current reporting period) is the end of the term stipulated in the agreement: that the time is up. The
prior year diluted earnings per share is not restated for the contingent shares since the contingent
shares are only taken into account from the date that the contingent share agreement was signed).
z If the passage of 3 years was the only condition before issuing the 500 000 shares, then the
denominator for basic earnings per share would be increased by 500 000 shares when the decision
was made to issue these shares, being the 2 January 20X5.
5.3 Multiple dilutive instruments (IAS 33.44)

Many companies have more than one type of dilutive instrument in issue. Some of these
instruments will be more dilutive than others.
If you recall, the objective of dilutive earnings per share is to show the most dilutive option or
‘worst case scenario’. In order to achieve this, all dilutive instruments must be ranked (most
dilutive to least dilutive).
The instrument that has the lowest incremental earnings per share is the most dilutive and is
ranked first. Options, which have no effect on earnings (numerator) but do have an effect on
the number of shares (denominator), will thus have a nil incremental earnings per share and
will always be the most dilutive. Other dilutive instruments cause an increase in shares but
this is often offset by cost savings (e.g. if convertible debentures are converted into ordinary
shares, interest will no longer have to be paid to the debenture-holder and thus profits will
increase).
After ranking the dilutive instruments, we test whether the instruments will actually reduce
the earnings per share if they are issued. This is done on a cumulative basis, where we start
by asking ‘what if our most dilutive instrument is issued?’ If the earnings per share drops, the
effect is dilutive. The earnings per share can increase, in which case it is called ‘anti-dilutive’.
1072 Chapter 24
If the most dilutive instrument did in fact reduce earnings per share, we then ask ourselves
‘now what would happen if not only that instrument were to be issued, but also our next most
dilutive instrument were to be issued’. We continue with this process to see how small our
earnings per share could become. If at any stage, the cumulative effect increases our earnings
per share, we stop the process and our diluted earnings per share will be the last earnings per
share figure that decreased (i.e. the lowest earnings per share). Thus the effect of anti-dilutive
instruments are not considered in calculating diluted earnings per share.
When we calculate whether an instrument is dilutive or not we must always be sure to use the
basic earnings from continuing operations. IAS33.41
Example 24: Multiple dilutive instruments
The following information relates to ABC Limited for the year ended 31 December 20X5:
Basic earnings: C1 000 000
Headline earnings: C979 250
Basic number of shares: 995 500
The following potential shares are applicable on 31 December 20X5:
Convertible debentures (convertible at the option of the debenture holders) into 20 000 ABC Ltd
ordinary shares on 31 December 20X9. If the debentures are not converted into ordinary shares
they will be redeemed on 31 December 20X9. Finance costs of C10 000 (after tax) were expensed
in arriving at the profit for 20X5;
Convertible preference shares (convertible at the option of the shareholders) into 40 000 ABC
Limited ordinary shares on 31 December 20X9. If the shares are not converted into ordinary shares
they will be redeemed on 31 December 20X9. C50 000 finance cost (after tax) were expensed in
arriving at the profit for 20X5; and
Options to acquire 100 000 ordinary shares in ABC Ltd on or after 31 December 20X6 at a strike
price of C7, 50 per share. During 20X5 the average market price of the shares was C10 per share.
Required: Disclose earnings per share in ABC Limited’s statement of comprehensive income for the
year ended 31 December 20X5. Comparatives and notes are not required.
Solution 24: Multiple dilutive instruments

Ranking in order of dilution: Change in EPS for each potential share Dilutive Ranking:
Convertible debentures Increase in earnings C10 000 0,50 2
Increase in shares 20 000
Convertible preference shares Increase in earnings C50 000 1,25 3
Increase in shares 40 000
Options 100 000 x (10 – 7,5) ÷ C10 C0 0,00 * 1

(bonus element only) 25 000
* this will always be zero
Testing whether dilutive or not: Cumulative change in EPS for each incremental share C
Basic earnings C1 000 000 1,0045
Adjust for:
1. notionally exercised options C1 000 000 + C0 options C1 000 000 0,9799

995 500 basic + 25 000 options 1 020 500 Dilutive
2. notionally exercised options & C1 000 000 + C0 options + C10 000 finance cost C1 010 000 0,9707
convertible debentures 995 500 + 25 000 options + 20 000 debentures 1 040 500 Dilutive
3. notionally exercised options, C1 010 000 above + C50 000 finance cost C1 060 000 0,9810
convertible debentures & 1 040 500 above + 40 000 1 080 500 Anti-
convertible preference shares dilutive (*)
(*) This is anti-dilutive since the issue of the convertible preference shares would increase the EPS (increased
from 0.9707 to 0.9810).
Chapter 24 1073

ABC Limited
20X5
C
Basic earnings per share C1 000 000 ÷ 995 500 1,0045
Headline earnings per share C979 250 ÷ 995 500 0,9837
Diluted basic earnings per share C1 010 000 ÷ 1 040500 0,9707
Diluted headline earnings per share (C979 250 headline + C10 000 debentures) ÷ 1 040 500 0,9507
6. Presentation and Disclosure (IAS 33.66 - .73A)
6.1 Overview
Basic and diluted earnings per share should be disclosed for each class of ordinary share.
Both the basic and diluted earnings per share figures should be presented:
on the face of the statement of comprehensive income. See IAS 33.66
Where an entity’s profit for the year involves a discontinued operation, the entity must
calculate the earnings per share (basic and diluted) based on
the profit or loss from the continuing operations separately to Earnings from
the profit or loss from the discontinued operation. continuing operations
are sometimes called
The earnings per share for the continuing operation must ‘control earnings’
be presented on the face of the statement of
The earnings per share for the discontinued operation may be presented either on the face
of the statement of comprehensive income or in the notes.
Entities presenting two statements making up the statement of comprehensive income (i.e. an
income statement and a statement of comprehensive income), must present the earnings per
share in the separate income statement (i.e. the statement of profit or loss).
Details of the calculation thereof should be disclosed

by way of note.
As mentioned earlier, headline earnings per share is a SAICA and JSE requirement and is not
prescribed by the IFRSs. Headline earnings per share is thus presented in the earnings per
share note, together with the details of the calculation thereof: it may never be presented on
the face of the statement of comprehensive income.
Disclosure of dividends per share is required only by IAS 1 Presentation of financial

statements. IAS 1 requires that we present dividends per share in either the statement of
changes in equity or in the notes. see IAS 1.107
Interestingly, unlike earnings per share, when we calculate dividends per share, the number of
shares used as the denominator is generally the actual number of shares issued. However,
this is simply the general approach to calculating dividends per share because the calculation
of dividends per share is actually not stipulated anywhere in the IFRSs. There is a strong
argument that suggests that dividends per share should actually be calculated using same
denominator used when calculating earnings per share (i.e. the weighted number of shares)
because this would then enable the dividend payout ratio to be calculated without the user
having to first adjust the dividends per share figure (for your interest: the dividend payout
ratio is calculated as: dividends per share ÷ earnings per share).
1074 Chapter 24
6.1.1 Statement of comprehensive income
A suggested layout of the statement of comprehensive income disclosure is shown below.
Company name
20X2 20X1
C C
Other comprehensive income xxx xxx
Basic earnings per ordinary share 25 xxx xxx
continuing operations xxx xxx
discontinuing operations (*) xxx xxx
Diluted basic earnings per ordinary share 25 xxx xxx
continuing operations xxx xxx
discontinuing operations (*) xxx xxx
(*) These per share figures could be included in the notes instead of being disclosed on the face of the Statement
of Comprehensive Income.
6.1.2 Notes to the financial statements

The earnings per share figures disclosed in the statement of comprehensive income should be
referenced to a note. The information in this note should include (for basic, headline, diluted
basic and diluted headline earnings per share, where applicable):
the earnings amount used in each of the calculations;
a reconciliation of the each earnings figure used to the profit for the period per the
statement of comprehensive income (for headline earnings, before and after tax amounts
must be disclosed);
the weighted average number of shares used in each of the calculations;
a reconciliation between the weighted average number of shares used in calculating:
basic (and headline) earnings per share; and
diluted (and diluted headline) earnings per share (if applicable);
any dilutive instrument that was not included but could in the future still cause dilution
(potentially dilutive instruments);
any significant share transactions after the end of the reporting period.
6.1.3 Sample note disclosure involving earnings per share
Company name
25. Earnings per Share
The calculation of basic earnings per share is based on earnings of C XXX (20X4 C XXX) and a
weighted average of xxx (20X4 xxx) ordinary shares outstanding during the year.
Diluted basic earnings per share
The calculation of dilutive basic earnings per share is based on dilutive earnings of C YYY (20X4
C YYY) and a weighted average of yyy (20X4 yyy) shares during the year.
The calculation of headline earnings per share is based on earnings of C XXX (20X4 C XXX) and a
weighted average of xxx (20X4 xxx) ordinary shares outstanding during the year.
Diluted headline earnings per share
The calculation of dilutive headline earnings per share is based on dilutive earnings of C YYY (20X4
C YYY) and a weighted average of yyy (20X4 yyy) shares during the year.
Chapter 24 1075
Sample note disclosure: continued ...

Company name
Reconciliation of number of shares: Basic number of shares to diluted number of shares
20X5 20X4
Number Number
Basic number of shares xx xx
Notionally exercised options xx xx
Notionally converted debentures xx xx
Notionally converted preference shares xx xx
Diluted number of shares xx xx
Reconciliation of earnings: Profit – basic earnings – diluted earnings
20X5 20X4
C C
Profit/(loss) for the period xx xx
Preference dividend (xx) (xx)
Basic earnings xx xx
Potential savings:
Debenture interest xx xx
Preference share dividend avoided xx xx
Diluted basic earnings xx xx
Reconciliation of earnings: Basic earnings – headline earnings – diluted headline earnings
20X5 20X4
Gross Net Gross Net
C C C C
Basic earnings xx xx
Items needing reversing for headline purposes xx xx xx xx
Headline earnings xx xx
Potential savings:
Debenture interest xx xx
Notional preference share dividend xx xx
Finance costs avoided xx xx
Diluted headline earnings xx xx
20X5 20X4
Headline earnings per share Cxx/ share Cxx/ share
Diluted headline earnings per share Cxx/ share Cxx/ share
Potentially dilutive instruments

There are xxx convertible debentures in issue, which had the effect of being anti-dilutive and were thus
not included in the diluted earnings per share calculation.
Significant changes to the number of shares after the end of the reporting period
xxx ordinary shares were issued at Cxxx after …. (date: last day of the reporting period).
6.2 Disclosure of further variations of earnings per share (IAS 33.73)

An entity may wish to calculate and disclose a further variation on earnings per share by
using a different earnings figure (note: the number of shares may never vary).
If the entity does disclose a further variation of earnings per share and the earnings used is not
a reported line item in the statement of comprehensive income, then a reconciliation should be
provided reconciling:
the earnings used in the calculation with
a line item that is reported in the statement of comprehensive income.
1076 Chapter 24
Example 25: Disclosure of a rights issue; basic and headline earnings per share
The following information applies to company A for the year-ended 31 December 20X2:
Per the statement of comprehensive income: profit for the year of C100 000 (there are
no components of other comprehensive income);
Per the statement of changes in equity: preference dividends of C2 000.
Included in the calculation of profit for the year are the following income and expenses:
Revaluation expense on plant: C35 000 (C50 000 before tax)
Profit on sale of plant: C21 000 (C30 000 before tax)
The basic earnings and the headline earnings for the prior year (20X1) were correctly calculated as:
basic earnings: C150 000
headline earnings: C100 000
Details of the shares are as follows:
There were 10 000 shares in issue at 1 January 20X1.
There was no movement in shares during 20X1.
There was a rights issue of 1 share for every 5 shares held on 1 October 20X2. The exercise (issue)
price was C4 when the fair value immediately before the rights issue was C5 (i.e. market value
cum rights). All the shares offered in terms of this rights issue were taken up.
Required: Calculate and disclose the basic and headline earnings per share for 20X2.
Solution 25: Disclosure - rights issue; basic and headline earnings per share
Company A
Note 20X2 20X1
C C
Total comprehensive income for the year 100 000 xxx
Basic earnings per ordinary share (W4) 35 C9,11 C14,50
Company name
35. Earnings per share

Basic earnings per share: Basic earnings per ordinary share is calculated based on earnings of
C98 000 (20X1: C150 000) and a weighted average number of
ordinary shares of 10 759 (20X1: 10 345).
Headline earnings per share: Headline earnings per ordinary share is calculated based on earnings
of C110 000 (20X1: C100 000).
Headline earnings per share: (W5 and comment below) 20X2: C10.22/ share 20X1: C9.67/ share
20X2 20X1
Reconciliation of earnings Gross Net Gross Net
C C C C
Less preference dividends (2 000) xxx
Basic earnings 98 000 150 000
Adjusted for:
Revaluation expense on plant 50 000 35 000 xxx xxx
Profit on sale of plant 30 000 (21 000) xxx xxx
Headline earnings 112 000 100 000
Chapter 24 1077
Example 26: Disclosure involving multiple dilutive instruments

The following information relates to ABC Ltd for the year ended 31 December 20X5:
Profit for the year: C1 000 000
Other comprehensive income: nil
Basic earnings: C1 000 000
Profit on sale of plant: C25 000 (tax thereon: C4 250)
Basic number of shares: 995 500
The following potential shares are applicable on 31 December 20X5:

Convertible debentures (convertible at the option of the debenture holders) into 20 000 ABC Ltd
ordinary shares on 31 December 20X9. If the debentures are not converted into ordinary shares
in arriving at the profit for 20X5;
Options to acquire 100 000 ordinary shares in ABC Ltd on or after 31 December 20X6 at a strike
price of C7, 50 per share. During 20X5 the average market price of the shares was C10 per share;
Convertible preference shares (convertible at the option of the shareholders) into 40 000 ABC
Limited ordinary shares on 31 December 20X9. If the shares are not converted into ordinary shares
in arriving at the profit for 20X5.
Required: Disclose the earnings per share figures for inclusion in ABC Ltd’s statement of
comprehensive income for the year ended 31 December 20X5.
Solution 26: Disclosure including multiple dilutive instruments

Please see example 24 for the workings.
ABC Limited
20X5 20X4
Note C C
Profit for the year 1 000 000 xxx
Total comprehensive income for the year 1 000 000 xxx
Basic earnings per ordinary share C1 000 000/ 995 500 35 1,0045 xxx
Diluted basic earnings per ordinary share C1 010 000/ 1 040 500 35 0,9707 xxx
ABC Limited
35. Earnings per share
The calculation of basic earnings per share is based on earnings of C1 000 000 (20X4 C.….) and
a weighted average of 995 500 (20X4 xxx) ordinary shares in issue during the year.
Diluted basic earnings per share
The calculation of diluted basic earnings per share is based on diluted earnings of C1 010 000
(20X4 C…..) and a weighted average of 1 040 500 (20X4 yyy) shares during the year.
The calculation of headline earnings per share is based on earnings of C979 250 (20X4 C...…)
and a weighted average of 995 500 (20X4 xxx) ordinary shares in issue during the year.
Diluted headline earnings per share
The calculation of diluted headline earnings per share is based on diluted earnings of C989 250
(20X4 C…...) and a weighted average of 1 040 500 (20X4 yyy) shares during the year.
1078 Chapter 24
ABC Limited
35. Earnings per share continued ...
20X5 20X4
Reconciliation of basic number of shares to diluted number of shares Number Number
Basic number of shares 995 500 xx
Notionally exercised options 25 000 xx
Notionally converted debentures 20 000 xx
Diluted number of shares * 1 040 500 xx
*Note: remember not to include anti-dilutive instruments
20X5 20X4
Reconciliation of earnings: Profit – basic – diluted basic: C C
Profit for the period 1 000 000 xx
Preference dividend
Basic earnings 1 000 000 xx
Potential savings:
Debenture interest 10 000 xx
Notional preference share dividend xx
Diluted basic earnings 1 010 000 xx
Potentially dilutive instruments

Preference shares exist that are convertible, at the shareholders request, into 40 000 ordinary shares.
These convertible preference shares could potentially dilute earnings per share further. These have
been excluded from the diluted earnings per share calculation since they are currently anti-dilutive.
Reconciliation of earnings: Basic – headline – diluted headline:

20X5 20X4
Gross Net Gross Net
C C C C
Basic earnings 1 000 000 xx
Profit on sale of plant (25 000 – 4 250) 25 000 (20 750) xx xx
Headline earnings 979 250 xx
Potential savings:
Debenture interest 10 000 xx
Notional preference share dividend - xx
Diluted headline earnings 989 250 xx
20X5 20X4
C C
Headline earnings per ordinary share C0,9837 xxx
C979 250 / 995 500
Diluted headline earnings per ordinary share C0,9507 xxx
(C979 250 + C10 000 debentures)/ 1 040 500
Chapter 24 1079
7. Summary
Earnings per share: Types
Basic Diluted Headline Other variations

(IAS 33) (IAS 33) (Circular 03/12) (IAS 33)
Required by IFRS Required by IFRS if the Not required by IFRSs; Allowed if given in
entity had dilutive but is required for all SA addition to the
potential ordinary companies wishing to list BEPS and DEPS
shares on the JSE (a JSE Listing (where applicable)
Requirement)
Headline earnings per share (Circular 02/13)

HE = BE that are:
Adjusted for: ‘separately identifiable re-measurements’ as defined
Not adjusted for: ‘included re-measurements’ as defined
HEPS: Disclosed in notes (not on the face!)
Earnings per share: Calculation
Earnings Number of shares
Ordinary shares and

Issues for Issues for
Ordinary shares only participating
value no value
preference shares
Profit for the period Profit for the period Weight the current Adjust the number
Less preference Less preference year’s number of shares of shares so that
dividends on equity dividends based on the time the ratio of ‘CY
portion of preference Equals elapsed since the share shares: PY shares’
shares Earnings to be shared issue. remains unchanged
Combination issue
Diluted EPS: how potential shares affect the diluted EPS formula
Effect on EPS Convertible

Options Convertible Debentures
formula: Preference Shares
+ Finance costs saved

Earnings: No effect + Dividends saved
(net of tax)
Number of + Not for value possible + Number of possible + Number of possible
shares: number of extra shares extra shares extra shares
Earnings per share: Disclosure
Per share Reconciliation: Reconciliation: Potential dilutive After the

amounts Earnings Shares instruments reporting
period
Basic and diluted: Profit → BE →DBE Basic → Diluted Existence of Significant
in SOCI other potentially changes to
Headline: BE → HE → DHE dilutive number of
in notes instruments shares
1080 Chapter 24
Gripping GAAP Fair value measurement
Chapter 25
Fair Value Measurement
Reference: IFRS 13 (including any amendments to 10 December 2014)
Contents: Page
1.1 The reason for a standard on fair value measurement 1082
1.2 Scope of IFRS 13 1082
1.3 An overview of IFRS 13 1083
2. Measurement of fair value 1083

2.1 Overview 1083
2.2 The asset or liability (or group thereof) 1084
Example 1: Characteristics to include in fair value 1084
2.3 Orderly transaction, market participants and the market 1085
Example 2: Markets and the fair value 1086
Example 3: Markets and the fair value 1087
2.4 Market participants in relation to non-financial assets 1087
Example 4: Fair value of non-financial assets 1088
2.5 Market participants relating to liabilities and an entity’s own equity instruments 1089
Example 5: Settlement and transfer values 1089
2.6 Measurement date 1090
2.7 The price 1090
2.8 Fair value at initial recognition 1091
2.9 Valuation techniques 1091
3. Disclosure relating to measurement of fair value 1093

4. Summary 1094
Chapter 25 1081
1. Introduction
1.1 The reason for a standard on fair value measurement

Fair value is not a new accounting concept: many standards already require or permit the use
of fair value either for purposes of measuring an element or for disclosure purposes. Until the
issue of IFRS 13 Fair value measurement in May 2011, each and every standard that required
or permitted fair values for measurement or disclosure purposes also explained how to
measure fair value. This was clearly very cumbersome and having the measurement of fair
value referred to in so many different standards also led to contradicting guidance on how it
should be measured. To top it all, the ongoing discussions aimed at converging the IFRSs
with US GAAP required that certain measurement and disclosure requirements involving fair
value needed to be revised and standardised. Thus, it was decided that we needed a new
standard dedicated to the measurement of fair value. See IFRS 13.IN5-IN7
IFRS 13:
IFRS 13 Fair value measurement was thus developed to:
a) Define what is meant by the term ‘fair value’; Does not require further measurements
of fair value,
b) Provide a single framework that explains how to Simply clarifies how the fair values
measure fair value; and referred to in other standards should
c) Explain what needs to be disclosed regarding the be measured and disclosed.
measurement of fair value. See IFRS 13.1 Does not deal with the measurement
and disclosure of all fair values:
- certain fair values referred to in
IFRS 13 applies when another IFRS requires or permits some standards are excluded
fair value measurement or disclosure. ( IFRS 13.5 slightly reworded) from the scope of IFRS 13.
Some of these are listed in the table below: See IFRS 13.IN4
Standards currently permitting or requiring the use of fair value for measurement
of items:
Fair value as a measurement is permitted in the following standards:
IAS 16: Measuring property, plant and equipment under the revaluation model: depreciated fair value
IAS 38: Measuring intangible assets under the revaluation model: amortised fair value
IAS 40: Measuring investment properties under the fair value model: at fair value
Fair value as a measurement is required when:
IAS 36: Testing assets for impairment, where the recoverable amount is measured at the higher of:
fair value less costs of disposal and
value in use
IFRS 9: Measuring certain financial instruments at fair value
IFRS 5: Measuring non-current assets held for sale at the lower of:
carrying amount and
fair value less costs to sell
IAS 19: Measuring defined benefit plan assets at fair value.
1.2 Scope of IFRS 13

IFRS 13 measurement and disclosure requirements do not apply to:
Share-based payment transactions within the scope of IFRS 2 Share-based payments
Leasing transactions within the scope of IAS 17 Leases
Measurements that have some similarities to fair value but are not fair value, such as net
realisable value in IAS 2 Inventories or value in use in IAS 36 Impairment of assets IFRS 13.6
IFRS 13 disclosure requirements do not apply to:

Plan assets measured at fair value in accordance with IAS 19 Employee Benefits
Retirement benefit plan investments measured at fair value in accordance with
IAS 26 Accounting and Reporting by Retirement Benefit Plans, and
Assets for which the recoverable amount is fair value less cost of disposal in accordance
with IAS 36 Impairment of assets. IFRS 13.7
1082 Chapter 25
1.3 An overview of IFRS 13 (IFRS 13.2-.4)
A principal that is central to the measurement of fair Fair value is:

value is that fair value must reflect the market conditions a market-based measurement,
at measurement date. As such, it is considered to be a not an entity-specific
market-based measurement and not an entity-specific measurement IFRS 13.2
measurement. Management intentions regarding the
items being measured are thus ignored (e.g. whether management intends to keep or sell the
asset is irrelevant). See IFRS 13.2-3
Directly observable inputs are the most accurate source of information to use when measuring
fair value, (e.g. a quoted price for an identical asset, such as a share price on a stock
exchange), but these may not always be available. IFRS 13.2
If directly observable inputs are not available, other valuation techniques (e.g. a market
approach or income approach) may be used instead. When a valuation technique is used, we
aim to maximise the use of observable inputs in performing these calculations. IFRS 13.3
Although IFRS 13 refers mainly to assets and liabilities, this standard should be applied when
measuring and disclosing the fair value of its own equity instruments, if these are measured at
fair value. IFRS 13.4
2. Measurement of Fair Value
2.1 Overview
Probably the most important aspect emanating from the

Fair value is defined as:
definition of fair value is that:
it refers to market participants, which means that it is The price that would be:
a market-based measurement and received to sell an asset or
it refers to the sale of an asset (not the acquisition of paid to transfer a liability
an asset or the use thereof) and the transfer of a
between market participants
liability (not the acquisition of a liability or the
at the measurement date. IFRS 13.9
settlement thereof) which means that it is based on
an exit price.
There are some central and core factors in this definition that we need to consider:
we need to decide what the asset or liability is;
we need to decide who our market participants are, and when their transactions are
considered to be orderly or not – all of which also presupposes that we know what market
we should be using to measure our fair value;
we need to decide what is meant by price; and
we need to decide what the measurement date is.
Fair value is measured as at a specific measurement date.
The measurement date is not determined by IFRS 13 at all but is determined by the specific
IFRS that requires or permits the measurement or disclosure of an item at fair value. For
example, IAS 40 Investment property requires that investment property be measured at
reporting date whereas IFRS 5 Non-current assets held for sale requires that fair value be
measured when a non-current asset is classified to the category ‘held for sale’.
Let us now look at some of the various aspects of the measurement of fair value, with
reference to this definition and other paragraphs from IFRS 13.
Chapter 25 1083
2.2 The asset or liability (or group thereof) (IFRS 13.11-.14)
The definition of fair value refers to an asset or a

liability but it is possible that the fair value is not always The asset or liability
measured for a stand-alone asset or liability, but rather measured at FV might be
either of the following:
for a group of assets, group of liabilities or a group of
assets mixed together with liabilities (e.g. a cash a stand-alone asset or liability
generating unit or an entire business). Whether the a group of assets, a group of
measurement of fair value is to take place on a stand- liabilities, or a group of assets and
alone basis or a group basis is referred to as the liabilities. IFRS 13.13
measurement’s ‘unit of account’. IFRS 13.13 -.14
Whether or not the unit of account for the fair value measurement should be for a stand-alone
asset or liability or for a group is normally determined by applying the specific IFRS that
required or permitted the fair value measurement or disclosure. For example,
IAS 36 Impairment of assets may require that the recoverable amount (being the higher of fair
value less costs of disposal and value in use) be measured for a cash generating unit (a group)
in which case the fair value must be measured for the cash generating unit (a group of assets).
IAS 16 Property, plant and equipment, on the other hand, allows stand-alone assets to be
measured at fair value under the revaluation model, in which case the fair value measurement
would be based on these individual (stand-alone) assets.
When measuring the fair value one must bear in mind that the fair value measurement must
relate specifically to that asset or liability (or group thereof). In other words, fair value must
take into account the characteristics of that particular asset or liability (or group thereof).
Characteristics of an asset may include, for example: Characteristics of the
the condition and location of the particular asset; and asset or liability:
any restrictions on the asset that may exist on are only considered if the market
measurement date. IFRS 13.11 slightly reworded participants would consider these
characteristics. IFRS 13.11 reworded
As already mentioned above, the fair value is a market-
based measurement and thus the characteristics that would be considered when measuring the
fair value are only those that market participants would take into account when pricing the
asset or liability. IFRS 13.11 -.12
Example 1: Characteristics to include it the fair value
Entity A has a special right which allows them to develop residential apartments on a piece
of land they own.
If Entity A were to sell the land, the right to develop the residential apartments would not be
transferred to the buyer. Thus when entity A assesses the fair value of its land, the fair value would not
take into account the right to develop residential apartments. This is because this right is not
transferred upon sale, which means that the rights would never be able to be used by market
participants. The rights are thus not a characteristic that a market participant (the potential buyer)
would not consider when determining the value of the land.
Thus, in this situation the right to build residential apartments is an entity-specific characteristic and
should be ignored when determining fair value.
If the right to develop residential apartments would be transferred upon the sale of the land, the
measurement of fair value would take the right into account. The ability to transfer the right makes it a
characteristic of the asset (i.e. the land) and not a characteristic of the holder of the asset (i.e. Entity A).
In other words, a market participant, being a potential buyer, would consider the ability to develop
residential apartments in determining the value of the land as they have access to the right were they to
acquire the asset. For this reason the rights are a characteristic that market participants would consider
when valuing the land.
Thus, in this situation, the right is a market characteristic and should be taken into account when
determining fair value.
1084 Chapter 25
2.3 The market participants, market and orderly transactions (IFRS13 App. A & IFRS 13.15 -.19)
The definition of fair value refers specifically to market Market participants are
participants and orderly transactions between these defined as:
market participants. buyers and sellers in the:
principal market or
The term market participants is a defined term that refers most advantageous market
to buyers and sellers in either the principal market or for the A/L
most advantageous market, both of which are also that are:
defined terms. independent of each other
knowledgeable, having a
These market participants must have certain reasonable understanding about
characteristics before we consider them when measuring the A/L and the transaction
fair value. In this regard, the participants: using all available information
able to enter into a transaction
must be independent, which means that we would
for the A/L
ignore participants if they are related parties in terms willing to enter into a
of IAS 24 Related parties unless there is evidence to transaction for the A/L (i.e.
suggest that the transactions between two such they are motivated to but not
related parties would be on market terms. forced to enter into it).
must be knowledgeable, which means they must
IFRS 13 App A, Reworded
have a reasonable understanding of the asset or liability;

must be able to transact;
must be willing to transact, which means that they An orderly transaction is
defined as:
should be motivated to transact – not forced to
transact – and thus participants that are in a position a transaction that assumes exposure
to the market for a period before
that forces them to transact should not be considered.
the measurement date
to allow for marketing activities that
An orderly transaction is a transaction is one that is not
are usual and customary for
rushed or forced. In other words, market participants in transactions involving such assets or
an orderly transaction have enough time to consider the liabilities;
market and/ or complete normal marketing activities.
in other words, it is not a forced
transaction. IFRS 13: App A: Summarised slightly
The definition of market participants refers to
participants in either the principal market or the most advantageous market. In fact, the
market we should ideally look at is the principal market – it is only where a principal market
does not exist that we would look for market participants Principal market is defined
in the most advantageous market. as:
The principal market is the market with the biggest The market with
the greatest volume and
volume and level of activity for our asset or liability that
level of activity
our entity has access to. Interestingly, the principal for the asset or liability IFRS 13 App A
market for one entity may not necessarily be the same for
another entity because one entity may have access to a
market that another entity may not have access to. Most advantageous market
is defined as:
The most advantageous market is the market that would The market that:
give us the highest price for the sale of our asset or maximises the amount that
would demand the lowest price for the transfer of our would be received to sell the
liability, after taking in account transaction costs and asset or
transport costs. minimises the amount that would
be paid to transfer the liability,
It is important to note that, although the most after taking into account:
advantageous market is determined after deducting transaction costs and
transaction costs, fair value is not adjusted for transaction transport costs IFRS 13 App A
costs. This means that the most advantageous market may not necessarily lead to the highest
fair value. IFRS 13: Appendix A: definition of most advantageous market and IFRS 13.25
The fair value is based on the price that would be achieved in the principal market and would
only be based on the price that would be achieved in the most advantageous market if a
Chapter 25 1085
principal market does not exist. This means that the fair value may be measured at a price
lower than the price actually possible, even if the entity normally sells in the most
advantageous market. IFRS 13.16
It is not necessary for an entity to conduct an exhaustive

search of all possible markets to identify the principal
market (or the most advantageous market). Instead,
unless there is evidence to suggest otherwise, the market The FV in terms of both the principal
in which the entity would normally transact is presumed market & most advantageous market
are measured as follows:
to be the principal market, or if there is no principal
Market price
market, then this market is presumed to be the most Less transport costs
advantageous market. See IFRS 13.17
Transaction costs are always
In the event that the asset has neither a principal market excluded when measuring fair value!
nor most advantageous market, which often occurs in the But, when determining which is the
case of certain intangible assets and cash generating most advantageous market (if no
units, management should identify potential market principal market exists), we calculate
FV as follows:
participants who currently already own such assets or
Market price
owe such liabilities and then develop a market-based Less transport costs
estimate on the expectations and assumptions of these Less transactions costs
market participants. . See IFRS 13.21
Please note: Once the most
advantageous market has been
Also interesting is the fact that, although we are
determined, its fair value is still
measuring the fair value of an asset or liability in terms measured at the market price less
of certain markets (i.e. the principal or most transaction costs
advantageous market) on a specific measurement date,
the entity does not need to be in a position that enables it
to sell the asset or transfer that liability on that date. See IFRS 13.20
Example 2: Markets and the fair value
An entity can sell its asset in Market A or Market B:
If the asset were sold in Market A it would generate a return of 100;
If the asset were sold in Market B, it would generate a return of 80.
The entity normally trades in Market A since this is the market that normally generates the highest
returns although sales often occur slightly quicker in Market B due to the higher volume of transactions
in this market.
Required:
A. Identify the fair value and explain your answer.
B. Explain the circumstances under which the fair value would be measured in accordance with the
‘other’ market?
Solution 2A: Markets and fair value

The principal market is Market B since this appears to have the highest volume and level of activity.
The most advantageous market is Market A since this renders the highest return.
As the entity usually trades in Market A, we would presume that Market A is the principal market.
However, information exists that indicates that another market exists, being Market B, in which there is
a higher volume of transactions.
This fact means that Market B is the principal market and not Market A.
Since there is a principal market, the fair value must be determined in relation to the principal market,
Market B, even though a higher return can be achieved in Market A.
The fair value is thus measured as the price achievable in Market B, the principal market: 80
1086 Chapter 25
Solution 2B: Markets and fair value

The fair value would have been measured in terms of Market A, the most advantageous market:
If Market A and Market B had an equal level of volume and activity (i.e. there was no principal
market),
If the entity was not aware of Market B (i.e. the entity had no evidence that the principal market
existed), or
If the entity was aware of Market B but had no evidence to suggest that Market B had a higher
volume or level of activity than Market A.
Thus, in all three situations, the fair value would have been measured in terms of Market A, at C100.
Example 3: Markets and the fair value

Market: Market: Market:
Durban Cape Town Pretoria
Average number of transactions per year 1 200 600 750
Average price per transaction C16 C14 C17
Average transport cost per transaction C4 C1 C1
Average transaction costs C1 C1 C7
Required:
A Identify the principal market and the most advantageous market.
B Identify the fair value.
Solution 3A: Markets and the fair value

The principal market is the Durban market since it has the highest number of transactions being 1
200 per year as opposed to the 600 per year in Cape Town and the 750 per year in Pretoria.
The most advantageous market is the Cape Town market since this market maximises the net
proceeds (being the selling price less transport costs and transaction costs) at C12 (C14 –C1 –C1):
- the Durban market would only render net proceeds of C11 (C16 – 4 – 1) and
- the Rhodes market would only render net proceeds of C9 (C17 – 1 – 7).
Solution 3B: Markets and the fair value

The fair value is measured based on the price in the principal market, being the Durban market.
The fair value is measured after deducting transport costs (transaction costs are not deducted).
The fair value is thus 16 – 4 = 12
Note:
Selling the asset in the Durban market does not maximise the net proceeds! The highest net proceeds
are actually C12 and would be obtained by selling in the Cape Town market:
Market: Durban Market: Cape Market: Rhodes
Town
Average price per transaction C16 C14 C17
Average transport cost per C4 C1 C1
transaction
Average transaction costs C1 C1 C7
Average net proceeds C11 C12 C9
Note:
If there was no principal market, the fair value would have been based on the most advantageous
market (CT) instead and the fair value would thus have been C13 (C14 – transport costs: C1)
2.4 Market participants in relation to non-financial assets
When measuring the fair value of a non-financial asset (e.g. land, buildings and equipment)
additional consideration is given to the market participant’s ability to use the asset or sell it to
another market participant, who would then use the asset.
Chapter 25 1087
When assessing the market participant’s ability to use the asset (i.e. irrespective of whether
we are looking at it from the perspective of the market
Highest and best use is
participant who is the potential buyer or a secondary defined as:
market participant that the primary market participant,
i.e. potential buyer, would sell to), we must assume that The use of a non-financial asset
by market participants
this market participant would use the asset or group of that would maximise the value of:
assets consistently with its highest and best use. the asset or
the group of assets and
The notion of highest and best use is simply seen as the liabilities (e.g. a business) within
best way for the market participant to derive economic which the asset would be used.
benefit from the asset or the group of assets, consistent IFRS 13 App A
with the unit of account. . See IFRS 13.27
When assessing the highest and best use of a non-financial asset, three key areas need to be
considered:
Whether it is physically possible: we would need to Highest and best use
consider the physical characteristics of the asset requires consideration of
whether the use is:
which market participants would take into account
when determining the value of the asset. (i.e. the size physically possible
legally permissible
or location of a property/asset, and the physical See IFRS 13.28
financially feasible.
output of a machine);
Whether it is legally permissible: we would need to consider the any legal restrictions
which market participants would take into account when determining the use of the asset;
Whether it is financially feasible: we would need to consider whether the asset will
generate an adequate cash flow or income to produce an investment return. This includes
any costs which are required to convert the asset into a condition for use. . See IFRS 13.28
The highest and best use assumption does not change if the entity holding the non-financial
asset intends to use it differently from market participants. This may be the case when an
entity holds an asset, such as a patent, which it intends not to use but simply intends to hold in
order to prevent it from being used by another party, such as a competitor. See IFRS 13.29-30
The valuation premise for the highest and best use of an asset may be achieved by market
participants on a stand-alone basis or in conjunction with other assets and/ or liabilities.
If the asset would achieve its highest and best use on a stand-alone basis, the fair value is
measured on a stand-alone basis.
If an asset achieves highest and best use in conjunction with other assets and/ or liabilities
and market participants have access to those related assets and/ or liabilities, the fair value
is measured on the assumption that the asset will be used with the related assets and/or
liabilities.
It is important to note that, if the asset would achieve its highest and best use when used
together with a group of assets (or together with a group of assets and liabilities – e.g. as a
complete business) then each asset in this group of assets (or group of assets and liabilities)
must have its fair value measured using the same assumptions. In other words, all assets
within a group must have a fair value attributed to it consistent with how the group is being
measured. This applies even if a particular asset would achieve a higher fair value had it been
valued on a stand-alone basis or in conjunction with another set of assets. IFRS 13.31
Example 4: Fair value of non-financial assets

Entity A acquires three assets in a business combination namely computer hardware,
software and a patent to use intellectual property.
Entity A has determined that the highest and best use of the assets will be achieved if the assets are
used in conjunction with each other. Within the principal market, two groups of buyers were identified,
strategic buyers and financial buyers.
1088 Chapter 25
The amount attributed to the three assets, being sold as a group, is shown below:
Strategic buyers Financial buyers
Hardware C360 C300
Software C260 C200
Patent C30 C100
Total C650 C600
Required: Determine the fair value of the three assets.
Solution 4: Fair value of non-financial assets
The highest and best use of the assets in the principal market is achieved by selling the group of assets
to the strategic buyers as they maximise the value of the assets as a collective. The fair value of the
assets is therefore C360 for the hardware, C260 for the software and C30 for the patent. This will
mean that, even though the patent could be sold to the financial buyers for C100, the fair value of C30
is consistent with the valuation of the group of assets, being that all the assets achieve a higher
collective fair value of C650 when sold to the strategic buyers as opposed to only C600 when sold to
the financial buyers.
2.5 Market participants relating to liabilities and an entity’s own equity instruments
When determining the fair value of liabilities (whether financial or non-financial) or of an

entity’s own equity instrument we assume that the liability or equity is simply transferred on
measurement date. In other words:
A liability would remain outstanding and the market participant transferee would be
required to fulfil the obligation. The liability would not be settled with the counterparty or
otherwise extinguished on the measurement date.
An entity’s own equity instrument would remain outstanding and the market participant
transferee would take on the rights and responsibilities associated with the instrument.
The instrument would not be cancelled or otherwise extinguished on the measurement
date. IFRS 13.34
When the transfer price for an identical liability or equity instrument is not available, the
liability or equity instrument is valued from the perspective of the market participant who
holds the liability or equity instrument as an asset at the measurement date. See IFRS 13.37
Example 5: Settlement and transfer values

A bank holds a debt asset with a face value of C100,000 and a market value of C95 000.
Market interest rates are consistent with the amount in the note but the C5 000 discount is
due to market concerns about the risk of non-performance.
Required: Discuss what both the settlement value and the transfer value are and identify which amount
should be used for the purposes of IFRS 13.
Solution 5: Settlement and transfer values

Settlement value
Except in exceptional circumstances, we expect that the counterparty to the debt (counterparty A)
would be required to pay the full face value of the note to settle the obligation, as the bank may not be
willing to discount the note by the market discount or the credit risk adjustment. The settlement value
would therefore be equal to the face amount of the note.
Transfer value
In order to calculate the transfer value, the counterparty must construct a hypothetical transaction in
which another party (counterparty B), with a similar credit profile, is seeking financing on terms that
are substantially the same as the note. Counterparty B could choose to enter into a new note agreement
with the bank or receive the existing note from counterparty A in a transfer transaction.
Counterparty B should be indifferent to obtaining financing through a new bank note or assumption of
the existing note in transfer for a payment of C95 000.
Chapter 25 1089
The transfer value would therefore be C95 000, being C5 000 less than the settlement value.
This amount is the value ascribed by a market participant holding the identical liability as an asset,
consistent with the guidance in IFRS 13.34 and IFRS 13.37.
2.6 Measurement date (IFRS 13.20 - .21 & .24)
Fair value is measured as at a specific measurement date. The measurement date is not
determined by IFRS 13 at all but is determined by the specific IFRS that requires or permits
the measurement or disclosure of an item at fair value.
Measurements may occur on a recurring basis (e.g. investment property measured under the
fair value model would have its fair value measured at each reporting date) or on a non-
recurring basis (e.g. a non-current asset reclassified to ‘held for sale’ may need its fair value
measured on whatever date it is reclassified to held for sale, in other words, on
reclassification date).
Fair value must be measured as if a transaction took place on measurement date, even if there
is no observable market on this date. If directly observable inputs are not available,
alternative valuation techniques must be used instead. IFRS 13.21 & .24
Although fair value is the price measured on the specific measurement date, the entity does
not need to be in a position to actually sell the asset or transfer the liability on that
measurement date. IFRS 13.20
2.7 The price (IFRS 13.20-.26) Exit price is defined as:
The price to sell an asset or transfer a liability is referred The price that would be:
to as an exit price whereas the price to acquire an asset or received to sell an asset or
accept a liability would be considered to be an entry paid to transfer a liability.
IFRS 13 App A
price. The definition of fair value clearly refers to the
sale of an asset and the transfer of a liability and thus the fair value is based on an exit price
and not an entry price.
Fair value is based on the price one can sell an asset or Entry price is defined as:
transfer a liability (i.e. an exit price) between market
participants on measurement date. In other words, it is The price:
paid to acquire an asset or
an exit price received to assume a liability
based on current market conditions that: in an exchange transaction. IFRS 13 App A
- reflects the market participants’ expectations of future market conditions and not the
entity’s expectations thereof; and also
- reflects the assumption that market participants
Transaction costs are defined
would act in their best interests; IFRS 13 App A IFRS 13 App A
as:
exists on measurement date. IFRS 13.2 and.22 and .BC31
the costs to sell an A or transfer a L
in its principal/ most advantageous mkt
Fair value is measured: that:
are directly attributable to
using directly observable prices or by using another the disposal of the A or
valuation technique; the transfer of the L, and
must not be adjusted for transaction costs because result directly from and are
essential to that transaction; and
the method of selling is not a characteristic inherent
would not have been incurred by the
in the asset but rather a characteristic of the sale; entity had the decision to sell the A
would be adjusted for transport costs (where or transfer the L not been made
transport costs apply). (similar to costs to sell: IFRS 5)
1090 Chapter 25
Although the fair value must not be adjusted for transaction costs, it is important to realise
that transaction costs do not include transport costs.
Transport costs are defined as:
Whereas fair value is never adjusted for transaction
the costs that would be incurred
costs, fair value should be adjusted for transport costs, to transport an asset
although transport costs should only be deducted if they from its current location
are necessary to incur them in order to get the asset to to its principal/most advantageous mkt.
the relevant market (i.e. if the location is considered to IFRS 13 App A
be a characteristic of the asset). See IFRS 13.24 -.26
2.8 Fair value at initial recognition (IFRS 13.57 - .60)
If an IFRS requires or permits an asset or liability to be measured at fair value on initial

recognition (e.g. on an asset acquired through an asset exchange or by way of a government
grant of a non-monetary asset), care must be taken to correctly identify the fair value. This is
because:
the transaction price paid to acquire an asset or received to assume a liability is an entry
price, which may not necessarily be the same as
the fair value, being the price that would be received to sell the asset or paid to transfer
the liability, which is an exit price.
In most situations the transaction price and the fair value will equate but there are certain
circumstances in which they will not equate. For example, the transaction price (entry price)
and fair value (exit price) may differ if:
the market in which the transaction took place differs from the principal or most
advantageous market;
the transaction took place between related parties;
the transaction is a distressed sale (i.e. the seller is forced to accept the price offered); or
the unit of account reflected in the transaction price differs from the unit of account of the
asset or liability being measured. See IFRS 13.B4
2.9 Valuation techniques (IFRS 13.61)
If the fair value of the asset or liability cannot be directly observed the entity is required to use
an appropriate valuation technique in order to estimate this price.
The valuation technique used:

Should be appropriate for the circumstances; Valuation techniques could
Have sufficient relevant data available; include:
Maximise the use of relevant observable inputs
Market approach
Minimise the use of unobservable inputs Cost approach
May be one of the following techniques: market, Income approach.
income or cost approach;
Should produce a result that is consistent with the
definition of fair value. See IFRS 13.61-.62
Three widely used techniques described in IFRS 13 are the market approach, the cost
approach and the income approach:
The Market approach is a valuation technique that ‘uses prices and other relevant
information generated by market transactions involving identical or comparable assets,
liabilities or groups of assets and liabilities’;
Cost approach is a valuation technique that reflects ‘the amount that would currently be
required to replace the service capacity of an asset’ (also called the replacement cost);
Income approach is a valuation technique which ‘converts future amounts, such as cash
flows or income and expenses, to a single current (i.e. discounted) amount’. IFRS 13.B5, B8, B10
Chapter 25 1091
In utilising these valuation techniques the entity may be required to use input variables other
than a currently observable market price. If this is the case the inputs are grouped into a fair
value hierarchy:
Level 1 inputs are most reliable and are: Active market is defined
as:
- ‘quoted (unadjusted) prices
- in an active market for A place in which
- identical assets or liabilities’. IFRS 13.76 transactions for the asset or liability
take place with sufficient frequency
An example of a level 1 input is a share price listed and volume
upon the JSE (an active market) which we could use to provide pricing information
to measure an investment in shares. on an ongoing basis. IFRS 13 App A
A level 1 input is a quoted price that may not be

adjusted. Thus, if for example we own financial assets that are actively traded, we would
measure the fair value of the financial assets based on the number of units owned
multiplied by the quoted price. This calculation would apply, without any adjustment
being made to it, even if our holding was so great that the active market would not be
able to absorb all of our units (e.g. if we were to sell all our units on measurement date,
the market price per unit would either drop or there simply would not be enough buyers
for all our units).
There are certain instances where the price may have to be adjusted which would result
in a lower level of fair value comfort. These are not discussed further.IFRS 13.76-.80
Level 2 inputs are less reliable that level 1 inputs and are:
- ‘inputs other than quoted prices included within level 1 that are observable for assets
or liabilities, whether directly or indirectly’. IFRS 13.81
These may include:
- quoted prices for similar assets or liabilities in active markets or
- quoted prices for identical or similar assets or liabilities in inactive markets;
- interest rate curves, yield curves and credit spreads. IFRS 13.81-.85
Level 3 inputs are the least reliable inputs, reflecting
Hierarchy of inputs:
- ‘unobservable inputs for the asset or liability and
should only be used to measure fair value to the Level 1:
extent that the relevant observable inputs are not - quoted prices in an AM for
available’. IFRS 13.86-87 identical assets or liabilities
Level 2:
Allowing the use of level 3 inputs enables us to - quoted prices in an AM for
estimate a fair value in situations in which there is similar assets or liabilities
little or no market activity. However, the objective Level 3:
still remains the same: to estimate a price from the - unobservable inputs.
perspective of a market participant that holds the
asset or owes the liability. IFRS 13.86-.90
The valuation technique used to measure fair value should be applied consistently, although it
is possible to change the technique if another technique is found provides ‘an equally or more
representative indication of fair value’. This may happen if, for example, information that
was previously unavailable now becomes available. Any change in valuation technique
would be accounted for as a change in accounting estimated in terms of IAS 8 (although
disclosures relevant to changes in estimates are not required). See IFRS 13.66
In some cases a single valuation technique will be appropriate, while in other cases multiple
valuation techniques will be appropriate. If multiple valuation techniques are used, the results
shall be evaluated considering the range of values indicated by those results. The fair value
measurement is the point within the range that is representative of the fair value in the
circumstances. IFRS 13.63 slightly reworded
1092 Chapter 25
3. Disclosure Relating to Measurement of Fair Value (IFRS 13.91-.99)
There is copious disclosure required relating to the measurement of fair value. This section
does not intend to repeat all disclosures here but intends to merely summarise the main
aspects of these disclosure requirements.
An entity shall disclose information that helps the users of its financial statements assess both:
a) For assets and liabilities measured at fair value on recurring or non-recurring bases in the
statement of financial position after initial recognition: the valuation techniques used and
the inputs to develop those measurements,
b) For recurring fair value measurements using significant unobservable inputs (i.e. level 3
inputs): the effect of the measurements on profit or loss or other comprehensive income
for the period. IFRS 13.91
To meet the objectives as set out above, the entity is required to consider:
a) The level of detail necessary to meet the objectives;
b) The amount of emphasis to be placed on each requirement;
c) How much aggregation or disaggregation to undertake; and
d) Whether users of the financial statements require additional information to evaluate the
quantitative information disclosed. IFRS 13.92
The following minimum disclosure requirements are required for each class of asset and
liability measured at fair value after initial recognition on a recurring or non-recurring basis:
The fair value at the end of the reporting period, IFRS 13.93 (a)
The level at which the fair value measurement is categorised in its entirety (level 1/ 2/3)
IFRS 13.93 (b)
For fair value estimates categorised in level 2 or level 3, a description of the valuation
technique(s) and the inputs used in the fair value measurement. IFRS 13.93 9(d)
If the highest and best use of a non-financial asset differs from its current use, this must
be disclosed together with the reasons why it is not used at its highest and best use.
IFRS 13.93 (i)
For non-recurring fair value measurements, disclose:

The reasons for the measurement IFRS 13.93 (a)
For recurring fair value measurements, disclose:

The amount of any transfers between the different levels of the fair value hierarchy, the
reasons for the transfer and the policy for determining when such a transfer has taken
place: this information must be provided separately for transfers in and transfers out.
IFRS 13.93 (c)
For fair value measurement classified in level 3, a reconciliation between the opening and
closing balance showing the following:
- Total gains or losses for the period recognised in profit and loss,
- Total gains or losses for the period recognised in other comprehensive income,
- Purchases, sales, issues and settlements, and
- The amounts of any transfers into and out of level 3. IFRS 13.93 (e)
For fair value measurements categorised in level 3, narrative disclosure of the sensitivity
of the fair value measurement to changes in unobservable inputs if a change in those
estimates may result in a significantly higher or lower fair value measurement. IFRS 13.93 (h)(i)
Chapter 25 1093
4. Summary
Fair Value (IFRS 13)
Measurement
Market-based, not an entity-specific measurement

Market participants characteristics taken into account:
- condition and location
- restriction of use or sale of asset
Principal market Most advantageous market
The market with : The market that:

the greatest maximises the amount that would be
- volume and received to sell the asset; or
- level of activity minimises the amount that would be paid
for the asset or liability IFRS 13 App A to transfer the liability,
after taking into account:
transaction costs and
transport costs IFRS 13 App A
Fair value equals Fair value equals
Market price Market price

Less transport costs Less transport costs
But please note that when determining which is
the most advantageous market (if no principal
market exists) we use a FV calculated as:
Market price
Less transport costs
Less transactions costs
Non financial asset
Highest and best use requires consideration of whether the usage is:
physically possible
legally permissible
financially feasible See IFRS 13.28
Liability and entity’s own equity instruments
we assume that the liability or equity is simply transferred on

measurement date. See IFRS 13.34
Valuation techniques
market approach
income approach
cost approach
Fair value hierarchy
level 1 inputs
level 2 inputs
level 3 inputs
1094 Chapter 25
Gripping GAAP Accounting policies, estimates and errors
Chapter 26
Accounting Policies, Estimates and Errors
Reference: IAS 8, IAS 1 (including any amendments to 10 December 2014)
Contents: Page
2. Accounting policies 1096
2.1 Overview 1096
2.2 Choosing and applying accounting policies 1096
2.3 Developing your own accounting policy 1097
2.3.1 Relevance 1097
2.3.2 Reliability 1097
2.3.3 Judgement 1097
2.3.4 Consistency 1097
2.4 Disclosure of accounting policies 1098
2.4.1 Significant accounting policies 1098
2.4.2 Significant judgements affecting the application of accounting policies 1098
3. Changes in accounting policies 1099
3.1 Overview 1099
3.2 How to adjust for a change in accounting policy 1099
3.2.1 Retrospective application 1099
3.2.2 Prospective application 1100
Example 1: Change in accounting policy – journal entries 1100
3.3 Disclosure of a change in accounting policy 1101
Example 2: Change in accounting policy- disclosure 1102
4. Changes in accounting estimates 1105
4.1 Overview 1105
4.2 How to adjust for a change in accounting estimate 1105
Example 3: Change in estimated useful life: reallocation vs cumulative catch-up 1106
4.3 Disclosure of a change in accounting estimate 1108
Example 4: Disclosure of a change in accounting estimate 1108
Example 5: Change in estimated residual value: reallocation method 1109
Example 6: Change in estimated residual value: cumulative catch-up method 1111
5. Correction of errors 1113
5.1 Overview 1113
5.2 How to correct an error 1114
5.2.1 Errors occurring in the current period 1114
Example 7: Correction of errors occurring in the current period 1114
5.2.2 Immaterial errors occurring in a prior period/s 1115
Example 8: Correction of immaterial error occurring in prior periods 1115
5.2.3 Material errors occurring in a prior period/s 1116
Example 9: Correction of a material error that occurred in a prior
period/s 1116
Example 10: Correction of a material error that occurred in a prior
period/s 1117
5.3 Disclosure of a material prior period error 1119
Example 11: Correction of a material error that occurred in a prior period/s 1120
Example 12: Correction of a material error that occurred in a prior period/s 1122
6. Summary 1125
Chapter 26 1095
1. Introduction
As its name suggests, IAS 8 covers three main areas:

accounting policies, estimates and errors. In particular, it IAS 8 shows us 3 things:
shows us how to select an accounting policy and change
an accounting policy. It shows us how to change Accounting policies:
- How to select them
accounting estimates and how to correct errors. - How to change them
Accounting estimates:
This chapter explains each of these areas. - How to change them
Errors:
Interestingly, IAS 8 was developed in 2001 and has been - How to correct them.
amended many times due to changes that were made to a number of other standards.
However, IAS 8 has not been updated for the significant changes made to the Conceptual
Framework in September 2010. For example, IAS 8 still refers to the terms reliability and
prudence, both of which are no longer listed as qualitative characteristics. It is submitted that,
in time, IAS 8 will be updated for these anomalies.
2. Accounting Policies (IAS 8.7 - .13)
2.1 Overview
It is important to emphasise that an ‘accounting policy’ is Accounting Policies are

very different to just any ‘policy’. The business entity defined as:
may have a ‘policy’ of donating 10% of its profits to a
the specific principles, bases,
charity each month and you may have a ‘policy’ of not conventions, rules and practices
taking your worries home with you at night. You may applied by an entity
even have an insurance policy. We are, however, only in preparing and presenting
concerned with the policies that are adopted by the financial statements. IAS 8.5
accountant in connection with the preparation and presentation of financial statements. These
policies are really the rules used by the entity when drawing up and publishing its annual
2.2 Choosing and applying accounting policies (IAS 8.7 - .9)
Choosing and applying accounting policies means finding Choosing and applying
an IFRS that deals with your transaction and applying it; accounting policies:
although if the item or transaction is immaterial, then you
may ignore the IFRS requirements. IAS 8.7 – 8 reworded. Find a relevant IFRS and apply the
policies contained therein;
If the IFRS contains guidance that is
IFRSs contain guidance to help us apply the requirements integral, any requirements contained
contained in the IFRS. This guidance will be described in the guidance must also be applied.
either as being an integral part of the IFRS or not:
If it is integral, it means that the guidance contains requirements that are compulsory;
If it is not integral, it means that it does not contain compulsory requirements. IAS 8.9 reworded
Some IFRSs dictate the policy that must be used (i.e. Accounting policies in the
there is no choice), for example, IAS 2 Inventories IFRSs:
requires that inventory be measured at the lower of cost or
net realisable value. Some IFRSs give you no choice in AP
(e.g. inventories must be measured at
the lower of cost and net realisable
Conversely, some IFRSs allow a choice in policy, for value)
example, IAS 16 Property, plant and equipment allows Some IFRSs give you a choice of AP
items of property, plant and equipment to be measured (e,g. PPE may be measured using the
using either the cost model or revaluation model. cost model or the revaluation model)
1096 Chapter 26
2.3 Developing your own accounting policy (IAS 8.10 - .13)
On rare occasions, it may happen that you cannot find an accounting policy in the IFRSs that
is suitable to a certain transaction or event. In this case, the management of the entity (which
will include you, the accountant) will need to develop your own accounting policy! When
forced to develop your own accounting policy, the most important thing to remember is that
you need to prepare financial statements that provide relevant and reliable information.
2.3.1 Relevance (IAS 8.10) When developing your own

AP ensure the information
In order to ensure relevance, ask yourself whether the will be:
item is material to the user in his economic decision- Relevant
making: it stands to reason that users are not interested in Reliable:
immaterial information. - Faithful representation
- Substance over form
2.3.2 Reliability (IAS 8.10) - Neutral
- Prudent
For the information provided to be reliable, it means it: - Complete
is a faithful representation of the entity’s financial position, performance and cash flows;
reflects the economic substance rather than the legal form of the transaction: legal jargon
is often misleading: for example, if we carefully read IAS 8 includes terms that
what lawyers call a ‘finance lease contract’ we see are no longer qualitative
that it really is a purchase that is simply paid for over characteristics in the CF!
Reliability (is now called faithful
time, so we record finance leases as a purchase (being representation)
its reality) and not as a lease (its legal form); Prudence (removed because it is
be neutral (i.e. does not include material error/ bias); considered to be a form of bias)
be prudent (i.e. always be on the more cautious or Substance over form (removed since
pessimistic side but not so much so that you end up it is considered redundant: for
something to be a faithful
hiding reserves or profits belonging to the entity!); representation, it automatically has
be complete (depending on materiality and cost). to show its economic substance).
2.3.3 Judgement (IAS 8.11 - .12)
On occasion, it may be difficult to understand an accounting policy or how to apply it and you
may need to use your professional judgement. Professional judgement is required even more
so if you find yourself having to develop your own accounting policy for a certain transaction.
This judgement of yours should be based on the following (and in this order!):
standards and interpretations on similar issues; Your judgement should be
the definitions, recognition criteria and measurement guided by:
concepts in the Conceptual Framework; and IFRSs on similar issues
on condition that they do not conflict with the The Conceptual Framework
standards and interpretations on similar issues and the If they don’t conflict with the above:
Conceptual Framework, we are also allowed to - Pronouncements from other
consider recent pronouncements from other standard- standard-setters
setting bodies, other accounting literature and industry - Accounting literature
accepted practices. - Industry accepted practice.
2.3.4 Consistency (IAS 8.13 and CF: QC20-QC25)
One of our goals is to ensure that our financial statements are comparable from one year to
the next and from one entity to the next. In order to make financial statements comparable,
we need to ensure that the accounting policies we select are consistently applied for similar
transactions or classes of transactions, unless another IFRS specifically requires or permits
you to do otherwise. For example, if you choose to revalue one of your vehicles, then all your
vehicles will need to be revalued.
Chapter 26 1097
2.4 Disclosure of accounting policies (IAS 1.114 and .117 - .124)
2.4.1 Significant accounting policies
IAS 1 Presentation of financial statements requires that The summary of significant

the notes to the financial statements must include a accounting policies must
summary of significant accounting policies. This include the:
summary should include: measurement basis (or bases) used, &
other accounting policies used that are
the measurement basis (or bases) used in preparing the considered relevant. IAS 1.117 Reworded
financial statements, and
the other accounting policies used that are relevant to an understanding of the financial
statements. IAS 1.117
The measurement bases that could be used include, for example, historical cost, current cost,
net realisable value, fair value or recoverable amount.
Other accounting policies may be relevant to a user’s understanding and thus require
disclosure. A policy would be considered relevant to a user’s understanding if, for example:
the IFRS specifically requires that disclosure of that accounting policy be given (e.g.
IAS 16 Property, plant and equipment specifically requires that the measurement bases
used be disclosed);
there are choices in accounting policy allowed in the IFRSs and thus the user would need
to be told which policy was chosen (e.g. whether investment property was measured using
the cost model or fair value model);
the nature of the business suggests that the accounting policy would be useful information
(e.g. a note to say which accounting policy is used to recognise foreign exchange gains
and losses would be important if the entity has many transactions involving foreign
currency – disclosure of the accounting policy would be necessary even if the amounts of
the foreign exchange gains and losses were not material);
there is no accounting policy offered by an IFRS and thus the entity has had to select an
accounting policy from another source or create its own policy.
2.4.2 Significant judgements affecting the application of accounting policies
When deciding on which accounting policy should be used, management is often required to
make certain judgements (we are not referring to judgements regarding issues of estimation).
Disclosure is required of the judgements that: Judgements made in

management has made in the process of applying the applying accounting policies
entity’s accounting policies and that may be disclosed either in:
have the most significant effect on the amounts the summary of significant APs, or in
recognised in the financial statements. IAS 1.122 other notes. IAS 1.122 Reworded extract
The disclosure of the judgements may be made in the summary of significant accounting
policies or any of the other notes. See IAS 1.122
Worked example: Judgements affecting the application of accounting policies

Management may need to assess whether a property:
is owner-occupied: if it is owner-occupied, the accounting policies in IAS 16 Property
plant and equipment must be applied; or
meets the definition of investment property: if it meets the definition of investment
property, the accounting policies in IAS 40 Investment property must be applied.
The accounting policies to be applied to this property are clearly dependent upon management’s
decision regarding whether the property is property, plant and equipment (IAS 16) or investment
property (IAS 40). If the conclusion reached by management has a significant effect on the amounts
recognised in the financial statements, then disclosure of these judgements must be included.
1098 Chapter 26
3. Changes in Accounting Policies (IAS 8.14 - .31)
3.1 Overview (IAS 8.14 - .18)

In order to achieve comparability and consistency from one year to the next, the accounting
policies adopted by an entity are very rarely changed. This does not mean that they never
change. A change in accounting policy is considered acceptable when it is:
required by an IFRS; or
a voluntary change resulting in reliable and more relevant presentation. IAS 8.14 reworded
In order to maintain a measure of comparability, substantial disclosure is required when there
is a change in accounting policy.
The treatment and disclosure required varies depending on whether the change is one that is:
required as a result of the initial application of an IFRS in which:
transitional provisions are given; or
no transitional provisions are given; or A change in accounting
policy is either:
a voluntary change in accounting policy.
compulsory: if required by an IFRS; or
voluntary: if it provides information
IAS 8 specifically refers to two situations when the that is:
adoption of an accounting policy should not be - reliable and IAS 8.14 reworded
considered a ‘change in policy’. These two situations are - more relevant.
when the adoption of an accounting policy relates to an event or transaction that either:
differs in substance from previously occurring events or transactions; or
did not occur previously or that was previously immaterial. IAS 8.16 reworded
3.2 How to adjust for a change in accounting policy (IAS 8.19 - .27)
In the event that the change in accounting policy is as a result of the initial application of an
IFRS in which transitional provisions are given, these provisions should take precedence over
the general guidance supplied in IAS 8.
If the change results from applying an IFRS for the first time where there are no transitional
provisions or it is a voluntary change in accounting policy, the general guidance given in
IAS 8 needs to be followed. Only this general guidance is discussed in this chapter.
The general guidance in IAS 8 requires that a It is considered impracticable for an
change in accounting policy: entity to apply a change in accounting
policy when the entity cannot apply it
be applied retrospectively, unless
after making every reasonable effort to do so.
it is impracticable to do so. IAS 8.5 Reworded
3.2.1 Retrospective application (IAS 8.22 - .27)

The retrospective application of a change in accounting Retrospective application
policy entails stating both the current year’s figures is defined as applying a
based on the new policy, as well as adjusting all prior new accounting policy ...
years’ figures in accordance with the new policy (i.e. as as if the policy had always
if the ‘policy had always been applied’). It may not, been applied (i.e. both the current
however, always be possible to calculate the effect on all year and prior year figures change)
the prior years’ figures, in which case the new policy is
applied from the earliest prior period possible and the cumulative effect on the assets,
liabilities and equity before this period is simply disregarded.
All prior periods that are disclosed as comparatives in an annual report (even if not part of the
financial statements i.e. including any additional reports provided) must be restated based on
the new policy. All prior periods that are not given as comparatives must still be adjusted, but
with the cumulative effect on the opening balance of retained earnings disclosed as a single
adjustment (i.e. in the statement of changes in equity).
Chapter 26 1099
Where the calculation of the adjustment to a specific prior period/s is impracticable (not
possible), the accounting policy is simply applied to the elements from as early as possible
with a net adjustment made to the opening retained earnings from this ‘earliest year’.
3.2.2 Prospective application (IAS 8.25)
Applying a new policy prospectively means that the Prospective application
policy is applied to only the current and future years with means the current &
prior years’ figures remaining unchanged. This is only future years’ figures are
allowed if it is impracticable to apply the policy impacted (not prior yrs).
retrospectively as it would compromise comparability and consistency.
Example 1: Change in accounting policy – journal entries
During 20X7, a revised IFRS on borrowing costs (IAS 23) was published.
The company had previously been expensing borrowing costs as a period
cost, but the revised IFRS required that all borrowing costs be capitalised to the related asset.
The borrowing costs were all incurred on construction of a plant.
The revised IFRS provided transitional provisions that allowed the company to capitalise the costs
from years beginning on or after 20X8, or before this date, if preferred.
This entity chose to capitalise the borrowing costs from the earliest date possible.
The construction of the plant is not yet complete and not yet available for use.
The effect of this change on the interest expense is as follows:
20X5 20X6 20X7
Old policy C15 000 C17 000 C9 000
New policy 0 0 0
The tax rate was 30% throughout all affected years.
The interest incurred each year was correctly claimed as a deduction in that year in terms of the
relevant country’s tax legislation.
The tax authorities have indicated that they will not re-open the tax assessments.
Required: Prepare the necessary adjusting journals for the year ended 31 December 20X7.
Solution 1: Change in accounting policy – journal entries
The following would have been processed if it was possible to process journals in each of the prior
affected years:
20X5 Debit Credit
Interest expense (E) This will affect the 20X6 & 20X7 opening retained earnings 15 000
Capitalise interest that was previously expensed
Tax expense (E) This will affect the 20X6 & 20X7 opening retained earnings 4 500
Tax increases due to decrease in interest expense
20X6
Interest expense (E) This will affect the 20X7 opening retained earnings 17 000
Tax expense (E) This will affect the 20X7 opening retained earnings 5 100
20X7
Interest expense (E) 9 000
Tax expense (E) 2 700
1100 Chapter 26

The following are the journal entries that would be processed given that the prior years’ (20X5 and
20X6) income and expense accounts have already been closed off (transferred to retained earnings):
20X7 Debit Credit
Plant: cost (A) (15 000 + 17 000) 32 000
Retained earnings (Eq) (15 000 + 17 000 – 4 500 – 5 100) 22 400
Deferred tax (L) (4 500 + 5 100) 9 600
Capitalise interest that was previously expensed: 20X5 & 20X6
Interest expense (E) 9 000
Capitalise interest that was previously expensed: 20X7
Tax expense (E) 2 700
Tax increases due to decrease in interest expense in 20X7
* Note that since the tax authorities disregard the accounting treatment of capitalising borrowing
costs, the change in policy would not have affected the interest deduction given by them and would
therefore not have impacted the current tax payable amount. This adjustment is thus clearly a
deferred tax adjustment as it is as a result of a temporary difference.
If a policy change did change the amount of tax that would be charged (i.e. would affect current
tax payable) and the tax authority did allow the company’s assessment to be re-opened, then the
current tax payable account would have been adjusted instead.
3.3 Disclosure of a change in accounting policy (IAS 8.28 - .31)

The following disclosure is required for a change in accounting policy when the change
resulted from an initial application of an IFRS:
the title of the Standard or Interpretation; Disclosure of a change
the nature of the change; in AP includes:
an extra year of comparatives in the statement of
Description of what policy changed
financial position; IAS 1.10 requirement
the amount of the adjustment made to each line item Explanation of ‘why’ (unless it was a
compulsory change)
in the financial statements for the periods presented
Effect on each line item
(including basic and diluted earnings per share if
these are shown) in: Extra comparative yr in the SOFP
the current period; and
each comparative period presented;
the amount of the adjustment made to periods before the periods that are presented;
if a prior period/s is not restated, the entity must disclose:
the reason why it was impracticable to restate; and
a description as to how and from what date the new policy has been applied;
if transitional provisions were provided:
the fact that the change has been made in accordance with transitional provisions;
a description of these provisions; and
the possible effect of these provisions on future periods.
The following disclosure is required when the change is a voluntary one:
the reasons why the new policy results in reliable and more relevant information;
the nature of the change;
an extra year of comparatives in the statement of financial position; IAS 1.10 requirement
the amount of the adjustment made to each line item in the financial statements for the
periods presented (including basic and diluted earnings per share if these are shown) in:
the current period; and
each comparative period presented; and
the amount of the adjustment made to periods before the periods that are presented;
a description as to how and from what date the new policy has been applied.
Chapter 26 1101
Financial statements of subsequent periods need not repeat these disclosures.
Where a new Standard or Interpretation has been issued, but which has not and does not yet
need to be applied, the entity must disclose:
this fact; and
the effect of the future change in accounting policy on its financial statements, where this
is known or is reasonably estimable.
Example 2: Change in accounting policy – disclosure

Use the same information given in example 1 together with the following additional
information:
The following financial statements were produced before adjusting for the change in accounting policy:
Draft statement of comprehensive income

20X7 20X6
C C
Income tax expense 345 000 320 000
Profit after tax 455 000 380 000
Retained earnings at the beginning of the year 500 000 120 000
Retained earnings at the end of the year 955 000 500 000
Draft statement of financial position

20X7 20X6 20X5
C C C
ASSETS
Plant 500 000 450 000 300 000
Deferred tax: income tax 250 000 300 000 100 000
Retained earnings 955 000 500 000 120 000
Required: Disclose the change in accounting policy in the financial statements for the year ended
31 December 20X7, in accordance with IFRSs.
Solution 2: Change in accounting policy – disclosure
Company name
2.1 Borrowing costs
Borrowing costs are capitalised to qualifying assets. This is a change in accounting policy (note 5).
5. Change in accounting policy
The company changed its accounting policy from expensing borrowing costs as they are incurred to
capitalising borrowing costs to plant, a qualifying asset.
The change was made to comply with the revised IAS 23 Borrowing costs issued during the year.
IAS 23 included transitional provisions in which borrowing costs could be capitalised from 20X8 or
from an earlier date if preferred:
The company has opted to capitalise the borrowing costs from the earliest date possible.
The effect on future years is that depreciation expense will be proportionately increased due to
borrowing costs now being capitalised.
1102 Chapter 26
Company name
5. Change in accounting policy continued ...
The effect of the change in accounting policy is as follows:

20X7 20X6
Effect on the statement of comprehensive income C C
Increase/ (decrease) in expenses or losses
- Finance costs Given (9 000) (17 000)
- Income tax expense Above x 30% 2 700 5 100
(Increase)/ decrease in income or profits
- Profit for the year Balancing (6 300) (11 900)
20X7 20X6 20X5

Effect on the statement of financial position C C C
Increase/ (decrease) in assets
- Plant 20X5: given 41 000 32 000 15 000
20X6: 15 000 + 17 000
20X7: 32 000 + 9 000
(Increase)/ decrease in liabilities and equity
- Deferred tax 20X5: 15 000 x 30%* (12 300) (9 600) (4 500)
20X6: 32 000 x 30%*
20X7: 41 000 x 30%*
- Retained earnings – closing Balancing (28 700) (22 400) (10 500)
* Since the tax authorities are not re-opening (i.e. are not changing) the past tax assessments, there is no
change to the current tax payable.
In other words, the tax base remains the same yet the carrying amount will change.
The policy change thus results in a temporary difference with regard to tax, and thus gives rise to a deferred
tax adjustment. See example 1 for further explanation.
Company name
20X7 20X6 20X5
C C C
Restated Restated
ASSETS
Plant (500 000 + 41 000)* 541 000 482 000 315 000
(450 000 + 32 000)*
(300 000 + 15 000)*

Retained earnings (statement of changes in equity) 983 700 522 400 130 500
Deferred tax: income tax (250 000 + 12 300)* 262 300 309 600 104 500
(300 000 + 9 600)*
(100 000 + 4 500)*
* Adjustments come from your change in accounting policy note. You could also use the
adjustments per your journals.
Note that you were given a draft statement of comprehensive income, which is not in accordance with
IAS 1 (the standard governing the presentation of financial statements). Your solution therefore also
requires appropriate reformatting. See chapter 1 for more information in this regard.
Chapter 26 1103
Company name
Note Retained
earnings
C
Balance: 1/1/20X6 - restated (120 000 + 10 500) 130 500
- As previously reported Given 120 000
- Change in accounting policy Per the note 5 10 500
Total comprehensive income: 20X6 - restated Statement of compr. income 391 900
Balance: 1/1/20X7 - restated 522 400
- As previously reported Given 500 000
- Change in accounting policy Per the note 5 22 400
Total comprehensive income: 20X7 Statement of compr. income 461 300
Balance: 31/12/20X7 * 983 700
Check: 955 000 adjusted for the journals: + 15 000 – 4 500 + 17 000 – 5 100 + 9 000 – 2 700 = 983 700
* Comment: this balance is not broken down into ‘as previously reported’ and ‘change in
accounting policy’ since this is the first time that it has ever been reported.
Company name
20X7 20X6
C C
Restated
Profit before finance charges (800 000 + 9 000)(700 000 + 17 000) 809 000 717 000
Finance charges (9 000 – 9 000) (17 000 – 17 000) 0 0
Income tax expense (345 000 + 2 700) (320 000 + 5 100) 347 700 325 100
Tips on answering comprehensive questions involving changes in accounting policies :
prepare the ‘change in accounting policy note’ first; then
prepare the statement of comprehensive income (remember to ensure that the profit
before tax and tax expense are adjusted using the same adjustments you disclose in your
‘change in accounting policy’ note); then
prepare the statement of changes in equity (remember to ensure that the total
comprehensive income in the statement of changes in equity agrees with the revised
statement of comprehensive income and that the effect on opening retained earnings is
adjusted using the same adjustment in your ‘change in accounting policy’ note – and that
your statement of changes in equity is referenced to this note); and then
prepare the statement of financial position (remember to ensure that the assets and
liabilities are adjusted using the same adjustments you disclose in your ‘change in
accounting policy’ note and that the revised retained earnings (calculated in your
statement of changes in equity) appears in your revised statement of financial position).
1104 Chapter 26
4. Changes in Accounting Estimates (IAS 8.32 - .40)
4.1 Overview
There are many items that require recognition and/ or A change in estimate is
disclosure, but cannot be precisely measured. The defined as:
accountant (in conjunction with other interested parties) is an adjustment of the carrying
therefore frequently required to make estimates. amount of an asset or a liability, or
Estimates include, for example, bad debts, inventory the amount of the periodic
obsolescence or useful lives of property, plant and consumption of an asset,
equipment (for estimating depreciation). Making that results from the assessment
estimates is thus an integral part of the preparation of of the present status of, and
financial statements and as long as they are reasonable, expected future benefits and
they will not undermine the reliability of our financial obligations associated with, assets
and liabilities. IAS 8.5
statements.
Almost just as frequently as estimates are made, is it discovered that previous estimates are
overestimated or underestimated. These are not errors, since estimates by their very nature,
need to be adjusted as and when the circumstances relating to the original estimate change.
IAS 8 specifically advises that if it is difficult to distinguish between a change in estimate and
a change in policy, the change should rather be treated as a change in estimate (which is great
news since a change in estimate is a lot simpler to account for than a change in policy). IAS 8.35
Please note that a change in measurement basis is considered to be a change in policy and not
a change in estimate. IAS 8.35 For example, regarding inventories, a change from the FIFO
method to the WA method is a change in accounting policy rather than a change in estimate.
4.2 How to adjust for a change in accounting estimate (IAS 8.32 - .38)
A change in estimate is applied prospectively (not
retrospectively). This means that it will affect the figures A change in accounting
estimate:
in the current and future periods (if applicable), but will
never affect the prior year figures. Certain changes in is applied prospectively, thus
estimates will affect only the current year, for example an affects current & future periods
allowance for credit losses, whereas others will affect
future years as well, for example changing the estimated remaining economic useful life of an
asset will affect both the current and the future years (until the asset is fully depreciated).
Although not specifically mentioned in IAS 8, there are two methods of making a change in
estimate: the cumulative catch-up method and the reallocation method. The amounts of the
change in estimate and the related disclosure will differ depending on which method is used.
The standard is not clear that the cumulative catch-up method is not allowed, but comments
included in IFRIC 1 (BC 12 – 17) suggest that IAS 8 only intended to allow the reallocation
method. In complete contradiction, other standards make it clear that the cumulative catch-up
method is the preferred method (e.g. IAS 20.32). Both methods are covered in this chapter.
When using the cumulative catch-up method, the adjustment made in the current year actually
includes the effect of the change on prior years. This method ensures that the current year’s
balances in the statement of financial position are the latest estimates (i.e. best estimates). The
downside is that this method distorts the current year profits since the change in estimate
adjustment includes the effect on prior year balances (i.e. change in estimate adjustments are
always made prospectively, even when the cumulative catch-up method is used).
When using the reallocation method, no adjustment is made in the current year for the effect
of the change on prior years. Example: the opening carrying amount of plant (calculated in
accordance with the previous estimate) is simply reallocated over the remaining revised
estimated useful life.
Chapter 26 1105
Thus the reallocation method ensures that the impact of the change in estimate is spread
evenly over the future and therefore does not distort the current year profits. The downside is
that no effort is made to update the balances in the statement of financial position for the
latest estimates.
These two approaches are best explained by way of examples.
Example 3: Change in estimated useful life: reallocation method vs
cumulative catch-up
Machinery was purchased on 1 January 20X7, on which date it was estimated to have a useful life of
5 years and a nil residual value. The carrying amount on 31 December 20X8 was as follows:
Cost (1/1/20X7) C500 000

Accumulated depreciation Being: (500 000 – 0) / 5 yrs x 2 yrs (200 000)
Net carrying amount (31/12/20X8) 300 000
On the 1/1/20X9, the total economic useful life was re-estimated to be 4 years.
Required:
A. Assuming that the re-allocation method is used:
i) Show the journals assuming that the 20X9 depreciation journal had not yet been processed.
ii) Show all depreciation journals that would be processed in 20X9 assuming that the 20X9
depreciation journal had already been processed (i.e. before the change in estimate).
B. Assuming that the cumulative catch-up method is used:
i) Show the journals assuming that the 20X9 depreciation journal had not yet been processed.
ii) Show all depreciation journals that would be processed in 20X9 assuming that the 20X9
depreciation journal had already been processed (i.e. before the change in estimate).
Solution 3A: Change in estimated useful life: the ‘reallocation method’

There is a change in estimated useful life: the original estimate had it that there were 3 years still
remaining (5 years – 2 years), whereas the remaining life is now only 2 years (4 years to 2 years).
Using the reallocation method, no consideration is given to the effect of the change in estimate on prior
years.
W1 Calculations Was Is Difference

Reallocation method (a) (b) (b) – (a)
Cost Given 500 000
Accum. depr: 31/12/20X8 500 000 / 5 x 2 yrs (200 000)
Carrying amount: end 20X8 Put this in the ‘is’ 300 000 300 000 0 (c)
column as well
Remaining useful life (5 – 2yrs) (4 – 2 yrs) 3 years 2 years
Depreciation – 20X9 (300 000 / 3 years) (100 000) (150 000) (50 000) (d) More depr
(300 000 / 2 years)
Carrying amount: end 20X9 200 000 150 000 (50 000) (e) = (c) + (d)

Depreciation – future Balancing (200 000) (150 000) 50 000 Less depr.
Carrying amount: future Residual value 0 0 0
Notice that the carrying amount at 31 December 20X8 was C300 000.
By the end of year 20X9, the carrying amount must be reduced to C150 000.
.: This means that depreciation of C150 000 must be journalised in 20X9 (300 000 – 150 000):
C
Depreciation – based on previous estimate Per W1: column ‘was’ 100 000
Change in estimate Per W1: column ‘difference’ (e) 50 000
Total depreciation 150 000
1106 Chapter 26
i) Depreciation journals in 20X9: depreciation had not yet been processed

If the accountant ‘found out about’ the change in estimate before he had processed the 20X9
depreciation, the 20X9 depreciation journal would be:
Debit Credit
Depreciation (E) CA o/b: 300 000– CA c/b: 150 000 150 000
Machinery: accumulated depreciation (-A) 150 000
Depreciation on machinery using total UL of 4 yrs
ii) Depreciation journals in 20X9: depreciation had already been processed

If the accountant ‘found out about’ the change in estimate after he had already processed the 20X9
depreciation based on the old estimate, the 20X9 depreciation journals would be:
Debit Credit
Depreciation (E) (500 000 – 0) / 5 yrs x 1 yr 100 000
Depreciation (E) CA o/b: 300 000 – CA c/b: 150 000 50 000
– depreciation already processed: 100 000
Change in estimated depreciation on machinery: depreciation for
20X9 already processed based on TUL of 5yrs: 100 000, but TUL
since changed from 5 yrs to 4 yrs
Solution 3B: Change in estimated useful life: ‘cumulative catch-up method’
There has been a change in estimate, since based on the original estimate, the asset had a total useful
life of 5 years, whereas this has now been shortened to 4 years (2 years past + 2 years remaining).
W1: Calculations Was Is Difference

Cumulative catch-up (a) (b) (b) – (a)
Cost Given 500 0 500 000
Accum. depr.: end 20X8 500 000 / 5 x 2 yrs (200 000 (250 000) (50 000)
500 000 / 4 x 2 yrs
Carrying amount: end 20X8 300 000 250 000 (50 000) (c) More depr

Depreciation – 20X9 (300 000 / 3 years) (100 000 (125 000) (25 000) (d) More depr
(250 000 / 2 years)
Carrying amount: end 20X9 200 000 125 000 (75 000) (e) = (c) + (d)

Depreciation – future Balancing (200 000 (125 000) 75 000 Less depr.
Carrying amount: future Residual value 0 0 0
C
Depreciation – based on previous estimate Per table above ‘was’ 100 000
Change in estimate Per table above ‘difference’ 75 000
(e)
Chapter 26 1107

i) Depreciation journals in 20X9: depreciation had not yet been processed
Debit Credit
Depreciation on machinery using TUL of 4 years
ii) Depreciation journals in 20X9: depreciation had already been processed

If the accountant ‘found out about’ the change in estimate after he had already processed the 20X9
depreciation based on the old estimate, the 20X9 depreciation journals would be:
Debit Credit

Depreciation (E) CA o/b: 300 000 – CA c/b: 125 000 – 75 000

depreciation already processed: 100 000
20X9 already processed based on TUL of 5yrs: 100 000, but TUL
since changed from 5 yrs to 4 yrs
4.3 Disclosure of a change in accounting estimate (IAS 8.39 - .40)
The nature and amount of the change in estimate must be Disclosure of a change
disclosed, where the amounts to be disclosed are as in accounting estimate
follows: includes:
the effect on the current period; and Brief description of ‘what’
the effect on future periods, unless estimating the Effect on each line item
future effect is impracticable, in which case this fact should be disclosed.
Example 4: Disclosure of a change in accounting estimate
Use the same information as that provided in example 3
Required:
A. Disclose the change in estimate using the re-allocation method.
B. Disclose the change in estimate using the cumulative catch-up method.
Solution 4A: Disclosure of a change in estimate: re-allocation

Company name
20X9 20X8
3. Profit before tax Note C C
Depreciation 150 000 100 000
original estimate 100 000 100 000
change in estimate 5 50 000 0
1108 Chapter 26
Company name
20X9 20X8
5. Change in estimate Note C C
The estimated economic useful life of machinery was changed from 5 years to 4 years.
The (increase)/ decrease in profits caused by the change is as follows:
Current year’s profits: 50 000
Future profits: (50 000)
Solution 4B: Disclosure of a change in estimate: cumulative catch-up
Company name
20X9 20X8
change in estimate 5 75 000 0
The estimated economic useful life of machinery was changed from 5 years to 4 years.
Current year’s profits: 75 000
Comment regarding both Part A and Part B:

The effect on the current year’s profits equals the effect on the future year’s profits although the
one decreases profit and the other increases profit. These two amounts negate each other since the
change in estimate does not change the cumulative profits over the current and future years.
The reason for this is that it is just the timing of the depreciation that has been changed: the full
cost of the asset will still be expensed – thus the profits will be reduced by C500 000 over the life
of the asset irrespective of what this estimated useful life is.
Example 5: Change in estimated residual value: reallocation method

Machinery was purchased on 1 January 20X7, on which date it was estimated to have a
useful life of 5 years and a nil residual value.
The carrying amount on 31 December 20X8 was:

Cost (1/1/20X7) 500 000
Accumulated depreciation 200 000
Net carrying amount (31/12/20X8) 300 000
On the 1/1/20X9, the residual value was re-estimated to be C90 000.
Required:
Using the re-allocation method:
A. Calculate the effect of the change in estimate.
B. Show all 20X9 depreciation journals assuming that depreciation had not yet been journalised.
C. Show all 20X9 depreciation journals assuming that depreciation had already been processed.
D. Disclose the change in estimate.
Chapter 26 1109
Solution 5A: Change in estimated residual value: reallocation

W1: Calculations Was Is Difference
Reallocation method (a) (b) (b) – (a)
Cost Given 500 000
Accum. depr.: end 20X8 (500 000 - 0)/ 5 x 2 (200 000)
Carrying amount: end 20X8 Put this under ‘is’ 300 000 300 000 0 (c)

Residual value Given (0) (90 000)
Depreciable amount 300 000 210 000
Depreciation – 20X9 (300 000 / 3 years) (100 000) (70 000) 30 000 (d) Less depr
(210 000 / 3 years)
Carrying amount: end 20X9 (300 000 – 100 000) 200 000 230 000 30 000 (e) = (c) + (d)
(300 000 – 70 000)
Depreciation – future (200 000 – RV: 0) (200 000) (140 000) 60 000 Less depr
(230 000 – RV:
90 000)
Carrying amount: future Residual value 0 90 000 90 000
C
Depreciation – based on previous estimate W1: column ‘was’ 100 000
Change in estimate W1: column ‘difference’ (e) (30 000)
Solution 5B: Change in estimated residual value: journals
Debit Credit
Depreciation on machinery using a TUL of 5 yrs and a RV of 90 000
Solution 5C: Change in estimated residual value: journals

If the 20X9 depreciation had already been processed an extra change in estimate journal would still be
needed:
Debit Credit
Depreciation on machinery using total UL of 5 yrs and a nil RV

– depreciation already processed: 100 000
20X9 already processed based on RV of nil: 100 000, but RV since
changed from nil to C90 000
1110 Chapter 26
Solution 5D: Change in estimated residual value: disclosure

Company name
20X9 20X8
Profit before tax is stated after taking the following into
account:
change in estimate 5 (30 000) 0
The estimated residual value of machinery was changed from nil to C90 000.
The (increase)/ decrease in profits caused by the change is as follows::
Current year’s profits: (30 000)
Comment:
Notice how, contrary to the previous examples (where the estimated useful life had been
changed), the effect on the current year’s profits does not equal the effect on the future year’s
profits. In this example, the total effect on profit is an increase in profit of C90 000 (C30 000 in
the current year and C60 000 in future years).
The reason for the net increase in profit owing to the change in estimate is that the residual value
was increased from C0 to C90 000. This means that instead of expensing the whole cost of
C500 000 as depreciation over the life of the asset, only C410 000 will now be expensed as
depreciation. If depreciation decreases by C90 000, profit over the life of the asset obviously
increases by C90 000!
Example 6: Change in estimated residual value: cumulative catch-up method

Use the same information as provided in example 5.
Required: Using cumulative catch-up method:

A. Calculate the effect of the change in estimate.
B. Show the journal entries assuming that depreciation had not yet been journalised.
C. Show the journal entries assuming that depreciation had already been processed.
D. Disclose the change in estimate.
Solution 6A: Change in estimated residual value: cumulative catch-up

Calculation: Calculations Was Is Differenc
Cumulative catch-up (a) (b) e
(b) – (a)
Cost Given 500 000 500 000
Accum. depr: end 20X8 (500 000 -0 )/ 5 x 2 (200 000) (164 000) 36 000 Less depr
(500 000 – 90 000) / 5 x 2 yrs
Carrying amount: end 20X8 300 000 336 000 36 000 (c) less depr

Residual value (0) (90 000)
Depreciable amount 300 000 246 000
Remaining useful life (5 – 2yrs) 3 years 3 years
Depreciation – 20X9 (300 000 / 3 years) (100 000) (82 000) 18 000 (d) less depr
(246 000 / 3 years)
Carrying amount: end 20X9 200 000 254 000 54 000 (e) = (c) + (d)

Depreciation – future (200 000 – RV: 0) (200 000) (164 000) 36 000 Less depr
(254 000 – RV: 90 000)
Carrying amount: future Residual value 0 90 000 90 000
Chapter 26 1111

Notice: Look at the table calculating the relevant carrying amount and depreciation amounts:
Notice that the table shows the CA at the end of 20X8 to be C300 000. ()
Notice that the table shows that, by the end of 20X9, the CA must be reduced to C254 000. ()
Thus, if we compare what the CA was at the end of last year with the CA (C300 000) that we
must achieve by the end of the current year (C254 000), we can see that the depreciation we must
journalise in the current year is C46 000 (300 000 – 254 000).
Notice that the table shows what the CA at the end of the current year would have been if we had
not changed our estimate (200 000) and what the CA must be at the end of the current year using
the new estimate (C254 000) and thus the table shows that the effect of the change in estimate is
C54 000 (C254 000 – C200 000).
C
Depreciation – based on previous estimate Per table above ‘was’ 100 000
Change in estimate Per table above ‘difference’ (e) (54 000)
Solution 6B: Change in estimated residual value: journals

The journal in 20X9, assuming depreciation had not yet been processed, would be:
Debit Credit
Depreciation on machinery using TUL of 5 years and RV of 90 000
Solution 6C: Change in estimated residual value: journals

If the 20X9 depreciation had already been processed an extra change in estimate journal would still be
needed:
Debit Credit

Change in estimated depreciation on machinery: depreciation for 20X9
already processed based on RV of nil: 100 000, but RV since changed from
nil to C90 000
Solution 6D: Change in estimated residual value: disclosure
Company name
20X9 20X8
- original estimate 100 000 100 000
- change in estimate 5 (54 000) 0
The estimated residual value of machinery was changed from nil to 90 000.
Current year’s profits: (54 000)
1112 Chapter 26
Comment:
Notice that, just as with example 5, the effect on the current year’s profits does not equal the effect
on the future year’s profits: in this example, the total effect on profit is an increase in profit of
C90 000 (C54 000 in the current year and C36 000 in future years).
The reason for the overall increase in profit of C90 000 is the same as in example 5: the residual
value increased from C0 to C90 000 so depreciation decreases by C90 000!
A further, more comprehensive example of a change in estimate may be found in the chapter:
provisions, contingencies and events after the reporting period (example 11 and 12).
5. Correction of Errors (IAS 8.41 - .49)
5.1 Overview
There are very few people who, whether we like to admit it or not, have not been ‘wrong’ and
therefore, since most of us are well-acquainted with errors, there would seem to be little need
of further explanation. But this is not so! The term ‘errors’, from an accounting perspective,
needs a little clarification.
When one makes an estimate in one year and then discovers, in the next year, that this
estimate should have been larger or smaller, although we might actually refer to the previous
estimate as being ‘wrong’, this is actually not an ‘error’ in terms of accounting jargon! This is
because an estimate is simply an approximation that, by nature, needs reassessment based on
changing circumstances and therefore generally needs adjustment at some stage. This was
explained in the last section on changes in estimates.
There are essentially three categories of errors:

Current period errors
Prior period errors that are immaterial
Prior period errors that are material.
Current period errors are errors that happen in the current year and are discovered in the
current year. These are simply corrected in the current year , with no disclosure required, as
there would have been no error actually disclosed in the
Prior period errors are
first place. defined as:
Prior period errors are those errors that happened before omissions from, & misstatements
the current year but which are only discovered in the in,
current year. Such errors include the effects of the entity’s financial statements
mathematical mistakes, mistakes in applying accounting
policies, oversights or misinterpretations of facts, and for one or more periods
fraud. arising from a failure to use, or
misuse of, reliable information
Since IFRSs only ever apply to material items, immaterial that:
prior period errors are not corrected in terms of this was available when those prior
standard. This is not to say that we don’t correct period financial statements
immaterial errors! We should correct these errors, but we were authorised for issue; and
correct these errors in the current year and we do not could reasonably be expected
bother providing any disclosure thereof. to have been obtained and
taken into account in the
preparation and presentation of
Thus IAS 8 only applies to: those financial statements.
material prior period errors IAS 8.5
Chapter 26 1113
5.2 How to correct an error (IAS 8.41 - .48)
The various types of errors

Errors occurring in the current period (not covered by IAS 8 or any IFRS): adjust in CY
Immaterial errors occurring in a prior period (not covered by IAS 8 or any IFRS): adjust in CY
Material errors occurring in a prior period (covered by IAS 8): retrospective adjustment & full
disclosure
5.2.1 All errors that occurred in the current period

All errors that occurred during the current year, whether material or immaterial, are adjusted
in the current year. No disclosure of the correction of these errors is required.
Example 7: Correction of errors occurring in the current period
A vehicle was purchased for C100 000 on 1 January 20X9.
Its 20X9 depreciation (i.e. current year depreciation) of C10 000 was erroneously
debited to the vehicles: cost account.
The error is discovered in 20X9.
The tax authorities granted wear and tear of C4 000 in 20X9 based on the correct cost.
Required: Journalise the correction of this error.
Solution 7: Correction of errors occurring in the current period

Adjusting journal in 20X9 Debit Credit
Vehicles: cost (A) 10 000
Correction of journal dated …20X9
Deferred taxation: income tax (L/A) 3 000
Taxation expense (E) 3 000
Tax effect of reduced profits (10 000 x 30%)
Comment: since the tax authorities disregard the accountant’s depreciation when calculating taxable profits:
the incorrect depreciation would not have affected the current tax payable (see proof 1 below); and
the tax adjustment will therefore be a deferred tax adjustment instead (see proof 2 below).
Proof 1: Current tax calculation Incorrect Correct Difference

Profit before depreciation (assumed figure) 200 000 200 000
Less depreciation 0 (10 000)
Add back depreciation 0 10 000
Less wear and tear Given (4 000) (4 000)
Current income tax at 30% 58 800 58 800 0
Comment: the calculation above proves that the error did not affect current tax.
Proof 2: Deferred tax calculation CA TB TD DT

Balance at 31 December 20X1:
Incorrect balance: 100 000 96 000 (4 000) (1 200) Liability
(CA: 100 000 + 10 000 – 10 000)
(TB: 100 000 – 4 000)
Correct balance: 90 000 96 000 6 000 1 800 Asset
(CA: 100 000 – 10 000)
(TB: 100 000 – 4 000)
Correction required 3 000 Dr DT; Cr TE
Comment: the calculation above proves that the error does affect deferred tax.
Disclosure: No disclosure of this correction is required because the error occurred in the current year.
1114 Chapter 26
5.2.2 Immaterial errors that occurred in a prior period/s
If in the current period you find an error that was made in a prior period but which is
immaterial:
it should be corrected in the current period;
no disclosure would be required.
Example 8: Correction of immaterial errors occurring in a prior period/s

A vehicle was purchased for C100 000 on 1 January 20X8.
In 20X8, depreciation on the vehicle of C10 000 was recorded instead of C25 000 but
this was only discovered during 20X9 after the 20X8 financial statements had been
published.
The error is considered to be immaterial.
The tax authorities granted a wear and tear allowance of C4 000 (correct) in 20X8.
Required: Journalise the correction of this error.
Solution 8: Correction of immaterial errors occurring in a prior period/s

Comment: The essence is that the adjustment is not made in 20X8 – it is made in the current year!
20X9: correcting journal Debit Credit
Depreciation (E) (25 000 – 10 000) 15 000
Vehicles: accumulated depreciation (-A) 15 000
Correction of journal dated …20X8
Deferred taxation (A) (see comment below) (15 000 x 30%) 4 500
Taxation expense (E) 4 500
Tax effect of reduced profits
Comment: the tax authorities ignore the accountant’s depreciation when calculating taxable profits:
the incorrect depreciation thus has no effect on current tax payable (see proof 1 below); and
the tax adjustment will therefore be a deferred tax adjustment instead (see proof 2 below).
Proof 1: Current tax calculation Incorrect Correct Difference

Profit before depreciation (assumed figure) 200 000 200 000
Less depreciation (10 000) (25 000)
Add back depreciation 10 000 25 000
Less wear and tear (4 000) (4 000)
Current income tax at 30% 58 800 58 800 0
Proof 2: DT calculation CA TB TD DT
Balance at 31 December 20X1:
Incorrect balance 90 000 96 000 6 000 1 800 Asset
(CA: 100 000 – 10 000)
(TB: 100 000 – 4 000)
Correct balance: 75 000 96 000 21 000 6 300 Asset
(CA: 100 000 – 25 000)
(TB: 100 000 – 4 000)
Correction required 4 500 Dr DT; Cr TE
Comment:
These calculations prove that the error does not affect current tax but does affect deferred tax.
Disclosure:
No disclosure of this correction would be made in either year since the amounts are immaterial.
Chapter 26 1115
5.2.3 Material errors that occurred in a prior period/s
If, in the current period, discovery is made of a material error that occurred in a prior period:
corrections should be made to the particular period/s in which the error/s were made
(retrospective restatement); and
full disclosure of the error and the effects of the correction would be required.
Such a discovery is serious and means that the previously

Retrospective
published financial statements (i.e. already issued to restatement is defined as:
users) are wrong! This then means that the figures in
these financial statements need to be corrected. We need correcting the recognition,
to correct these prior year figures in the current year’s measurement and disclosure of
financial statements by restating the comparatives elements in the financial
statements
(retrospective restatement) and providing note disclosure
so as to alert the user to the fact that we had made an error as if a prior period error had
in the prior period/s’ financial statements. never occurred. IAS 8.5
It may not, however, always be possible to calculate the effect on all the prior periods’
figures, in which case the correction is simply made from the earliest prior period possible
and the cumulative effect on the assets, liabilities and equity before this period are simply
disregarded. IAS 8.47
The adjustments are the same as that for a change in accounting policy, but the disclosure
differs slightly.
Example 9: Correction of a material error that occurred in a prior period/s
Valentino Limited purchased a specialised machine on the 1/1/20X7 for C1 000 000.
Valentino Limited provides for depreciation on the diminishing balance method at 20%.
Valentino Limited made the following error:
it processed depreciation of C200 000 in 20X8
This error was only picked up in 20X9 after the current period’s entries had been processed.
The information for tax assessment purposes was not affected by this error in any way.
The income tax rate is 30% and has been unchanged for many periods.
The tax authorities allow the annual deduction of 20% of the cost of the asset.
Required: Provide the correcting journal entries for the current year ended 31 December 20X9.
Solution 9: Correction of a material error that occurred in a prior period/s

Machines: accum. depr. (-A) 200 000 – [(1 000 000 – 200 000) x 20%] 40 000
Deferred taxation (L) 40 000 x 30% 12 000
Retained earnings (Eq) Balancing: 40 000 – 12 000 28 000
Correction of error made in the prior year (20X8)
31/12/20X9
Depreciation (E) Correct depr.[(1 000 000 – 200 000 – 160 000) 8 000
Machines: accum. depr. x 20%] – Incorrect depr already processed 8 000
[(1 000 000 – 200 000 – 200 000) x 20%
Deferred tax (L) See comment below 2 400
Taxation expense (E) 8 000 x 30% 2 400
Correction of error made in the current year (20X9)
1116 Chapter 26
Comment
Please remember that it is not possible to correct the income and expense accounts of a
prior year directly since these accounts have already been closed off to retained
earnings. Thus, correcting a prior year income or expense account needs the adjustment
to be made in retained earnings instead.
The effect on tax is a deferred tax adjustment in example 9, rather than an adjustment
to current tax payable.
This is because depreciation is not used in calculating the taxable profit, and therefore
an error in depreciation would not have affected taxable profit or current tax.

Use the same basic information as that provided in example 9 but where the error was as
follows:
During the current year it was discovered that the specialised machinery purchased in
20X7 had in fact been expensed as a special marketing fee instead.
This error affected the tax calculations and the forms submitted (i.e. the incorrect
information was also submitted to the tax authorities).
The income tax rate is 30% and has been unchanged for many years.
The tax authorities allow the annual deduction of 20% of the cost of the asset.
Required: Prepare the correcting journal entries for the year ended 31 December 20X9 assuming:
A. The tax authorities have indicated that they will re-open the relevant tax assessments.
B. The tax authorities have indicated that they will make the corrections in the current year
assessment (i.e. will not re-open the relevant prior tax assessments).
Solution 10A: Prior tax assessments are re-opened
01/01/20X9: correcting journal Debit Credit

Machine: accum. depr. (-A) 200 000 + 160 000 360 000
Current tax payable (L) (1 000 000 – 200 000 – 200 000) x 30% [W1] 180 000
Deferred tax (L) (TB: 600 000 – CA: 640 000) x 30% [W2] 12 000
Retained earnings (1 000 000 – 200 000 – 160 000) x 70% 448 000
Correction of errors occurring in 20X7 and 20X8
31/12/20X9: correcting journal

Depreciation (E) (1 000 000 – 200 000 – 160 000) x 20% 128 000
Machine: accum. depr. (-A) 128 000
Current tax payable (L) (200 000 x 30%) [W1] 60 000
Deferred tax (L) (depr: 128 000 – w&t: 200 000) x 30% [W2] 21 600
Tax effect of reduced profits
Comment: The effect on retained earnings is the after tax effect of the correction to prior years’ profits.
W1: Current tax calculation

A deduction of 1 000 000 was incorrectly claimed upfront in 20X7 and no further deductions were then
claimed. What should have happened is a deduction of 200 000 should have been claimed per year
(with 400 000 claimed in prior years and 200 000 in the current year and another 400 000 still to be
claimed in the future). This means that our current tax expense/ payable in each of the years has been
measured incorrectly.
Chapter 26 1117
W1: Current tax calculation cont ... 20X7 and 20X8 20X9
Incorrect Correct Incorrect Correct
Profit before depreciation (assumed figure) 4 000 000 4 000 000 4 000 000 4 000 000
Less deduction incorrectly claimed (1 000 000) - -
Less deductions should have been claimed - (400 000) (200 000)
Taxable profits 3 000 000 3 600 000 4 000 000 3 800 000
Current income tax at 30% 900 000 1 080 000 1 200 000 1 140 000
20X7 & 20X8: extra tax to be recognised: 1 080 000 – 900 000 = 180 000 [Dr TE, Cr CTP]
20X9: less tax to be recognised: 1 140 000 – 1 200 000 = 60 000 [Cr TE, Dr CTP]

Since the accountant expensed the 1 000 000 and also deducted it for tax purposes, there would not have been a
carrying amount or tax base on which to recognise deferred tax. I.e. no deferred tax was recognised. However, the
following table shows what balances and adjustments should have been recognised.
CA TB TD DT
Purchase: 01/01/20X7 1 000 000 1 000 000
Depreciation/ deduction: 20X7 (200 000) (200 000)
Balance: 31/12/20X8 640 000 600 000 (40 000) (12 000) L
Depreciation/ deduction: 20X9 (128 000) (200 000) (21 600) Cr DT Dr TE
Balance: 31/12/20X9 512 000 400 000 (112 000) (33 600) L
Solution 10B: Prior tax assessments not re-opened

Comment:
Part B simply illustrates a deferred tax principle in that, if the tax authorities do not ‘open’ the prior year assessments,
any effects on tax in the prior years would not have affected current tax payable, and thus all adjustments in prior years
would be to deferred tax. When the tax authorities then process all these cumulative adjustments in the current year, all
the deferred tax adjustments accumulated to the beginning of the current year must be reversed out to the current tax
payable account (e.g. if the error in the prior year would have resulted in increased tax and the tax authorities were not
going to open the prior assessments but simply account for the increased tax in the current year assessment, the
increased tax liability would have been credited to deferred tax liability). At the beginning of the current year, this
deferred tax liability would need to be transferred to current tax payable (debit DTL and credit CTP).
01/01/20X9: correcting journal Debit Credit

Machine: accum. depr. (-A) 200 000 + 160 000 360 000
Deferred tax (L) (TB: 0 – CA: 640 000) x 30% [W2] 192 000
Retained earnings (Eq) (1 000 000 – 200 000 – 160 000) x 70% 448 000
Correction of errors occurring in prior years (20X7 and 20X8)
31/12/20X9: correcting journal

Depreciation (E) (1 000 000 – 200 000 – 160 000) x 20% 128 000
Machine: accum. depr. (-A) 128 000
Current tax payable (L) (1 000 000 – 200 000 x 3 yrs) x 30% [W1] 120 000
Deferred taxation (L) (TB: 400 000 – CA: 512 000) x 30% - 192 000 L or 158 400
[W2]
Correction of errors occurring in the current year (20X9)
1118 Chapter 26

W1: Current tax calculation
A deduction of 1 000 000 was incorrectly claimed upfront in 20X7 and no further deductions were then claimed.
What should have happened is a deduction of 200 000 should have been claimed per year (with 400 000 claimed
in prior years, 200 000 in the current year and 400 000 still to be claimed in the future). Thus our current tax
expense/ payable in each of the years has been measured incorrectly. If the tax authorities do not re-open the
prior tax assessments but make the correcting adjustments in the current tax assessment instead, the following
will be the effect on current tax payable:
20X7 and 20X8 20X9
Incorrect Incorrect Correct
Profit before depreciation (assumed figure) 4 000 000 4 000 000 4 000 000
Less deduction incorrectly claimed (1 000 000) -
Add back incorrect deduction - 1 000 000
Less deductions should have been claimed - (600 000)
Taxable profits 3 000 000 4 000 000 4 400 000
Current income tax 900 000 1 200 000 1 320 000
20X7 & 20X8: extra tax to be recognised: No adjustment: prior tax assessments are not re-opened
20X9: less tax to be recognised: 1 320 000 – 1 200 000 = 120 000 [Dr TE, Cr CTP]
Since the accountant expensed the 1 000 000 and also deducted it for tax purposes, there would not have been a
carrying amount or tax base on which to recognise deferred tax. I.e. no deferred tax was recognised. The
following table shows what balances and adjustments must be recognised once the correcting adjustments to the
tax assessments are made in the current year.
# CA TB TD DT
Purchase: 01/01/20X7 1 000 000 0
Depreciation/ deduction: 20X7 (200 000) 0
Balance: 31/12/20X7 800 000 0 (800 000) (240 000) L
Depreciation/ deduction: 20X8 (160 000) 0
Balance: 31/12/20X8 640 000 0 (640 000) (192 000) L
Purchase: 01/01/20X7 1 000 000
Depreciation/ deduction: 20X7 (200 000) 158 400 Dr DT Cr TE
Depreciation/ deduction: 20X8 (200 000)
Balance: 31/12/20X9 512 000 400 000 (112 000) (33 600) L
5.3 Disclosure of a material prior period error (IAS 8.49)
The following disclosure is always required for a Disclosure of a

correction of a material prior period error: correction of error
the nature of the prior period error; includes:
an extra year of comparatives in the statement of Brief descript of ‘what’
financial position (IAS 1.10 requirement); Effect on each line item
the amount of the adjustment made to each line item Extra yr of comparatives in SOFP
in the financial statements for the periods
presented(including basic earnings per share, as well as diluted earnings per share if these
are shown) in each comparative period presented;
the amount of the adjustment made to all periods before the periods that are presented;
a description as to how and from what date the figures have been corrected.
Financial statements of subsequent periods need not repeat these disclosures.
All prior periods that are disclosed as comparatives in an annual report (even if not part of the
financial statements, i.e. including any additional reports provided) must be restated based on
the corrected figures.
Chapter 26 1119
All prior periods that are not disclosed as comparatives are obviously still adjusted, but with
the cumulative correction on the opening balance of retained earnings disclosed as a single
adjustment (e.g. in the statement of changes in equity).

Use the information provided in example 9 together with the following additional
information:
The following financial statements were produced before adjusting for the correction of error:
Draft Statement of financial position 20X9 20X8

As at 31 December 20X9 (extracts) C C
ASSETS
Retained earnings 760 000 605 000
Deferred tax liability 300 000 380 000
Draft Statement of comprehensive income 20X9 20X8

For the year ended 31 December 20X9 (extracts) C C
Income tax expense (45 000) (82 000)
Other comprehensive income for the year 0 0
The affected balances in the statement of financial position at 31 December 20X7 included:
property, plant and equipment: C1 300 000;
retained earnings: C442 000;
deferred tax: C400 000 (liability).
Required: Prepare the corrected financial statements for the year ended 31 December 20X9 in as
much detail as is possible and in accordance with IFRSs.
Solution 11: Correction of a material error that occurred in the prior period
Valentino Ltd
5. Correction of error
During 20X8, depreciation was incorrectly recorded as C200 000 instead of as C160 000.
The effect of the correction is as follows:
Effect on the statement of comprehensive income 20X8
Increase/ (decrease) in expenses or losses C
- Depreciation (40 000)
- Income tax expense 12 000
- Profit for the year (28 000)
Effect on the statement of financial position 20X8 20X7
Increase/ (decrease) in assets C C
- Property, plant and equipment 40 000 0
- Deferred taxation (12 000) 0
- Retained earnings (28 000) 0
0 0
1120 Chapter 26
Comment regarding the note:
Please notice that the effect of an error on the statement of comprehensive income only shows:
the effect on the prior year: 20X8 (the effect on the current year is not shown).
Please also note that the effect of an error on the statement of financial position must show both:
the effect on the prior year: 20X8; and
the effect on the year before the prior year: 20X7 (restatements need two comparative years), but
this example has no effect on years prior to 20X8 since the error only occurred in 20X8.
Valentino Ltd
20X9 20X8
C C
Restated
Profit before tax 20X8: 245 000 + 40 000 * 192 000 285 000
20X9 : 200 000 – 8 000 *
Income tax expense 20X8: 82 000 + 12 000 * (42 600) (94 000)
20X9:45 000 – 2 400
* these adjustments can be found in the correcting journals (see example 9)
Valentino Ltd
Note Retained
Earnings
C
Balance: 1 January 20X8 Not affected: the error occurred in 20X8 442 000
Total comprehensive income: restated Revised statement of compr. income 191 000
Balance: 31 December 20X8 - restated (442 000 + 191 000) 633 000
- as previously reported Given: 442 000 + 163 000 605 000
- correction of material error See note: effect on retained earnings 5 28 000
Total comprehensive income Revised statement of compr. income 149 400
Balance: 31 December 20X9 782 400
Comment regarding the statement of changes in equity:
The opening retained earnings in 20X8 is not broken down into:

- as previously reported
- correction of material error
This is because the retained earnings balance at the end of 20X7 was correct (the error only
occurred in 20X8).
The closing retained earnings in 20X9, the current year, must not be broken down into:
This is because the retained earnings balance at the end of 20X9 had never been reported before.
Chapter 26 1121
Valentino Ltd
20X9 20X8 20X7
C C C
Restated
ASSETS
Property, plant & equipment 20X7: (1300 000 – 0) * 912 000 1 040 000 1 300 000
20X8: (1000 000 +40 000)*
20X9: (880 000 + 40 000 – 8 000)*

Retained earnings Statement of changes in equity 782 400 633 000 442 000
Deferred tax liability 20X7: (400 000 – 0) * 309 600 392 000 400 000
20X8: (380 000 + 12 000)*
20X9: (300 000 + 12 000 – 2 400) *
* these adjustments can be found in the correcting journals (see example 9)
Comment:
Remember that the statement of financial position reflects balances.
Therefore, whatever adjustment is made to a balance in 20X8 will also affect the balance in 20X9
(because the revised closing balance in 20X8 is carried forward into 20X9).

Use the same information as that provided in example 10A together with the following
uncorrected draft financial statements.
Draft Statement of financial position 20X9 20X8

As at 31 December 20X9 (extracts) C C
ASSETS
Deferred tax liability 300 000 380 000
Current tax payable 100 000 100 000
Draft Statement of comprehensive income 20X9 20X8

For the year ended 31 December 20X9 (extracts) C C
Income tax (45 000) (82 000)
The affected balances in the statement of financial position at 31 December 20X7 included:
property, plant and equipment: C500 000
retained earnings: C442 000
deferred tax: C400 000 (liability)
current tax payable: C100 000
Required:
Provide the corrected financial statements and the correction of error note for the year ended
31 December 20X9 in accordance with IFRSs.
1122 Chapter 26
Solution 12: Correction of a material error that occurred in the prior period
Valentino Ltd
20X9 20X8 20X7
C C C
ASSETS Restated Restated
Property, plant & 20X7: 500K + (1 000K – 200K)* 812 000 1 040 000 1 300 000
equipment 20X8: 400K + (800K−160K)*
20X9: 300K+ (640K – 128K)*

Retained earnings Statement of changes in equity 1 118 400 1 053 000 1 002 000
Deferred tax: income 20X7: 400K + 0 * 333 600 392 000 400 000
tax 20X8: 380K+ (0 + 12K)*
20X9: 300K + (12K + 21.6K) *
Current tax payable 20X7: 100K + 240K * 220 000 280 000 340 000
20X8: 100K+ (0 + 180K)*
20X9: 100K + (180K- Jnl:60K)
* these adjustments could be taken either from your note or from your journals, whichever you
have available in a test – or whichever you prefer, if you have both.
Comment:
Remember that the statement of financial position reflects balances. Therefore, whatever adjustment is
made to a balance in 20X8 will also affect the balance in 20X9 (because the revised closing balance in
20X8 is carried forward into 20X9).
This example was similar to example 11, but example 11 does not have an error that affects the years
before the prior year of 20X8 whereas example 12 has an error that, because it occurred so long ago,
affects not only the prior year of 20X8, but the year before this prior year (20X7).
Valentino Ltd
Note Retained
Earnings
C
Balance: 1 January 20X8 - restated 442 000 + 560 000 1 002 000
- as previously reported Given 442 000
- correction of material error Note 5 560 000
Total comprehensive income: Revised statement of comprehensive income 51 000
restated
Balance: 1 January 20X9 - restated (605 000 + 448 000) 1053 000
- as previously reported Given: 442 000 + 163 000 605 000
- correction of material error Note 5 448 000
Total comprehensive income Revised statement of comprehensive income 65 400
Balance: 31 December 20X9 1 118 400
Comment:
The closing retained earnings in 20X9, the current year, must not be broken down into:
This is because the retained earnings balance at the end of 20X9 had never been reported before.
Chapter 26 1123

Valentino Ltd
20X9 20X8
C C
Restated
Profit before tax 20X8: 245 000 − 160 000 * 72 000 85 000
20X9 : 200 000 – 128 000 *
Income tax expense 20X8: 82 000 − 48 000 * (6 600) (34 000)
20X9:45 000 – 38 400
* these adjustments could be taken either from your note or from your journals
Valentino Ltd
5. Correction of error
During 20X7, A specialised machine costing C1 000 000 was incorrectly expensed as a special
marketing fee. As a result no depreciation on the machine was processed.
The effect of the correction is as follows:
Effect on the statement of comprehensive income 20X8
Increase/ (decrease) in expenses or losses C
- Depreciation (1 000 000 – 200 000) x 20% 160 000
- Income tax expense 160 000 x 30% (48 000)
- Profit for the year 112 000
Effect on the statement of financial position 20X8 20X7
Increase/ (decrease) in assets C C
- Property, plant and 20X7: 1 000K – 200K 640 000 800 000
equipment
20X8: 800K – 160K
- Current taxation payable 20X7: W1: (1 000K – 200K) x 30% (180 000) (240 000)
20X8:W1: ( 1 000K – 200Kx2yrs) x 30%
- Deferred taxation liability 20X7: W2 (12 000) 0
20X8: W2/ Jnls
- Retained earnings (448 000) (560 000)
0 0
Comment:
Please notice that the effect of an error on the statement of comprehensive income only shows:
the effect on the prior year: 20X8 (the effect on the current year is not shown).
Please also note that the effect of an error on the statement of financial position must show both:
the effect on the prior year: 20X8; and
the effect on the year before the prior year: 20X7 (restatements need two comparative years).
Please also notice that the figures in the statement of position are compounded. This is because
the statement of financial position reflects balances. Therefore, whatever adjustment is made to a
balance in 20X7 will also affect the balance in 20X8 (because the revised closing balance in 20X7
is carried forward into 20X8).
1124 Chapter 26
6. Summary
Plan your answer: identify which of the above three areas are being examined and then
prepare a skeleton answer as follows (depending on the ‘required section’!):
Correction of
Change in AP Change in AE
PPE
Statement of comprehensive income:
- Head up PY: ‘restated’ 9 9 N/A
- Disclosure on face N/A N/A N/A
Statement of changes in equity:

- reconciliation of opening retained 9 9 N/A
earnings
- profit for the prior year ‘restated’ 9 9 N/A
Statement of financial position:

- Include figures for year prior to the
prior year 9 9 N/A
- Head up PY columns: ‘restated’ 9 9 N/A
Notes:
- Brief description of ‘what’ 9 9 9
- Explanation of ‘why’ N/A 9 N/A
- Comparatives are restated 9 9 N/A
- Effect on each line item of the
financial statements (including basic
and diluted earnings per share,
where these are provided):
- current year N/A 9 9
- prior year 9 9 N/A
- year before prior year 9 9 N/A
- future years N/A N/A 9
- Effect on opening retained earnings:
- current year 9 9 N/A
- prior year 9 9 N/A
Legend (abbreviations used):

PPE: errors occurring in a prior period that are material
AP: accounting policy
AE: accounting estimate
Chapter 26 1125
Gripping GAAP Statement of Cash Flows
Chapter 27
Statement of Cash Flows
Reference: IAS 7 (including amendments to 31 December 2014)
Contents: Page
2. Presenting cash flows 1128
2.1 Overview 1128
2.2 The two methods of presentation direct and indirect methods 1129
2.2.1 Direct method 1130
2.2.2 Indirect method 1130
3. Calculating cash flows 1131
3.1 Overview 1131
3.2 Movements in working capital 1131
Example 1: Movements in working capital: cash received from customers 1131
Example 2: Movements in working capital: cash paid for inventory 1132
3.3 Non cash flow items 1133
Example 3: Non-cash flow items: depreciation and profit on sale 1134
3.4 Single transactions that are split into more than one cash flow 1134
3.5 Items requiring separate disclosure 1134
Example 4: Calculating cash flows 1134
Example 5: Disclosing cash flows – direct method 1140
Example 6: Disclosing cash flows – indirect method 1141
4. Netting off cash inflows and cash outflows 1141
Example 7: Cash flows to be netted off 1142
Example 8: Cash flows relating to borrowings 1142
5. Cash and cash equivalents 1142
5.1 What is a ‘cash equivalent’? 1142
Example 9: Bank overdrafts 1143
5.2 Disclosure specific to cash and cash equivalents 1144
Example 10: Cash and cash equivalent disclosure 1144
Example 11: Restricted use of cash 1144
6. Interest, dividends and taxation 1145
6.1 Interest and dividends 1145
6.2 Taxation on income 1145
7. Foreign currency 1146
7.1 Foreign currency cash flows 1146
Example 12: Foreign cash flows can be converted at average rates 1146
7.2 Foreign currency cash and cash equivalent balances 1146
Example 13: Foreign currency cash and cash equivalent balances 1147
8. Non-cash flow transactions 1147
Example 14: Purchase of asset by finance lease 1147
9. Miscellaneous issues 1148
9.1 Overview 1148
9.2 Construction of plant with the capitalisation of borrowing costs 1149
Example 15: Self-constructed plant with capitalisation of borrowing costs 1149
9.3 Finance lease from the perspective of a lessee 1150
Example 16: Finance lease 1150
9.4 Finance lease from the perspective of a lessor 1151
1126 Chapter 27

9.5 Operating leases from the perspective of a lessee and lessor 1151
9.6 Sale and operating leaseback from the perspective of a lessee and lessor 1151
9.7 Transactions involving shares and debentures 1151
9.7.1 Overview 1151
9.7.2 Share buy-backs 1151
9.7.3 Issues of shares for cash 1152
9.7.4 Issues of shares that do not involve cash 1152
9.7.5 Redemption of preference shares or debentures 1152
9.7.6 Conversion of preference shares or debentures 1152
9.7.7 Dividends 1152
Example 17: Share transactions 1152
9.8 Changes in accounting policy and corrections of prior period errors 1153
10. Presentation and disclosure 1153
10.1 Compulsory presentation and disclosure 1153
10.2 Encouraged disclosure 1154
10.2.1 Sample presentation of a statement of cash flows 1155
11. Summary 1157
Chapter 27 1127
1. Introduction
The Statement of Cash Flows is one of the 5 financial Cash is defined as :

statements that constitute a ‘set of annual financial cash on hand; and
statements’ according to IAS 1. demand deposits. IAS 7.6
The statement of cash flows is essentially an analysis of the entity’s bank account (and any
other account so closely aligned to cash that it meets the Cash equivalents are defined
definition of a ‘cash equivalent’). as:
short term, highly liquid
The purpose of the statement of cash flows is to add to the investments that; are
usefulness of the financial statements by classifying the readily convertible to known
cash inflows and cash outflows for the period into the amounts of cash and which are;
three main areas of a business: subject to an insignificant risk of
changes in value. IAS 7.6
Financing activities.
Cash flows are defined as:
There are numerous benefits to be derived from preparing inflows and outflows of;
a statement of cash flows, these are discussed below. cash and cash equivalents. IAS 7.6
See IAS 7.4-.5

Benefits of preparing a statement of cash flows
The statement of cash flows provides additional useful information, especially with regard to
the assessment of liquidity.
Statements of cash flows help identify the main source of cash and the main uses thereof.
The subjectivity and judgment that is inherent in the other financial statements does not influence the
information contained in a statement of cash flows. For instance the use of different accounting policies,
estimating the rates of depreciation and deciding whether to revalue non-current assets or not makes the
statement of comprehensive income and statement of financial position prone to subjectivity and
judgment.
The lack of subjectivity and judgment in a statement of cash flows allows for more reliable comparisons
to be made.
Statements of cash flows enable the careful monitoring of cash movements and cash budgetary
requirements.
Records of existing cash flow patterns will be available to help predict future cash flows. This is
important as the value of the entity is reflected by the present value of its future cash flows.
Drawback of relying only on a statement of cash flows

Cash flows are volatile and may be influenced by external factors such as upswings and downswings in the
economy and may therefore not always be able to be used to reliably predict future cash flows.
2. Presenting Cash Flows (IAS 7.10 – 7.21)
2.1 Overview
The general format of the statement of cash flows, shown overleaf, involves the analysis of
the movement in and out of the entity’s cash (bank) account into three areas of activity,
namely operating activities, investing activities and financing activities.
In some cases, the entity may have other accounts that closely resemble cash. These are
referred to as cash equivalents. An example of this is a 2 month fixed deposit. Where you
have both cash and a cash equivalent, these accounts must be added together. This means that
the statement of cash flows will then reflect an analysis of the movements in and out of the
entity’s combined cash and cash equivalent accounts.
1128 Chapter 27
The following is a basic outline of the statement of cash flows. Inflows of cash are shown
without brackets (positive) whereas outflows are shown in brackets (negative).
Company name
Note 20X2
C
Cash flows from operating activities 1 000
Cash flows from investing activities (2000)
Cash flows from financing activities 5 000
Net cash (outflow)/ inflow 4 000
Cash and cash equivalents: opening balance (per statement of financial position) 1 500
Cash and cash equivalents: closing balance (per statement of financial position) 5 500
Cash flows from operating activities are those that result Operating activities are
from the main activities that generate revenue for the defined as:
entity and any other activity that does not meet the principle revenue producing
definition of an investing or financing activity. Since activities;
operating activities are generally those that are involved and other activities that are not
with generating revenue, the related transactions are investing or financing activities.
IAS 7.6
generally those that are recognised in profit or loss. There
are exceptions, however, such as a profit on sale of plant which, although included in the
calculation of profit or loss, is not considered to be an operating activity but an investing
activity instead (this is because the intention of the original cash outflow was to invest in a
plant and not to immediately generate revenue).
Cash flows from investing activities are those that involve Investing activities are
buying and selling long term assets. They reflect how defined as:
much of the entity’s cash was invested with the purpose the acquisition and disposal of long
of generating future cash flows. An outflow must result term assets; and
in an asset being recognised in the statement of financial other investments not included in
position, for it to be classified as an investing activity. cash equivalents. IAS 7.6
Example illustrating investing activities:

The cash outflow to purchase an additional plant would be classified as an investing activity
since the outflow is recognised as an asset. The outflow relating to the cost of maintaining
this plant, however, is expensed and would thus not be classified as an investing activity (but rather an
operating activity). The cash inflow from the sale of an old plant that had previously been recognised
as an asset would also be classified as an investing activity.
Cash flows from financing activities are those that

Financing activities result in:
involve the entity’s equity and borrowings. The net cash
flows from financing activities reflect to what extent third changes in size;
parties may make claims on the cash resources of the composition of the contributed
equity and;
entity. borrowings of the entity. IAS 7.6
2.2 The two methods of presentation: direct and indirect methods (IAS 7.18 and 7.19)
IAS 7 (the standard covering ‘Statements of Cash Flows) allows for two different methods to
be used in presenting the cash flows of an entity:
the direct method; and
the indirect method.
Chapter 27 1129
The direct method and indirect method differ only with respect to the presentation of the 'cash
generated from operations', which is a line item found under the heading ‘cash effects of
operating activities’. In other words, the presentation of all other aspects of the statement of
cash flows will be identical no matter whether you used the direct method or indirect method
and the same amount will be calculated for ‘cash generated from operations’.
The direct method involves presenting the calculation of cash generated from operations by
calculating and presenting the: Direct & indirect methods
cash receipts from customers and are methods of presenting:
cash paid to suppliers and employees. cash generated from operations.
The direct method presents:
The indirect method involves presenting the calculation cash receipts from customers and
of cash generated from operations by presenting a cash paid to suppliers & employees;
reconciliation that converts: The indirect method presents a
the profit before tax line item (from the SOCI) into reconciliation between:
the cash generated from operations. profit before tax and
cash generated from operations.
The conversion of profit before tax into the cash generated from operations involves:
reversing income and expense items that are non-cash flow items (e.g. depreciation); and
reversing income and expense items whose related Which method do I choose?
cash flows must be separately disclosed (e.g. interest IAS 7 allows both methods to
expense must be converted to interest paid and be used; it encourages the use
separately disclosed); and of the direct method, since this
adjusting it for changes in working capital balances method involves extra disclosure of
useful information (i.e. ‘cash receipts
(e.g. deducting an increase in the accounts receivable from customers’ and ‘cash paid to
balances during the year). suppliers and employees).
The effect that these two methods have on the layout of the statement of cash flows is shown
below, with the areas that differ being highlighted.
2.2.1 Direct method
Company name
For the year ended 31 December 20X2 (direct method) (extracts)
Note 20X2
Cash flows from operating activities (extracts) C
Cash receipts from customers XXX
Cash paid to suppliers and employees (XXX)
Cash generated from operations . XXX
2.2.2 Indirect method

Company name
For the year ended 31 December 20X2 (indirect method) (extracts)
Note 20X2
Cash flows from operating activities (extracts) C
Profit before taxation XXX
Adjustments for:
Depreciation XXX
Foreign exchange loss XXX
Investment income (XXX)
Interest expense XXX
Operating profit before working capital changes XXX
Working capital changes (XXX)
Increase in trade and other receivables (XXX)
Decrease in inventories XXX
Decrease in trade payables (XXX)
Cash generated from operations XXX
1130 Chapter 27
3. Calculating Cash Flows
3.1 Overview
The easiest way to calculate the amounts included in the statement of cash flows, is to
reconstruct the ledger accounts. For this to be done, you will generally need the current year
statement of financial position (with its comparative figures), the current year’s statement of
comprehensive income, additional information and/ or the statement of changes in equity.
When calculating cash flows to be included in the statement of cash flows, we will often be
required to convert an item recognised on the accrual basis to an item recognised on the cash
basis (e.g. converting revenue into cash received from customers). When we do these
conversions, we will need to make adjustments for changes in working capital balances (e.g.
the balances on trade accounts receivable, expense prepaid accounts etc).
Quick Tip: Recreate the
We will also need to be on the lookout for and make relevant ledger account(s)
adjustments where necessary for non-cash flow items in order to balance back to
such as depreciation and impairments of assets. the amount that is the cash flow.
When we choose to present our statement of cash flows on the indirect method, we would
need to convert our profit before tax into the cash generated from operations line-item. In this
case, we would need to adjust this profit not only for working capital changes and non-cash
flow items but also for income and expense items which, once converted into cash flows,
need to be disclosed separately after the cash generated from operations line-item.
3.2 Movements in working capital

An entity’s working capital refers to its current assets and current liabilities. When we
convert income and expense items into cash flows, we need to remember that we are
converting items that were recognised on the accrual basis into items recognised on the cash
basis. Thus when we convert these income and expense accounts into cash amounts, we need
to remove the effects of selling and buying on credit (i.e. an income or expense would be
recognised even if it was not a cash flow). For example, when we convert the revenue line-
item (an income in the SOCI) into the cash receipts from customers line-item (a line-item in
the SOCF) we will need to make adjustments for the change in the related opening and
closing balance of trade accounts receivable (debtors).
Example 1: Movements in working capital: cash received from customers

The following are extracts from Bilbo Limited’s financial statements:
Statement of comprehensive income: Revenue is C100 000.
Statement of financial position: Trade receivable balances:
- Opening balance: C50 000
- Closing balance: C110 000
Required:
Calculate ‘cash receipts from customers’ to be disclosed in the ‘direct method statement of cash flows’.
Solution 1: Movements in working capital: cash received from customers

In order to convert the revenue line-item (from the SOCI) into the cash receipts from customers line-
item (in the SOCF presented on the direct method), we will need to be able to reconstruct the trade
receivables account (i.e. debtors):
Trade receivables
Opening balance 50 000 Bank (balancing) 40 000
Revenue 100 000 Closing balance 110 000
150 000 150 000
Balance b/f 110 000
By reconstructing this account, we can balance bank to the cash received from our customers: C40 000.
Chapter 27 1131
Alternative calculation:
Instead of reconstructing the ledger account, the cash received from customers could have been
calculated using the following calculation instead: C
Revenue Given: from the statement of comprehensive income 100 000
Less increase in trade receivables C/bal: 110 000 – O/bal: 50 000 (60 000)
Cash receipts from customers Balancing: used in the SOCF as the cash receipts from customers 40 000
Comment:
The C60 000 increase in the trade receivables balance is deducted as if it was an outflow of cash.
To understand this, imagine what the cash inflow would have been if all the revenue had been
earned on a cash basis (i.e. if we had not offered credit to our customers). If we had not offered
credit, then the cash received would have been C100 000. However, as you can see, the cash
inflow from customers was only C40 000. The reason for this is that during the year, our trade
accounts receivable balance increase by C60 000. This means that, of the revenue of C100 000,
C60 000 was revenue generated on credit. Thus, by selling on credit, we have effectively delayed
C60 000 of the C100 000 that would otherwise have been a cash inflow.
Similarly, certain cash flows will not be reflected in the SOCI but in the SOFP. For example,
inventory purchases that are recorded on the perpetual system would not be reflected as an
expense if they are still on hand at year-end and yet these purchases may have been partially
or entirely cash purchases and should thus be reflected in the SOCF. Thus, when we calculate
the cash payments made to suppliers in respect of inventory purchases, we are not calculating
the related cash flow using the cost of sales expense and the related trade accounts payables
balances, but we must also remember to adjust for the movements in the opening and closing
balances of inventory.
Example 2: Movements in working capital: cash paid for inventory
The following are extracts from Baggins Limited’s financial statements:
Statement of comprehensive income: Cost of sales is C50 000.
Statement of financial position: Trade payables balances:
Statement of financial position: Inventory balances:
Required:
Calculate the cash paid for inventory to be included in ‘cash payments to suppliers and employees’.
Solution 2: Movements in working capital: cash paid for inventory

In order to convert the cost of sales line-item (from the SOCI) into the cash paid for inventory to be
included as part of the cash payments to suppliers and employees line-item (in the SOCF presented on
the direct method), we will need to be able to reconstruct the trade payables account (i.e. creditors) as
well as the inventory account:
Inventory
Opening balance 30 000 Cost of sales 50 000
Trade payables (balancing) 80 000 Closing balance 60 000
110 000 110 000
Balance b/f 60 000
Trade payables
Bank (balancing) 100 000 Opening balance 40 000
Closing balance 20 000 Inventory 80 000
120 000 120 000
Balance b/f 20 000
By reconstructing these accounts, we balance bank to the cash paid to the suppliers of inventory:
C100 000.
Alternative calculation:
1132 Chapter 27
Instead of reconstructing the ledger account, the cash paid to the suppliers of inventory could have been
calculated using the following calculation instead: C
Cost of sales Given: from the statement of comprehensive income 50 000
Add increase in inventory C/bal: 60 000 – O/bal: 30 000 30 000
Add decrease in trade payables C/bal: 20 000 – O/bal: 40 000 20 000
Cash paid to suppliers of inventory Balancing 100 000
Comment:
The cash paid to suppliers of inventory would be just part of the line item called ‘cash paid to
suppliers and employees’. Other suppliers include suppliers of electricity, water, labour etc. The
same principles of calculating the cash flow by removing the changes in the working capital
balances would apply equally when converting these expenses (electricity, water, wages etc).
3.3 Non-cash flow items

When reconstructing ledger accounts or when converting a profit figure into a cash flow, we
need to be on the look-out for non-cash flow items that will need to be reversed. Non-cash
flow items include things such as depreciation, impairments of assets and profits on sale of
Example 3: Non-cash flow items: depreciation and profit on sale

The following are extracts from Gandalf Limited’s financial statements:
Statement of comprehensive income: Depreciation is C10 000.
Statement of comprehensive income: Profit on sale of plant: C5 000.
Statement of financial position: Plant cost:
Statement of financial position: Plant accumulated depreciation:
- Closing balance: 68 000
Additional information: plant with a cost of C12 000 was sold during the year.
Required:
Calculate the cash flows relating to plant
Solution 3: Movements in working capital: depreciation and profit on sale

In order to calculate any cash flows relating to plant we need to remember that the reconstruction of the
plant account involves the non-cash flow item of depreciation and any profit or loss on sale of plant.
By reconstructing all the related accounts and removing the non-cash flow items, you will find that
there were two cash flows relating to the plant: one was a cash inflow from the sale of a plant of
C15 000 and the other was a cash outflow of C62 000 relating to the purchase of a plant.
Plant: cost
Opening balance 100 000 Asset disposal (given) 12 000
Bank (balancing) 62 000 Closing balance 150 000
162 000 162 000
Balance b/f 150 000
Plant: accumulated depreciation

Asset disposal (balancing) 2 000 Opening balance (given) 60 000
Closing balance (given) 68 000 Depreciation (given) 10 000
70 000 70 000
Balance b/f 68 000
Asset disposal: profit on sale

Plant: cost (given) 12 000 Plant: acc depr (see AD account) 2 000
Total c/f 5 000 Bank (balancing) 15 000
17 000 17 000
Total b/f (given: profit on sale) 5 000
Chapter 27 1133
3.4 Single transactions that are split into more than one cash flow (IAS 7.12)
Certain transactions involve cash flows that are classified under more than one activity. For
example, a cash payment to settle or partly settle a loan would typically include both interest
and capital. The payment of interest would be classified as an operating activity and yet the
repayment of capital would be classified as a financing activity.
3.5 Items requiring separate disclosure (IAS 7.31 and IAS 7.35)
Cash flows relating to interest, dividends and tax must be disclosed separately. This is
discussed in more detail in section 6.
However, it is important to remember this because interest income, interest expense and
dividend income may be included in the profit before tax. This will affect your calculations
whether you are using the indirect or direct method, for example:
indirect method: when converting profit before tax into cash generated from operations,
we will not only need to reverse non-cash items (e.g. depreciation) and movements in
working capital (e.g. the difference between the opening and closing balance in the trade
receivable accounts), but will also need to reverse any interest income, interest expense
and dividend income that may be included in the profit before tax line-item.
Direct method: when converting revenue into cash receipts from customers, we will need
to exclude any interest income that may have been classified as revenue in the SOCI and
similarly, when converting expenses into the cash payments to suppliers and employees,
we must exclude any interest and tax expenses since these would not form part of the cash
payments to suppliers and employees line item.
Example 4: Calculating cash flows

The inexperienced junior accountant of Baggins Limited has been unable to calculate the
relevant cash flows in order to prepare a statement of cash flows. You have been asked
to assist him in this regard. He has provided you with some notes and the statement of
comprehensive income and statement of financial position:
Notes:
1. Profit before tax includes: sales of C800 000, cost of sales of C350 000, profit on sale of plant
of C10 000, total depreciation of C50 000, an impairment loss on vehicles of C10 000 and other
operating, distribution and administration costs of C60 000 and finance charges of C20 000.
2. One item of plant, with a carrying amount of C80 000 was sold during the year. All purchases
and sales were paid for in cash.
3. There was a capitalisation issue (market price of C10 000) during 20X2 utilising retained
earnings. There was a further issue of ordinary shares during 20X2 at a market price of C4 each.
4. A loan of C20 000 was repaid to Gocha Bank in 20X2. No other repayments were made.
5. Dividends of C40 000 were declared during the year.
Baggins Limited
For the year ended 31 December 20X2 (extract)
20X2
C
Profit before tax (see note 1) 320 000
Profit for the year (see note 5) 210 000
Other comprehensive income for the year 0
Total comprehensive income for the year 210 000
1134 Chapter 27
Baggins Limited
20X2 20X1
C C
ASSETS 670 000 450 000
Property, plant and equipment (see note 2) 350 000 300 000
Trade receivables 40 000 30 000
Expense prepaid 8 000 10 000
Inventory 120 000 100 000
Bank 152 000 10 000
EQUITY AND LIABILITIES 670 000 450 000
Share capital (see note 3) 90 000 60 000
Loans (see note 4) 60 000 50 000
Shareholders for dividends 30 000 2 000
Expenses payable 5 000 6 000
Trade payables 10 000 20 000
Current tax payable: normal income tax 15 000 12 000
Required:
Ignoring deferred tax, calculate as many cash flows as is possible from the information presented.
Solution 4: Calculating cash flows

C
Cash receipts from customers W1 790 000
Cash payments to suppliers & employees W2: C380 000 + C59 000 439 000
Interest paid W3 20 000
Plant purchased for cash W4 190 000
Plant sold for cash W4 90 000
Proceeds from share issue W5 20 000
Loan repaid W6 20 000
Loan raised W6 30 000
Tax paid W7 107 000
Dividends paid W8 12 000
W1: Cash receipts from customers: debtors and sales
In order to convert the sales figure, (which is part of the profit before tax in the statement of
comprehensive income), into a cash amount to be shown in the statement of cash flows using the direct
method: ‘cash receipts from customers’, one must reconstruct the trade receivables account:
Trade receivables (A)
Opening balance (1) 30 000 Bank (4) 790 000
Revenue(2) 800 000 Bad debts (3) 0
Closing balance (1) 40 000
830 000 830 000
Balance b/f (1) 40 000
Revenue (I)
(2)
Trade receivables 800 000
Bank
Trade receivables (4) 790 000
The steps followed (numbered above) are:
(1) Fill in the opening and closing balances per the statement of financial position.
(2) Insert the revenue figure into the trade receivables account (given in the additional information).
(3) Insert the bad debts figure into the trade receivables account: since no information was given, this
was assumed to be zero.
(4) Balance the trade receivables account to the amount received during the year.
Chapter 27 1135

W2: Cash paid to suppliers & employees: creditors, inventory, cost of sale & other expenses
The line item ‘cash paid to suppliers and employees’ includes payments for wages and salaries
(payments to employees) and payments for many other supplies (payments to suppliers: for example,
inventory purchased, electricity, telephone and water used etc). The calculation thereof will therefore
include numerous accounts, including inventory, trade payables and cost of sales:
Inventory (A)
Opening balance (1) 100 000 Cost of sales (given) (2) 350 000
Trade payables (3) 370 000 Closing balance (1) 120 000
470 000 470 000
Balance b/f (1) 120 000
Trade payables (L)
Bank (4) 380 000 Opening balance (1) 20 000
Closing balance (1) 10 000 Inventory (3) 370 000
390 000 390 000

Cost of sales
(2)
Inventory 350 000
Bank
Trade payables (4) 380 000
(2) Insert the cost of sales figure into the inventory account.
(3) Balance the inventory account to the value of inventory purchased: insert this entire amount into the
trade payables account. It makes no difference if some of the purchases were paid for in cash: by taking
the movement in the opening and closing balance of the trade accounts payable account, we will
balance to the amount paid in cash.
(4) Balance the trade payables account to the amount paid during the year.
Payments to other suppliers and employees may be calculated by reconstructing the other expenses and
related accrual accounts in the balance sheet.
Expenses prepaid (A)
Opening balance (1) 10 000 Expenses (2) 10 000
(4)
Expenses 8 000 Closing balance c/f 8 000
18 000 18 000
Balance b/f 8 000
Expenses payable (L)
Expenses (3) 6 000 Opening balance (1) 6 000
Closing balance c/f 5 000 Expenses (5) 5 000
11 000 11 000
Balance b/f 5 000
Operating, distribution and administration expenses (E)
Expenses prepaid o/ balance(2) 10 000 Expenses prepaid c/balance (4) 8 000
(5)
Expenses payable c/ balance 5 000 Expenses payable o/balance (3) 6 000
(7)
Bank 59 000 Profit or loss (6) 60 000
74 000 74 000
Bank
O, D & A expenses (7) 59 000
(1) Fill in the opening balances per the statement of financial position
(2) Reverse the opening balance of expenses prepaid to the expense account
(3) Reverse the opening balance of expenses payable to the expense account
(4) Insert closing balance of expense prepaid by crediting the expense account
(5) Insert closing balance of expense payable by debiting the expense account
(6) Insert total expenses taken to the statement of comprehensive income
(7) Balance back to the amount paid for in cash
1136 Chapter 27

The total paid to suppliers and employees will therefore be: C
Cash paid to suppliers of inventory 380 000
Cash paid to employees and other suppliers 59 000
439 000
W3: Interest prepaid and interest expense (interest paid)
Interest expense
Bank (3) 20 000 Profit or loss (2) 20 000
20 000 20 000
Bank
Interest expense (3) 20 000

(1) Fill in the opening and closing balances of interest prepaid or interest payable per the statement of
financial position. There were no such balances in this example, but the same principles as those
used when calculating the amount paid to suppliers and employees are applied here (W2).
(2) Fill in the related expense per the statement of comprehensive income.
(3) Balance to the amount paid in cash (since there was no interest payable or prepaid at either the
beginning or end of the year, the actual interest expense must have been paid ).
W4: Property plant and equipment and depreciation (plant purchased or sold for cash)
Plant (carrying amount)
Opening balance (1) 300 000 Depreciation (per SOCI) (2) 50 000
Impairments (per SOCI) (2) 10 000
Asset disposal (given) (3) 80 000
Bank (4) 190 000 Closing balance (1) 350 000
490 000 490 000
Balance b/f (1) 350 000
Depreciation expense
PPE (per SOCI) (2) 50 000
Impairment expense
PPE (per SOCI) (2) 10 000
Asset disposal: profit on sale

Plant (carrying amount) (given) (3) 80 000 Bank (6) 90 000
Profit and loss (5) 10 000
90 000 90 000
Bank
Asset disposal (6) 90 000 Plant: cost (4) 190 000

(1) Fill in the opening and closing balances per the statement of financial position
(2) Fill in the related depreciation and impairment expenses per the statement of comprehensive
income
(3) Fill in the carrying amount of the disposals
(4) Balance the PPE account back to the purchases (either the disposals figure or the purchases figure
will need to be known and the remaining unknown figure will be the balancing figure: this
question gave the disposals figure, but not the purchases figure)
(5) Insert profit on sale of plant
(6) Balance the Asset disposal account back to the proceeds received on disposal
Chapter 27 1137

W5: Share capital (proceeds from share issue)
Share capital
Opening balance (1) 60 000
Issue – retained earnings (2) 10 000
Closing balance (1) 90 000 Issue – bank (3) 20 000
90 000 90 000
Retained earnings
Share capital (2) 10 000 Opening balance (1) 300 000
Dividends declared 40 000
Closing balance (1) 460 000 Profit or loss 210 000
510 000 510 000
Balance b/f (1) 460 000
Bank
Share capital (3) 20 000

(1) Fill in the opening and closing balances per the statement of financial position
(2) Insert the capitalisation issue and any other issue not for cash (C10 000: given - at market price)
(3) Balance to the share movements made for cash.
W6: Liabilities (liabilities raised and liabilities repaid)

Liabilities
Repaying of loan – bank (2) 20 000 Opening balance (1) 50 000
Closing balance (1) 60 000 Raising of a loan – bank (2) 30 000
80 000 80 000
Bank
(2)
Liabilities - raised. 30 000 Liabilities – repaid (2) 20 000

(2) Either the repayment or the raising of any liability would need to be known (in this case, the
repayments were given as C20 000 in which case the amount of the loans raised is the balancing
figure).
W7: Current tax payable and Income tax expense
Current tax payable: income tax (L)
Closing balance (1) 15 000 Income tax expense (E) (3) 110 000
122 000 122 000
(3)
Current tax payable: income tax 110 000 Deferred taxation (3) 0
Profit or loss (2) 110 000
110 000 110 000
Bank
Current tax payable: income tax (4) 107 000
1138 Chapter 27

(2) Insert the income tax expense per the statement of comprehensive income.
(3) Balance the income tax expense account in order to calculate the current tax charge in the
statement of comprehensive income and insert this into the current tax payable account. In this
example we were told to ignore deferred tax and therefore the entire income tax expense is the tax
owing to the tax authorities in respect of the current year. Please note, however, that if deferred
tax was not ignored, it is important to remember to separate the deferred tax into its elements that
relate to ‘profit or loss’ and those that relate to ‘other comprehensive income’. The amount
relating to ‘other comprehensive income’ will not be included in the tax expense ledger account.
(4) Balance the current tax payable account to the amount paid to the tax authorities.
W8: Shareholders for dividends and dividends declared

Shareholder for dividends (L)
Closing balance (3) 30 000 Dividends declared (2) 40 000
42 000 42 000
Dividends declared (equity distribution)

(2)
Shareholders for dividends 40 000
Bank
Shareholders for dividends (4) 12 000

(1) Fill in the opening balances.
(2) Insert the dividend/s declared for the year (crediting shareholders for dividends).Dividends
declared will appear in the Statement of Changes in Equity.
(3) Insert closing balance.
(4) Balance back to the amount paid for in cash.
W9: Retained earnings account

If not yet already done, it is a useful check to reconstruct the retained earnings account (which is
generally the last remaining account in the statement of financial position to be reconstructed). This
ledger account obviously does not reveal any further cash flows but it is useful to reconstruct it simply
to ensure that all movements have been reconciled for and that we haven’t forgotten some aspect.
Retained earnings
Share capital (3) 10 000 Opening balance (1) 300 000
Dividends (3) 40 000 Profit and loss account (2) 210 000
Transfers (3) 0
Closing balance (1) 460 000
510 000 510 000
Balance b/f (1) 470 000

(2) The profit for the year will be transferred to the retained earnings account at year-end.
(3) Dividends paid to shareholders, capitalisation issues and transfers to other reserve accounts
would need to be adjusted for, although, in this example there were no transfers. The retained
earnings account is in balance.
Chapter 27 1139
Example 5: Disclosing cash flows – direct method

Use the same information as that provided in example 2.
Required: Disclose the statement of cash flows using the direct method.
Solution 5: Disclosing cash flows – direct method
Company name
For the year ended 31 December 20X2 (direct method)
Calculation per 20X2
example 1 C
Cash receipts from customers W1 790 000
Cash paid to suppliers and employees (see comment 1) W2 (439 000)
Cash generated from operations 351 000
Interest paid W3 (20 000)
Dividends paid W8 (12 000)
Normal tax paid W7 (107 000)
Cash flows from investing activities (100 000)

Disposal of plant W4 90 000
Additions to plant - replacement W4 (190 000)

Loans repaid W6 (20 000)
Proceeds from loans raised W6 30 000
Cash and cash equivalents: opening balance (per SOFP) 10 000
Cash and cash equivalents: closing balance (per SOFP) 152 000
Comment 1:
‘Cash paid to suppliers and employees’ is made up of numerous operating payments such as the
payment of electricity, water, telephone, wages and salaries as well as the payment to trade creditors
for the purchase of inventory.
Although you can reconstruct each of these accounts and thus balance back to the related cash
payments, add them together to get the total ‘cash payments to suppliers and employees’, you may
prefer to convert ‘profit before tax’ to ‘cash generated from operations’ as is done when using the
indirect method (where this reconciliation would be shown as one of your workings instead of on the
face of the Statement of Cash Flows) and then balance back to the ‘cash paid to suppliers and
employees’: 790 000 – 351 000 = 439 000.
However, although this may be quicker, this approach should be used with caution in an exam situation
since marks may be attached to calculations showing the reconstruction of account making up cash
paid to suppliers and employees. Check with your lecturer before using this approach!
Comment 2:
The working capital changes must be taken into account in converting the profit figure into a cash
amount (e.g. conversion of ‘sales’ into ‘cash received from sales’ involves reconstructing the trade
receivables balance and eliminating the opening and closing balance).
Comment 3:
In order to check yourself, the sum of the cash flows from operating, investing and financing activities
should equal the net cash flows from cash and cash equivalents.
1140 Chapter 27
Example 6: Disclosing cash flows – indirect method

Assume the same information as that provided in example 2.
Required: Disclose the statement of cash flows using the indirect method
Solution 6: Disclosing cash flows – indirect method
Company name
For the year ended 31 December 20X2 (indirect method)
Calculation per 20X2
example 1 C
Adjustments for:
Depreciation 50 000
Profit on sale of plant (10 000)
Interest expense 20 000
Operating profit before working capital changes 390 000
Working capital changes (39 000)
Increase in trade and other receivables and prepayments (8 000)
Increase in inventories (20 000)
Decrease in trade and other payables (11 000)
Interest paid W3 (20 000)
Normal tax paid W7 (107 000)
Cash flows from investing activities (100 000)

Disposal of plant W4 90 000
Additions to plant - replacements W4 (190 000)

Loans repaid W6 (20 000)
Proceeds from loans raised W6 30 000

Cash and cash equivalents: opening balance (per SOFP) 10 000
Cash and cash equivalents: closing balance (per SOFP) 152 000
4. Netting Off Cash Inflows and Cash Outflows (IAS 7.22 - .24)
Cash flows are generally disclosed on a gross basis. In certain instances, however, cash flows
may be disclosed on a net basis. These instances are as follows:
The cash receipt and cash payment is on behalf of customers and the cash flows reflect
the activities of the customers rather than the activities of the reporting entity, for
example: rent income collected and paid over to the property-owners (landlords).
The cash receipt and cash payment are in respect of items that are turned over quickly, the
amounts are large and the maturity periods are short, for example:
the frequent purchase and re-sale of large investments; and
raising and repaying short-term borrowings with maturity periods of 3 months or less.
Chapter 27 1141
Example 7: Cash flows to be netted off

An estate agent collects C10 000 rent from a tenant and pays the client (the landlord)
C9 000 after deducting commissions of C1 000 for overseeing the rental agreement.
Required: Calculate the cash flows to be disclosed.
Solution 7: Cash flows to be netted off

Although cash of 10 000 was received and cash of 9 000 was paid, only the net cash receipt of 1 000
needs to be disclosed in the statement of cash flows since the receipt and payment of the 9 000 was on
behalf of a third party, the landlord.
Example 8: Cash flows relating to borrowings

A company raised and repaid two loans during 20X2:
a loan of C100 000: repaid within three months of receipt
a loan of C150 000: repaid within nine months of receipt.
Required: Disclose the above in the statement of cash flows.
Solution 8: Cash flows relating to borrowings
Company name
20X2
Financing activities C
Loans raised 150 000
Loans repaid (150 000)
It can be seen from above that the loan of C100 000 (that was raised and repaid within three months)
does not appear at all. This is because the existence of the loan was so short that the receipt and
payment may be set-off against each other.
5. Cash and Cash Equivalents (IAS 7.7 – 7.9)
5.1 What is a ‘cash equivalent’?
A cash equivalent is, in essence, an item that may be readily converted into a known amount
of cash. The two important characteristics of a cash equivalent are that the item must be:
readily convertible Cash equivalents are
defined as:
- this requires that in the case of an investment that
there be a short maturity period (IAS 7 suggests a short term, highly liquid
period of 3 months or less); and investments that are;
readily convertible to known
into a known amount of cash amounts of cash; and
- this means that there must be an insignificant which are subject to an
amount of risk that there will be a change in insignificant risk of changes in
value. value. IAS 7.6
An example of a cash equivalent is a three-month fixed Cash is defined as :
deposit since it meets the criteria above:
convertible back into cash within 3 months cash on hand and;
demand deposits. IAS 7.6
the amount of cash that will be received is known.
It is submitted that a volatile share investment would not be considered a cash equivalent since,
although the shares may be readily converted into cash, the volatility of the market price of the share
means that the amount of cash that it could be converted into is not known.
1142 Chapter 27
It should be noted that bank borrowings normally form part of the financing activities, but a
bank overdraft may, if it is repayable upon demand, be considered to be ‘an integral part of
the entity’s cash management’, (the balance on such an account typically fluctuating between
positive and overdrawn), in which case it would also be treated as a cash equivalent.
Example 9: Bank overdrafts

Prett Limited purchased shares costing C150 000 during its financial year ended
31 December 20X2.
Prett Limited had cash of C100 000 at 1 January 20X2 and at 31 December 20X2 its
cash balance was nil.
In order to finance the entire purchase of shares, a bank overdraft was raised for the
shortfall of C50 000 (Cost of purchase: C150 000 – Cash on hand: C100 000).
There were no other transactions during 20X2 other than those referred to above.
Required: Disclose Prett ’s statement of cash flows for the year ended 31 December 20X2 assuming:
A. The bank overdraft is not repayable upon demand and is not considered to be integral to the
entity’s normal cash management.
B. The bank overdraft is repayable upon demand and is considered to be integral to the entity’s
normal cash management.
Ignore finance charges.
Solution 9A: Bank overdrafts

Where the bank overdraft is not a normal part of the company’s cash management policy, it must be
recorded as a separate financing activity:
Prett Limited
Note 20X2
C
Cash flows from investing activities
Purchase of shares (150 000)
Cash flows from financing activities
Bank overdraft raised 50 000
Cash and cash equivalents: net outflow (100 000)
Cash and cash equivalents: opening balance Cash: 100 000 + CE: 0 100 000
Cash and cash equivalents: closing balance Cash: 0 + CE: 0 0
Solution 9B: Bank overdrafts

Where the bank overdraft is a normal part of the company’s cash management policy, it will be
recorded as part of the cash reserves of the company:
Company name
Note 20X2
Cash flows from investing activities C
Purchase of shares (150 000)
Cash and cash equivalents: net outflow (150 000)
Cash and cash equivalents: opening balance C: 100 000 + CE: 0 100 000
Cash and cash equivalents: closing balance C: 0 + CE: 50 000 (50 000)
C: cash (the cash in bank balance) CE: cash equivalent (the bank overdraft balance)
Chapter 27 1143
5.2 Disclosure specific to cash and cash equivalents (IAS 7.45 – 7.48)
The composition of the cash and cash equivalents balance may need a supporting note that
reconciles, where applicable, the balance of cash and cash equivalents shown in the statement
of financial position to the balance of cash and cash equivalents shown in the statement of
cash flows. Example 10 (below) gives an example of a circumstance wherein the supporting
note is required to be prepared. The policy for determining the composition of cash and cash
equivalents must also be disclosed.
Example 10: Cash and cash equivalent disclosure
Use the same information as that given in part B of the previous example. The statement of
financial position discloses the bank overdraft separately under current liabilities as follows:
Company name
20X2 20X1
Current assets C C
Cash in bank 0 100 000
Current liabilities
Bank overdraft 50 000 0
Required: Prepare a note that discloses the composition of the cash and cash equivalents balance (you
may ignore the policy for determining cash and cash equivalents).
Solution 10: Cash and cash equivalent disclosure
Company name
Notes to the statement of cash flows
For the year ended …. (extracts)
20X2 20X1
23. Cash and cash equivalents C C
Cash and cash equivalents constitutes (50 000) 100 000
Cash in bank 0 100 000
Bank overdraft (50 000) 0
Comment:
This note above was needed for example 9’s Part B because the ‘cash and cash equivalents closing balance’
presented in the statement of cash flows at 31/12/X2 is negative C50 000 but yet the statement of financial
position reflects ‘cash in bank’ as nil – this note effectively reconciles these two amounts
Incidentally, a note reconciling the ‘cash and cash equivalents closing balance’ with the ‘cash in bank’ would
not be required for example 9’s Part A since both these amounts were reflected as nil.
If the entity changed its policy regarding the classification of an item that then results in such
item either:
suddenly being disclosed as a cash or cash equivalent; or
suddenly no longer being disclosed as a cash or cash equivalent;
the above changes should be reported in accordance with IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors.
In the event that a significant part of the cash and cash equivalents balance may not be used
by the reporting entity, this fact, together with management’s comments explaining any
restrictions and the amount affected by the restrictions, must be disclosed.
Example 11: Restricted use of cash
A company owns a branch in a foreign country where exchange controls prevent the use of
the funds by the local reporting entity. At year-end, 31 December 20X2, this branch has
cash of C50 000 (converted into the local reporting currency) and the local branch has cash
of C70 000. The total of C120 000 is disclosed in both the statement of financial position
and the statement of cash flows.
Required : Show the required note disclosure.
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Solution 11: Restricted use of cash

Since there are restrictions on the use of part of the combined cash (C120 000), the following note will
be required:
Company name
Notes to the Statement of cash flows
20X2
23. Cash and cash equivalents C
The cash and cash equivalents is constituted by: 120 000
Unrestricted funds 70 000
Restricted funds 50 000
The restrictions on the use of certain funds are as a result of government imposed exchange
control regulations relevant to the foreign branch.
6. Interest, Dividends and Taxation (IAS 7.31 – 7.36)
6.1 Interest and dividends (IAS 7.31 – 7.34)
Interest received and paid must be separately disclosed (as suggested by the rules for netting
off of receipts and payments, see ‘presenting cash flows on a net basis’). The same applies to
dividends received and paid. It is interesting to note, however, that there is no consensus over
whether these items should be classified as operating, investing or financing activities.
Both interest and dividends paid:

could be disclosed as part of the operating activities on the grounds that interest and
dividends are unavoidable and integral to the operation of the business. Disclosure of the
interest and dividends paid under ‘operating activities’ helps the user to determine the
ability of the entity to pay the interest and dividends out of the cash flowing directly from
operating activities; or
could be disclosed as part of the financing activities (on the grounds that both interest and
dividends could be argued to be the costs of financing the business).
Both interest and dividends received:

could be disclosed as part of the operating activities (on the grounds that both interest and
dividends received form part of the profit or loss and are simply a product of investing
cash that is temporarily surplus to the operating needs of the business); or
could be disclosed as part of the investing activities (on the grounds that both interest and
dividends could be argued to be the return on investments).
Despite the lack of consensus, it seems that the most common treatment is to disclose
dividend and interest receipts and payments as part of the operating activities. The treatment
that is chosen must be applied consistently from year to year.
It is also interesting and important to note that interest paid must be presented as interest paid,
whether the interest was expensed or capitalised in terms IAS 23 Borrowing costs.
6.2 Taxation on income (IAS 7.35 and 7.36)
Where it is possible to calculate the tax effect of a specific transaction, then this tax (paid or
received) should be classified under the same heading that that specific transaction is
classified under (e.g. investing, operating or financing activities). If, however, as is often the
case, the process of calculating the actual tax paid on a specific transaction is impracticable,
then the tax paid should be classified under operating activities instead.
Chapter 27 1145
7. Foreign Currency (IAS 7.25 – 7.28)
7.1 Foreign currency cash flows
Cash flows arising from transactions in a foreign currency shall be recorded in an entity’s
functional currency by applying to the foreign currency amount, the exchange rate between
the functional currency and the foreign currency at the date of the cash flow. However, if this
causes undue effort, an average exchange rate may be used in accordance with IAS 21 The
Effects of Changes in Foreign Exchange Rates.
Unrealised gains and losses arising from changes in foreign currency exchange rates are not
cash flows. However, the effect of exchange rate changes on cash and cash equivalents held
or due in a foreign currency will need to be disclosed in the statement of cash flows in order
to reconcile the cash and cash equivalents at the beginning and the end of the period. Since
this unrealised gain or loss is not considered to be a cash flow, this amount must be presented
separately from the operating, investing and financing activities.
Example 12: Foreign cash flows may be converted at average rates

A company with C as its functional currency, has a branch in a foreign country with $ as its
functional currency. The cash transactions of the two branches during 20X2 are as follows
Local branch Foreign branch
20X2 20X2
C $
Revenue 100 000 20 000
Expenses 50 000 10 000
Details of foreign exchange rates are as follows:
1 January 20X2 $1 = C2,00
31 December 20X2 $1 = C1,50
Average 20X2 $1 = C1,75
Required: Prepare the relevant extracts of the statement of cash flows assuming that the sales and
expenses constitute thousands of transactions occurring during the year ended 31 December 20X2.
Solution 12: Foreign cash flows may be converted at average rates

Revenue and expenses of the foreign branch should be converted to C at the spot rate on transaction
date. If this would cause undue effort, IAS 21 allows that the average rate be used.
Company name
20X2
Cash flows from operating activities C
Cash receipts from customers (C100 000 + $20 000 x C1, 75) 135 000
Cash payments to suppliers and employees (C50 000 + $10 000 x C1,75) (67 500)
7.2 Foreign currency cash and cash equivalent balances
An entity may have a balance of cash or a cash equivalent that is denominated in a foreign
currency. As mentioned previously, unrealised gains and losses on foreign balances are not
reflected in the statement of cash flows. However, in order for the cash flow movements from
the operating, investing and financing activities to reconcile to the difference between the
opening and closing balances, it will be necessary to disclose an adjustment for the unrealised
gains or losses on such an item of foreign cash or cash equivalent. see IAS 7.28
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Example 13: Foreign currency cash and cash equivalent balances

Bella Limited conducts its operations both in SA and the USA and has the South African
Rand as its functional currency.
The statement of financial position as at 31 December 20X3 reflected cash and cash
equivalents of R2 500 000 (1 January 20X3: R2 000 000). Included in these balances is an
amount of $10 000 held in a bank account in the USA and converted at the spot rate on the
relevant reporting dates. This balance has not changed since 20X1.
The statement of cash flows for the year ended 31 December 20X3 reflected a net cash
inflow of R505 000.
The relevant spot foreign exchange rates were as follows:
31 December 20X2 $1 = C2,00
31 December 20X3 $1 = C1,50
Required:
Prepare the reconciliation between the opening and closing balances of cash and cash equivalents, as
would appear in the statement of cash flows. Clearly show the effect of the $10 000 that is held in a US
bank account
Solution 13: Foreign currency cash and cash equivalent balances

Bella Limited
20X2
R
Cash and cash equivalents: net cash inflows Given 505 000
Cash and cash equivalents: opening balance (1/1/20X3) Given 2 000 000
Unrealised loss on USA bank balance $10 000 x (C1,50 - C2,00) (5 000)
Cash and cash equivalents: closing balance (31/12/20X3) Given (2 500 000)
8. Non-Cash Flow Transactions (IAS 7.43 - .44)
Some transactions that fall into the categories of investing and financing activities do not
require the use of cash or cash equivalents. Examples of such transactions include:
acquiring assets by finance lease or other directly related liabilities;
acquiring an entity by issuing shares; and
converting debt into equity.
As these transactions do not involve cash, they are excluded from the statement of cash flows.
These transactions, however, change the capital and asset structure of the entity, and may
greatly affect future cash flows. Thus disclosure of such transactions would provide relevant
information to users. Accordingly, these transactions must be disclosed elsewhere in the
Example 14: Purchase of asset by finance lease

A company purchased an item of equipment with a cash cost of C500 000 by means of a
finance lease on 31 December 20X2. The first lease payment is due on 31 December 20X3.
Required:
Disclose the above transaction in the statement of cash flows of this company for the year ended
31 December 20X2.
Solution 14: Purchase of asset by finance lease

This transaction does not appear on the face of the statement of cash flows for the year ended
31 December 20X2 as no inflow or outflow of cash has occurred. However, note that, should the first
lease payment have been paid by 31 December 20X2, then the capital portion of the lease payment
would have been included under cash flows from financing activities. If this transaction is considered
material to users, the following note may need to be disclosed:
Chapter 27 1147

Company name
Notes to the Statement of cash flows
24: Purchase of asset by finance lease

An item of equipment with a cost of C500 000 was purchased on 31 December 20X2 in terms of a
finance lease agreement. Lease payments of xxx are made annually, the first payment being due on
31 December 20X3. The liability incurs interest at a rate of x% per annum.
9. Miscellaneous issues
9.1 Overview
When preparing a statement of cash flows for an entity, we need to consider the impact of all
accounting standards (i.e. IAS and IFRS) that may have applied to the entity. There are many
different transactions that the entity may have entered into (causing many different accounting
standards to be brought into play) and it is impossible to cover all possibilities in this chapter.
However, in order to calculate the cash flows for presentation in the statement of cash flows,
we merely have to be able to visualise what entries would be processed in the related ledger
accounts and whether any of these entries included in the ledger account involved a contra
entry to bank. If an entry in a ledger account has the bank account as its contra entry, this
would mean that this transaction has a direct effect on the statement of cash flows and our
next step would then simply be to decide where it fits best: operating, financing or investing.
Thus, irrespective of the accounting standard/s that may apply, when preparing our statement
of cash flows, our steps should be:
Start by taking each line item of our statement of financial position and then, using all the
information at our disposal, try to identify all its related accounts (e.g. the property, plant
and equipment line item normally involves a cost account and accumulated depreciation
account and depreciation account – it may also involve impairment accounts too). It is
normally best to start with each of the line items in the statement of financial position
since, after analyzing each and every line item in the statement of financial position, we
will normally find that we have, by default analysed (i.e. reconsutructed) most of the line
items in the statement of comprehensive income too. At this point, we simply scan our
statement of comprehensive income to identify any final remaining line-items that still
require analysis.
Scribble out the t- accounts for each of the ledger accounts that we identified as being
related to the line-item in the statement of financial position (e.g. draw a blank t-account
for the cost account, accumulated depreciation account and depreciation account).
Populate these t-accounts with all the information available to us – opening and closing
balances from the statement of financial position (e.g. cost and accumulated depreciation
balances) and then also all of the other movements that are apparent from the information
provided in the other statements (e.g. depreciation).
After populating the t-accounts with everything we have, we should then be able to
extract the figure pertaining to cash – in other words, this is usually the balancing figure.
Our last step is simply to classify this cash (or cash equivalent) amount as operating,
investing or financing.
Typically, a cash flow would be classified as :

investing if it was associated with a return on an investment,
financing activity if it was associated with the cost of financing a business
operating activity if it can be argued that the cost is unavoidable and integral to the
operation of the business.
1148 Chapter 27
The above methodology focuses on balance sheet items (asset, liability and equity accounts)
that have a “cash” movement as a balancing item. However, in certain cases, a ledger account
has no contra entry involving bank but an investing or financing transaction has indeed taken
place, and assuming this transaction has a material effect on the ‘capital and asset structure of
the entity’, then a note would be needed in order to provide the user with the necessary
information to understand its potential effect on the entity.
It is virtually impossible to detail the impact of every IFRS and combination of IFRSs on the
varied transactions that an entity may enter into and which may thus have an impact on the
statement of cash flows. However, the following is an overview of some of the more
common transactions and how they would affect the statement of cash flows.
9.2 Construction of plant with the capitalisation of borrowing costs (IAS 16 & IAS 23)
Should an entity incur costs that are capitalised to property, plant and equipment, these costs
would then be presented under investing activities on the face of the statement of cash flows.
However, borrowing costs that have been capitalised to property, plant and equipment, would
be presented under operating activities as “interest paid”
Example 15: Self-constructed plant with capitalization of borrowing costs

On the 01 September 20X4 Seedat Limited began with the construction of a new plant that
met the definition of a qualifying asset in terms of IAS 23.
Seedat Limited initially utilised its internal funds to finance the construction costs, however a loan of
C 500 000 was taken out on 1 January 20X5 to specifically finance the cost of construction.
The loan bears interest at 10% per annum and was fully settled on 31 December 20X5.
Expenditure of C35 000 per month was incurred on the plant since the inception of the project.
Construction was completed on 30 September 20X5 and the plant was immediately brought into
use. The useful life of the plant is considered to be 6 years with a residual value of C127 500.
All items of property, plant and equipment are accounted for using the cost model.
The carrying amount of plant at 31 December 20X4 was C 375 000.
Required: Insofar as the information permits, disclose the above transactions in the Statement of cash
flows of Seedat Limited for the year ended 31 December 20X5.
Solution 15: Capital cost and borrowing costs
Seedat Limited
20X5
Cash generated from operating activities C
Interest paid (W1: 37 500 + W2: 12 500) (50 000)
Cash generated from investing activities
Expenditure capitalised to plant (315 000)
Cash generated from financing activities
Proceeds from loan raised 500 000
Repayment of loan (50 000)
W1: C
Expenditure incurred (01 Jan 20X5 – 30 Sep 20X5 = 9 months). 9 X C 35 000 315 000
Interest capitalised for the period: 1/01/X5 – 30/09/X5 (9 months) 500 000 x 10% x 9/12 37 500
Total cost capitalised to date 727 500
Depreciation [(C 727 500 - C 127 500) / 6 X 3/12] (25 000)
W2: Interest paid not capitalised to plant: 1/10/X5 – 31/12X5: C500 000 x 10% x 3/12 = C 12 500
Chapter 27 1149
9.3 Finance leases from the perspective of a lessee
Upon the acquisition of an asset, for example property, plant and equipment, under a finance
lease, no cash effect results. However the transaction changes the capital and asset structure of
the entity, thus this should be disclosed in the notes as a non-cash investing activity.
The subsequent transactions that result through the passage of time from the lease agreement
triggers a movement in cash. These movements must be disclosed on the face of the statement
of cash flows. The accounting treatment to the lessee and lessor has been summarised below:
The subsequent lease installments paid under a finance lease would be split between:
the capital repayment which would be presented as a financing activity; and
the interest payment which would be presented either as an operating or financing activity
It is more common in practice to disclose the payment of interest as an operating activity and
thus examples presented in this text have been prepared on this premise.
Example 16: Finance lease

Yusuf Limited leased equipment with a cash cost of C200 000 from Yogi Limited in terms
of a finance lease agreement.
Both companies have a 31 December year end.
The lease began on 1 January 20X3.
There are 4 installments of C71 475, paid annually in arrears.
The Effective interest rate table is as follows:

Date Interest (16%) Installment Balance
01/01/20X3 200 000
31/12/20X3 32 000 (71 475) 160 525
31/12/20X4 25 684 (71 475) 114 734
31/12/20X5 18 357 (71 475) 61 616
31/12/20X6 9 859 (71 475) 0
Required:
Insofar as the information permits, disclose the above transaction in the statement of cash flows of
Yusuf Limited for the year ended 31 December 20X5 and 20X4.
Solution 16: Finance lease
Yusuf Limited
20X5 20X4
C C
Cash flows from operating activities
Interest paid (18 357) ( 25 684)

Repayment of capital portion of finance lease (53 118) (45 791)
(20X5: 71 475 – 18 357) (20X4: 71 475 – 25 684)
Comment:
In both financial years, the instalment of C71 475 is split between its interest and capital component.
The repayment of:
- the interest component is classified under operating activities whereas
- the repayment of the capital portion is classified under finance activities.
1150 Chapter 27
9.4 Finance leases from the perspective of a lessor
The subsequent lease installments received under a finance lease would be split between:
the capital received which would be presented as a investing (on the basis that the entity
is disposing of an asset) and;
the interest received would be presented either as an operating or investing activity (most
commonly under operating).
Assuming the lessor is a manufacturer/ dealer type lessor then the capital received would be
presented under operating activities as ‘cash receipts from customers’ as the financing of
leases is a core part of the business operations of a manufacturer/ dealer type lessor.
9.5 Operating leases from the perspective of a lessee and lessor
Operating leases involve a series of payments over the period of the lease.
In the accounting records of the lessee:

the payments of installments would be presented in the statement of cash flows under
operating activities as ‘cash paid to suppliers and employees.’
In the accounting records of the lessor:

the receipt of lease installments would be presented in the statement of cash flows under
operating activities as ‘cash received from customers.’
9.6 Sale and operating leaseback from the perspective of a lessee and lessor
In terms of a sale and operating leaseback, the following accounting treatment(s) apply in the
books of the respective parties.
In the accounting records of the lessee:

the receipt could appear under investing activities (on the basis that we are disposing of
an asset) or under financing activities (on the basis that we are borrowing money); and
the payment of the subsequent operating lease installments would appear under operating
activities as ‘cash paid to suppliers and employees’.
In the accounting records of the lessor :

the payment for the purchase of the asset would appear under the ‘investing activities’;
and
the receipt of the subsequent operating lease installments would appear under operating
activities as ‘cash received from customers’.
9.7 Transactions involving shares and debentures
9.7.1 Overview
The issue of shares and debentures would be presented in the statement of cash flows under
financing activities since they relate to the financial structure of the entity.
9.7.2 Share buy-backs
A share buy-back is a simply entry involving a debit to share capital and a credit to bank.
The outflow of cash that results from a share buy-back would generally be classified as a
financing activity, but could also be classified as an operating activity should an entity be
principally involved in investing activities.
Chapter 27 1151
9.7.3 Issues of shares for cash
The issue of ordinary shares or preference shares could be classified as equity (e.g. the issue
of a non-redeemable preference share) or could be classified as a liability instrument (e.g. a
compulsorily redeemable preference share). However, irrespective of the classification, any
cash received from the issue would generally be classified as a financing activity. We must
remember that the cash inflow presented should always be net of the share issue costs,
assuming these have been paid.
9.7.4 Issues of shares that do not involve cash
Some share issues involve an inflow of cash while others may not. A typical example is a
capitalisation issue: a capitalisation issue increases our share capital account but does not
involve an inflow of cash and would thus not affect our statement of cash flows.
9.7.5 Redemption of preference shares/ debentures
The payment on the redemption of a redeemable preference share or debenture, irrespective of

whether the financial instrument was classified as equity or liability, will be classified as a
financing activity in the statement of cash flows.
9.7.6 Convertible preference shares/ debentures
If one instrument (e.g. a debenture) is converted into another instrument (e.g. a share), the
entry would simply be a debit to the one instrument and a credit to the other instrument (e.g.
debit debentures and credit ordinary shares). In this case, there is no cash and thus there
would be no effect on our statement of cash flows.
However, it is possible for a conversion to involve only part of an instrument being converted
and part being redeemed for cash. In this case, the journal would involve a debit to the
financial instrument and a credit to the share capital (i.e. the part being converted) and a credit
to bank (i.e. the part being redeemed for cash). This cash outflow would be classified as a
financing activity.
9.7.7 Dividends
We must be aware that a dividend appearing in the statement of changes in equity may not
necessarily have been paid entirely in cash. For example, a dividend may have been partly
paid in cash and partly by way of a capitalisation issue. Only the cash portion would appear
in our statement of cash flows whereas the non-cash dividend would be included in the note
as a non-cash activity. This cash outflow would be presented as an operating activity.
Example 17: Share transactions

Yusuf Limited is a JSE listed company involved in logistics management. As at
31 December 20X4, the company had a share capital balance of C500 000 (consisting of
100 000 ordinary shares), and a debenture liability balance of C4 990 712.
During the current financial year, the following share issue transactions occurred:
Date Transaction
01/02/20X5 Yusuf Limited issued 10 000 ordinary shares at an issue price of C6 per share.
05/04/20X5 Yusuf Limited acquired 40 000 ordinary shares in Jamaica Limited for C5 per share.
20/06/20X5 A rights issue of 2 shares for every 5 shares held at C6 each. At this date, shares were
trading at C7 per share.
15/08/20X5 Yusuf Limited bought back 40 000 of its own shares in a share buy-back for C10 each.
25/10/20X5 A final dividend of C0.40 per share was issued to shareholders
26/10/20X5 A dividend of C0.50 per share was received from Jamaica Limited
Required: Insofar as the information permits, disclose the above transactions in the Statement of cash
flows of Yusuf Limited for the year ended 31 December 20X5.
1152 Chapter 27
Solution 17: Share transactions
Yusuf Limited
20X5
C
Cash generated from operating activities
Dividend received (40 000 x 0.50) 20 000
Cash generated from investing activities

Acquisition of shares (40 000 x C5) (200 000)
Cash generated from financing activities

Redemption of debentures (10 000 x C500 x 1.1) (5500 000)
Share buy-back (40 000 x C10) (400 000)
Proceeds from the issue: ordinary share (10 000 x C6) 60 000
Proceeds from rights issue: ordinary share (W2) 264 000
W1: Dividends paid = Total number of ordinary shares in issue x Dividends per share
Total number of ordinary shares in issue =
100 000 + 10 000 + [(100 000 + 10 000) ÷ 5 x 2] – 40 000 = 114 000
Dividends per share = 114 000 x 0.40 = C45 600
W2: Proceeds from rights issue:
(100 000 + 10 000) ÷ 5 x 2 x C6 = C264 000
9.8 Changes in accounting policy and corrections of prior period errors

It is interesting to note that a change in an accounting policy or correction of a prior period
error never affects the statement of cash flows since the bank account is always based on an
economic reality rather than on the application of the requirements in an accounting standard.
10. Presentation and Disclosure (IAS 7)
10.1 Compulsory presentation and disclosure (IAS 7 - various)
The standard on cash flows is focused on presentation and therefore, the chapter so far has
already covered the main presentation and disclosure issues for statements of cash flows.
A summary of the presentation and disclosure requirements include:
The policy for determining the composition of cash and cash equivalents (changes in such
a policy are dealt with in terms of IAS 8). IAS 7.46
The statement of cash flows must be separated into three segments:

- Operating activities
- Investing activities
- Financing activities. IAS 7.10
Chapter 27 1153
The cash flows in the operating activities segment may be presented using either the:
- Direct method (the preferred method); or
- Indirect method. IAS 7.18
The cash flows in the investing and financing activities segments must separately present
(unless they fall into the exceptions: see below):
Gross cash receipts; and
Gross cash payments. IAS 7.21
There are exceptions to the above (i.e. when gross cash receipts may be set-off against
gross cash payments in each of the three segments). These are:
If the cash receipts and payments are on behalf of a customer and the cash flows
reflect the activities of the customer rather than of the entity; or
If the cash receipts and payments relate to items which have a quick turnover, are
large and have short maturities. IAS 7.22
Interest received, interest paid, dividends received and dividends paid must be presented
separately. There is no hard and fast rule about which segment to present these in:
Interest received and dividends received: could be presented under operating or
investing activities;
Dividends paid and interest paid: could be presented under operating or financing
activities. IAS 7.31-34
Taxes paid on income must be separately disclosed: it is normally included under the
operating activities section but can be included as investing or financing activities if there
is a direct link to a transaction that affected these other activities. IAS 7.35
The components of cash and cash equivalents must be disclosed. IAS 7.45
The total cash and cash equivalents must be reconciled to the equivalent items in the
statement of financial position. IAS 7.45
Investing and financing activities that did not involve cash must be disclosed in the notes
(since these are obviously not going to feature in the statement of cash flows). IAS 7.43
The amount of significant cash and cash equivalent balances held by the entity that is not
available for use by the group. IAS 7.48
10.2 Encouraged disclosure (IAS 7.50 - .52)
The following disclosure is encouraged but not required:

The amount of undrawn borrowing facilities together with any restrictions on the use
thereof;
The total of the cash flows relating to each of the operating, investing and financing
activities of a joint venture that is reported using proportional consolidation;
The separate disclosure of cash flows that maintain operating capacity and those that
increase the capacity;
The amount of the cash flows arising from the operating, investing and financing
activities for each of the separately reported segments (e.g. by industry or location).
1154 Chapter 27
10.2.1 Sample presentation of a statement of cash flows (IAS 7 - various)
Presentation using the indirect method
Company name
For the year ended …….
CY
C
Cash flows from operating activities
Profit before taxation
Adjustments for: (non-cash items & separately disclosable items)
- Interest expense (add back)
- Depreciation (add back)
- Profit on sale of vehicles (subtract)
- Investment income (deduct)
Operating profit before working capital changes
Working capital changes:
- (Increase)/ decrease in inventories
- (Increase)/ decrease in accounts receivable
- Increase/ (decrease) in trade payables
Cash generated from operations
Interest paid (-)
Interest received (+)
Dividends paid (-)
Dividends received (+)
Secondary tax paid (-)
Normal tax paid (-)

Purchase of plant
- additions/ expansion
- replacement/ maintaining capacity
Proceeds from the sale of vehicles
Purchase of shares

Redemption of debentures
Proceeds from the issue of debentures
Proceeds from the issue of ordinary shares
Proceeds from loan raised
Repayment of loan
Net (decrease)/ increase in cash and cash equivalents

Cash and cash equivalents: opening balance
Cash and cash equivalents: closing balance
CY = current year
Chapter 27 1155
Presentation using the direct method
Company name
For the year ended …….
CY
Cash flows from operating activities C
Cash Receipts from Customers
Cash Payments to Suppliers and Employees (-)
Cash Generated from Operations
Interest paid (-)
Interest received (+)
Dividends paid (-)
Dividends received (+)
Secondary tax paid (-)
Normal tax paid (-)

Purchase of plant
- additions/ expansion
- replacement/ maintaining capacity
Proceeds from the sale of vehicles
Purchase of shares

Redemption of debentures
Proceeds from the issue of debentures
Proceeds from the issue of ordinary shares
Proceeds from loan raised
Repayment of loan
Net (decrease)/ increase in cash and cash equivalents

Cash and cash equivalents: opening balance
Cash and cash equivalents: closing balance
CY = current year
1156 Chapter 27
11 Summary
Statements of Cash Flows
The statement of cash flows is split

into
4 main sections:
Financing activities
Reconciliation of the opening and
closing balance of cash and cash
equivalents
Disclosure (main)
Investing activities Cash and cash Operating activities

equivalents
All purchases should Where this balance is Two methods possible to
ideally be separated into made up of more than one calculate cash generated
purchases in respect of: item (e.g. cash in bank), from operations:
Maintenance of the breakdown of this direct and
capacity amount should be given in indirect.
Expansion of capacity. a note.
If restrictions on use,
this must be disclosed.
Non-cash financing and non-cash Amount of undrawn borrowings

investing activities and restrictions on its use
These do not form part of the cash inflows and You are encouraged but not required to give
outflows on the face of the statement of cash details of undrawn borrowings in the notes since
flows, but should be disclosed in the notes it is useful to the user in assessing, for instance,
whether the company is suffering possible cash
flow shortages
Presented in 4 sections:
1. Operating activities 2. Investing activities 3. Financing activities
4. Cash and cash equivalents recon
Chapter 27 1157
Gripping GAAP Financial analysis and interpretation
Chapter 28
Financial Analysis and Interpretation
Contents: Page
2. Users of Financial Statements 1160
3. Inherent Weaknesses in Financial Statements 1160
3.1 Overview 1160
3.2 Historical figures 1160
3.3 Limited predictive value 1161
3.4 Limited qualitative information 1161
3.5 Risks are not reported 1161
3.6 Limited comparability 1161
4. Techniques Used in the Analysis of Financial Statements 1162

4.1 Overview 1162
4.2 Statements of cash flows 1162
4.3 Common-sized financial statements 1162
4.3.1 Horizontal analysis 1163
4.3.1.1 The horizontal analysis of the statement of financial position 1163
4.3.1.2 The horizontal analysis of the statement of comprehensive
income 1163
4.3.2 Vertical analysis 1163
4.3.1.1 The vertical analysis of the statement of financial position 1164
4.3.1.2 The vertical analysis of the statement of comprehensive income 1164
4.4 Ratio Analysis in General 1164
4.4.1 Profitability analysis 1164
4.4.2 Liquidity analysis 1165
4.4.3 Solvency/ structure analysis 1165
5. Common-Sized Financial Statements in more Detail 1166

Example 1: Vertical and horizontal analysis 1166
6. Ratio Analysis in More Detail 1172

6.1 Profitability ratios 1173
6.1.1 Gross profit percentage/ margin 1173
Example 2: Cashew-head Limited: GP percentage/ margin 1174
6.1.2 Net profit percentage/ margin 1174
Example 3: Cashew-head Limited: net profit percentage margin 1174
6.1.3 Return on capital employed 1174
Example 4: Cashew-head Limited: return on capital employed 1175
6.1.4 Return on owners’ equity 1175
Example 5: Cashew-head Limited: return on owners’ equity 1175
6.1.5 Return on assets 1175
Example 6: Cashew-head Limited: return on assets 1176
6.1.6 Earnings per ordinary share 1176
Example 7: Cashew-head Limited: earnings per ordinary share 1176
6.1.7 Dividends per share 1176
Example 8: Cashew-head Limited: dividends per ordinary share 1176
6.1.8 Ordinary dividend payout ratio 1176
Example 9: Cashew-head Limited: ordinary dividend payout ratio 1177
1158 Chapter 28
6.1.9 Price earnings ratio 1177

Example 10: Cashew-head Limited: price earnings ratio 1177
6.1.10 Earnings yield 1177
Example 11: Cashew-head Limited: earnings yield 1177
6.1.11 Dividend yield 1177
Example 12: Cashew-head Limited: dividend yield 1177
6.2 Liquidity ratios 1178
6.2.1 Current ratio 1178
Example 13: Cashew-head Limited: current ratio 1178
6.2.2 Acid-test ratio 1178
Example 14: Cashew-head Limited: acid-test ratio 1178
6.2.3 Working capital ratio 1178
Example 15: Cashew-head Limited: working capital ratio 1178
6.2.4 Debtors’ collection period 1178
Example 16: Cashew-head Limited: debtors’ collection period 1179
6.2.5 Debtors’ turnover 1179
Example 17: Cashew-head Limited: debtors’ turnover 1179
6.2.6 Days supply (or inventory) on hand 1179
Example 18: Cashew-head Limited: days supply on hand 1179
6.2.7 Inventory turnover 1179
Example 19: Cashew-head Limited: inventory turnover 1180
6.2.8 Creditors’ payment period 1180
Example 20: Cashew-head Limited: creditors’ payment period 1180
6.2.9 Creditors’ turnover 1180
Example 21: Cashew-head Limited: creditors’ turnover 1180
6.2.10 Business cycle days 1180
Example 22: Cashew-head Limited: business cycle 1180
6.3 Solvency/ structure ratios 1180
6.3.1 Equity ratio 1180
Example 23: Cashew-head Limited: equity ratio 1181
6.3.2 Debt ratio 1181
Example 24: Cashew-head Limited: debt ratio 1181
6.3.3 Solvency ratio 1181
Example 25: Cashew-head Limited: solvency ratio 1181
6.3.4 Debt to equity ratio 1181
Example 26: Cashew-head Limited: debt equity ratio 1181
6.3.5 Borrowing ratio 1181
Example 27: Cashew-head Limited: borrowing ratio 1181
7. Summary 1182
Chapter 28 1159
1. Introduction
A set of financial statements is, despite the wealth of information contained therein, not able
to give a true picture of the business on its own. The financial statements require a more in-
depth analysis and an interpretation thereof. The type and extent of the analysis performed
depends on the user, the user’s specific needs and the information available to the user.
2. Users of Financial Statements
There are a variety of users including the following:

Users of financial
Bank managers and officials and other providers of statements:
finance: who perform a thorough investigation into
the level of risk involved with the entity and the Bank managers and providers of
entity’s ability to repay the debt. This type of finance
investigation would be performed when, for example, Tax authorities
Employees
a bank is considering extending credit or providing a Directors and managers
loan for the first time to an entity. Investors (current and potential)
Tax authorities: who analyse the entity’s financial Analysts
Auditors.
statements for tax purposes.
Employees: who analyse the financial statements to assess, for example, their job security.
Directors and managers: who scrutinise the financial statements since such scrutiny
provides important information that is essential in the decision-making process, budgeting
procedures for the future years as well as in the review for errors and fraud.
Investors (current shareholders and potential investors): who evaluate the level of return
earned on investments in the entity balanced against the level of risks involved and this,
in turn, is compared with the risks and returns offered by other entities and investments.
Merger and Acquisition Analysts: who analyse the worth of the entity and consider the
risks versus the returns involved, and based on such information, decide whether a merger
or acquisition with such a company would be beneficial to either party.
Auditors: who scrutinise every material element of the financial statements since they are
required to report on the fair presentation of the financial statements. An analysis
(analytical review) of the financial statements is generally performed before proceeding
with audit work, since such an analysis highlights areas of concern (possible errors, fraud,
misallocations and misstatements). A similar analysis may also be performed near the end
of the audit as a final check for ‘funnies’.
3. Inherent Weaknesses in Financial Statements
3.1 Overview
Financial statements, despite the International Financial Reporting Standards’ onerous

disclosure requirements, still have inherent weaknesses. In order to perform a reasoned
analysis and interpretation, it is imperative that the user is aware of the limitations of the
financial information that he is analysing.
3.2 Historical figures 5 inherent weaknesses in

financial statements:
The values shown in the financials are often historical
figures that are either understated or overstated because of Use of historical figures
Limited predictive value
the effects of inflation. In order to lessen this weakness, Limited qualitative information
some companies perform regular revaluations of their Limited reporting of risks
assets and/or provide their users with ‘inflation adjusted Limited comparability
financial statements’.
1160 Chapter 28
Events after year-end but before the issue of the financial

statements are also quite often important to the user and Historical figures
will be disclosed in accordance with the statement on
events after the reporting period, (IAS 10). However, Don’t reflect effects of inflation
events that occur after the issue of the financial Events after the issue of f/s are
obviously not reported (this means
statements (e.g. law suits, flood damage to inventory or it is imperative that f/s are
other assets, changes in management or ownership) will released quickly).
obviously not be disclosed and yet may be of interest to
the users. It is thus essential that financial statements are released as soon after year-end as is
possible so that they are still relevant.
3.3 Limited predictive value
The financial statements not only use historical figures Limited predictive value
but are, by definition, a record of past events. These past
events may have little or no bearing on the future if, for The f/s reflect history and yet
instance, there is a change in market trends, technology Current market trends etc may
(perhaps rendering part or all of the inventory or assets mean that this history will probably
obsolete), and/ or management etcetera. not be repeated.
3.4 Limited qualitative information
Financial statements are, in the main, a record of Limited qualitative

quantitative information with only a smattering of information
qualitative information. Qualitative information that
might not be found directly in the financial statements but F/s include very little qualitative
information and yet
which could nevertheless influence users include (inter
a decision to, for example, increase
alia) changes in management, technology and market marketing in the current year or
trends. An assessment of the level of labour productivity introduce a new product line would
and the competency of management would also be useful. be useful information.
Marketing decisions, an example of which is the decision on whether or not to adopt a
different marketing approach in the future, could also affect the decisions of users.
Management decisions, such as introducing a new product line, the dropping of a product in
the future, or making raw materials internally rather than purchasing them externally are also
important to the user and yet are not mentioned in the financial statements.
3.5 Risks are not reported
Although IFRSs are gradually requiring certain risks to be

disclosed, not all risks get disclosed. Bearing in mind that Risks not always reported
when deciding whether the returns offered by a particular
investment are acceptable or not, an investor invariably It is difficult to identify all risks
and thus, although f/s do report on
considers the risk related to the investment (the higher the some risks, not all are reported.
risk, the higher the required rate of return). Although Financial analysis helps us identify
financial statements do not directly refer to, or analyse risk areas.
all risks, the analysis of the information provided goes a long way to identifying risk areas.
3.6 Limited comparability
Comparability between different entities or comparability Changes in accounting

from one year to the next may be compromised by, for policy won’t compromise
example, the use of different accounting policies, comparability because:
abnormal items and seasonal fluctuations. the prior year figures are restated,
Different accounting policies: If one entity uses a different accounting policy to another entity
(e.g. one uses FIFO and the other WA to record inventory movements), it becomes difficult to
compare these two entities.
Chapter 28 1161
Abnormal items: Abnormal items make it difficult to compare one entity with another as well
as making it difficult to compare one year with another year within the same entity. These
items should, where necessary, be excluded from the analysis.
Seasonal fluctuations make it difficult to compare, for example, the period from September to
February (spring and summer) with the period from March to August (autumn and winter)
when the entity is a swimwear manufacturer.
4. Techniques Used in the Analysis of Financial Statements
4.1 Overview
There are many different techniques that may be used in the analysis of a set of financial
statements. Common techniques used include the use of cash flow statements, common-sized
financial statements and ratio analysis.
Analysis
‘Interpreting’ an analysis entails scrutinising and trying to make techniques
sense of any ‘trends’. This ‘trend analysis’ involves comparing include:
company figures, ratios and percentages:
Cash flow statements
To prior years: The more prior years that you have at your Common-sized f/s
disposal for the purpose of comparison the better. This gives Ratio analysis
a better idea of any trends.
To industry averages: This gives the user an idea as to how the entity’s performance
compares with the performance of similar entities in the same industry. Care should be
taken to compare entities of similar size. It is worth noting that, when an entity deviates
significantly from the industry average, this does not always bode ill, since if the entity
wishes to be the best in the industry, it will, by definition, not be ‘average ’!
To accepted standards: Accepted standards should be considered as a guide only and
once again, the leading entity in an industry will seldom adhere to any so-called norms.
To forecasts (past and future): The internal users may compare, for example, actual ratios
to the budgeted ratios over a certain period when planning budgets for the future. The
fluctuations between actual and budgeted ratios over the past period need to be
investigated and taken into account during the budgeting process for the next period.
4.2 Statements of cash flows
This is probably one of the most important statements to analyse since without adequate cash
flow, the company will run the risk of not being able to repay creditors and other short-term
debts (such as overdrafts) and perhaps also the long-term debts as well. A cash flow problem
that continues unchecked, will ultimately lead to liquidity problems and finally liquidation.
4.3 Common-sized financial statements

Common-sized
f/s involve:
This technique is useful for many different reasons. Using this
technique, the financial statements are redrafted showing Horizontal analyses
movements in either currency or percentage terms. Vertical analyses
The common-size analysis is best performed if changes are not seen in isolation, but rather as
part of a bigger picture: comparisons should be made with other connected accounts, whether
in the statement of comprehensive income or statement of financial position.
Consider, for instance, an increase in sales: very little information is gleaned simply from the
fact that sales increased. What the user needs to know is how the entity increased its sales and
what effect this has had on the business (e.g. on its profits, liquidity and asset base).
1162 Chapter 28
In order to answer these questions, we could look at some of the accounts related to sales:
Related accounts in the SOCI could include cost of sales, bad debts and profits,
Related accounts in the SOFP could include debtors and doubtful debts allowance .
Other accounts may be considered related, depending on the circumstances. Although the
doubtful debts allowance is not separately disclosed in the statement of financial position, it is
a useful account to analyse (where possible) since it gives an indication of the opinion of
management regarding the recoverability of debtors.
This common-sizing analysis can be done as a horizontal or vertical analysis, each approach
offering its own unique insights. Each of these two approaches (horizontal and vertical), will
now be discussed in more depth.
4.3.1 Horizontal analysis
Using this technique, the change from one year to the next
within each line item in the financial statements is analysed on Horizontal
analysis:
either a currency or percentage basis.
Involves comparing figures on
Analysing the changes as a percentage is particularly useful a year-on-year basis.
when trying to identify, at a glance, any unusual fluctuations. Is useful when trying to
Large percentage fluctuations could be followed up for identify unusual fluctuations.
corrective action by management (where necessary) or interpreted as best as is possible for
the purpose of assessing risk where the user is, for instance, a potential investor.
If the user is the external auditor, it acts as a particularly useful tool in identifying accounts
that appear to include errors, fraud or misallocation, thus highlighting areas requiring further
audit procedures.
An example of the use of the horizontal analysis by an auditor:

A material increase in the machinery account together with a similarly material decrease in
the repairs and maintenance account may indicate that expenditure on repairs and
maintenance has been erroneously debited to machinery (a misallocation).
4.3.1.1 The horizontal analysis of the statement of financial position:

The horizontal analysis of the statement of financial position:
highlights increases and decreases in the sources of finance (equity and liabilities), and
highlights increases and decreases in the assets, thus indicating how this finance has been
invested.
4.3.1.2 The horizontal analysis of the statement of comprehensive income:

The horizontal analysis of the statement of comprehensive income:
highlights increases and decreases in expenditure, (e.g. a significant increase may suggest
errors, fraud, overspending or changes in the spending habits of the entity); and
highlights increases and decreases in income, (e.g. a significant decrease in sales may
indicate the need for additional marketing or change in sales mix).
4.3.2 Vertical analysis

Vertical analysis:
Vertical analysis involves analysing each line item as a
percentage of a base. The base used depends on the user and the Involves comparing figures as
purpose of the analysis. a % of another figure (e.g.
Revenue)
These percentages are compared with the prior year’s Removes effects of inflation
percentages and any unusual fluctuation are investigated (by Enables easier comparison
auditors, managers or directors etc) or merely interpreted (by the between large and small
entities.
shareholders, potential investors or other external users).
Chapter 28 1163
The vertical analysis is useful in that it:

removes the element of inflation; and
enables the comparison of the efficiency of operations of large companies with small
companies by reducing all figures to percentage terms.
4.3.2.1 The vertical analysis of the statement of financial position:
If the vertical analysis were to be performed on the statement of financial position, each line
item of the ‘assets’ section could be analysed as a percentage of, for example, the ‘equity and
liabilities’ section. This indicates how the available finance has been spent: for example, 30%
of the total finance may have been invested in non-current assets in the current year whereas
only 10% had been spent in this area in the prior year. This may indicate a shift in the
company’s priorities and a more positive sentiment on the future of the company.
4.3.2.2 The vertical analysis of the statement of comprehensive income
If the vertical analysis were to be performed on the statement of comprehensive income,

each line item could be analysed as a percentage of the sales figure. Any figure could be used
as the base, however, depending on what objective the user is trying to achieve. If, for
example, a manager is trying to analyse expenses with the intention of reducing them in
future, he may calculate each expense as a percentage of the total expenses in order to
highlight the larger expenses. These percentages should also be compared with the
percentages calculated for the previous year and any unusual trend followed up.
4.4 Ratio analysis in general Ratio analysis

generally focuses on
Ratio analysis is a very useful technique that analyses the the following areas:
financial statements in a way that provides us with information
on the entity’s profitability, liquidity and solvency. Unlike other Profitability
techniques such as common-sized financial statements, the Liquidity
calculation and analysis of the ratios involves an examination of Solvency
the inter-relationship between various items whether in the statement of comprehensive
income or statement of financial position (in other words, it does not focus purely on the
comparison of single items over the years or on the comparison of two items within the same
financial statement, e.g. SOCI).
For instance, if one were to look at merely the actual/ nominal ‘profit after tax’ figures in a
statement of comprehensive income, a distorted view of the situation may be obtained:
Imagine that the profit after tax was C100 000 in the prior year and C150 000 in the
current year. It would appear, before comparing the profit with any other item in either
the statement of comprehensive income or the statement of financial position, that the
company’s profitability has improved by 50% ([150 000 - 100 000]/ 100 000).
However, imagine that at the same time the total of the assets in the comparative year was
C500 000 but had increased to C1 000 000 in the current year.
Although it initially seems that profits are increasing dramatically (50%), if the
relationship between the profits earned and the investment in assets is considered, it
becomes evident that this aspect of profitability (return on assets) has declined from 20%
(profit: 100 000/ assets: 500 000) to 15% (profit: 150 000/ assets: 1 000 000).
4.4.1 Profitability analysis
Profitability analysis involves calculating profitability by using line-items from the statement
of comprehensive income but it also includes analysing the profitability in relation to items in
the statement of financial position, such as the capital invested in assets and in relation to the
sources of capital.
The analysis of the profitability in relation to the capital invested in assets gives an indication
of management’s effectiveness in their utilisation of funds available to the business.
1164 Chapter 28
The analysis of the profitability in relation to the sources of finance gives an indication of
whether the profitability is sufficient relative to the cost
of the capital. Profitability
ratios include:
Thus profitability ratios can be divided into three areas: Gross profit percentage
Pure analysis of the statement of comprehensive Net profit percentage
income: Return on capital employed
e.g. gross profit percentage and net profit percentage; Return on owner’s equity
Return on capital supplied by the different providers Return on assets
of capital: Earnings per share
e.g. return on capital employed, return on equity, Dividends per share
earnings per share, dividend payout ratio; and Dividend payout
Price earnings
Return on the assets that were purchased with the Earnings yield
capital supplied: Dividend yield
e.g. return on assets
4.4.2 Liquidity analysis
This is the ability of the company to repay its debts in the short-term (one year).
Consequently, these ratios will focus on the current assets and the current liabilities.
Current assets can, by definition, generally be converted

into cash (liquidated) within 12 months of year-end and Liquidity ratios include:
similarly, current liabilities are debts that must generally
be settled within 12 months of year-end.
Current ratio
Acid-test ratio
These ratios give an indication of management’s
Working capital ratio
operational capabilities regarding the management of
Debtors’ collection period
working capital.
Debtors’ turnover
Inventory on hand
The main liquidity ratios include:
Inventory turnover
the current ratio;
Creditors’ payment period
the acid-test ratio; and
Creditors’ turnover
the working capital ratio.
Business cycle
The following ratios look at each of the individual components of the current assets and
current liabilities (indicating how liquid each item is):
debtors: collection period and turnover ratios;
inventory: days on hand and turnover ratios;
creditors: repayment period and turnover ratios; and
business cycle ratio
One of the line items under current assets and current liabilities that is not specifically
covered by the liquidity ratios is ‘cash and cash equivalents’. The reason for this is that it is
covered in detail when analysing the statement of cash flows.
4.4.3 Solvency/ structure analysis
This is the ability of the company to repay its debts in the long-term. The ratios, therefore, are
not restricted to the current assets and current liabilities but deal rather with the total assets and
total liabilities.
The solvency ratios give an estimate of the structural safety of the company, by calculating, in
various ways, the ratio of internally sourced finance to externally sourced finance.
Chapter 28 1165
Internally sourced finance is more expensive but yet a low risk source of finance (owners’
ordinary or preference share capital) versus externally sourced finance, which is cheaper but
yet a riskier source of finance (loans from the bank, debentures etcetera).
Examples of solvency/ structure ratios include: Solvency ratios include:

the solvency ratio: the extent to which total liabilities
are covered by total assets; Solvency ratio
the equity ratio and debt ratio: the percentage of assets Equity ratio
financed by either equity (internal financing) or debt Debt ratio
(external financing) respectively Debt equity ratio
the debt-equity ratio and borrowing ratio: the ratios Borrowing ratio
showing how the financing is structured/ shared
between external and internal financing.
Ratio analysis is only of use if, as with all other techniques, a trend analysis is also performed:
that is to say, the ratios are compared with the comparative year’s ratios, or compared with
industry averages or with ratios of another company. This trend analysis facilitates more
meaningful interpretation of the ratios.
5. Common-Sized Financial Statements in More Detail
Common-sized financial statements are best explained by way of a worked example.
Example 1: vertical and horizontal analysis

Edwards Stores is a fashion retail outlet comprising a large chain of stores. The accountant
has prepared the following financial statements for the year ended 31 December 20X2.
You must then analyse and interpret these financial statements of Edwards Stores with the intention of
investment therein.
Edwards Stores
20X2 20X1
C C
Gross revenue 5 000 000 3 000 000
Cost of sales 3 000 000 1 500 000
Gross profit 2 000 000 1 500 000
Add interest income 100 000 90 000
2 100 000 1 590 000
Other expenses: 800 000 290 000
Computer software 50 000 20 000
Bad debts 295 000 50 000
Advertising 120 000 60 000
Salaries and wages 90 000 40 000
Insurance 200 000 100 000
Profit from operations 1 300 000 1 300 000

Less finance charges 100 000 10 000
Taxation expense 440 000 645 000
Profit for the period 760 000 645 000
Other comprehensive income for the period 0 0
Total comprehensive income for the period 760 000 645 000
1166 Chapter 28
Example 1: Continued ...
Edwards Stores
share share capital earnings
capital C C C
C
Opening balances: 1/1/20X1 500 000 300 000 350 000 1 150 000
Less dividends:
- Preference dividends (30 000) (30 000)
- Ordinary dividends (20 000) (20 000)
Closing balances: 31/12/20X1 500 000 300 000 945 000 1 745 000
Less dividends:
Preference share issue 50 000 50 000
Closing balances: 31/12/20X2 500 000 350 000 1 658 000 2 508 000
Edwards Stores
20X2 20X1
Assets C C
Non-current assets: 2 900 000 2 100 000
Investment at cost 1 100 000 1 300 000
Current assets: 3 008 000 1 345 000
- Inventory 1 500 000 375 000
- Accounts receivable 1 500 000 350 000
- Cash 8 000 620 000
5 908 000 3 545 000
Equity and Liabilities

Ordinary share capital at C2 PV 500 000 500 000
10% Preference share capital 350 000 300 000
Retained earnings 1 658 000 945 000
Shareholders’ equity 2 508 000 1 745 000
Non-current loan 2 000 000 800 000
Debentures 600 000 600 000
Deferred tax 400 000 300 000
Current liabilities:
- Accounts payable 400 000 100 000
5 908 000 3 545 000
Required:
Analyse and interpret Edwards Stores, assuming you are considering investing in their ordinary shares,
by using:
A. A horizontal common-sized analysis of the financial statements.
B. A vertical common-sized analysis of the financial statements.
Chapter 28 1167
Solution 1A: Using the horizontal analysis

Edwards Stores
20X2 20X1 % increase/
C C (decrease)
Gross revenue 5 000 000 3 000 000 67%
Cost of sales 3 000 000 1 500 000 100%
Gross profit 2 000 000 1 500 000 33%
Add interest income 100 000 90 000 11%
2 100 000 1 590 000 32%
Other expenses: 800 000 290 000 176%
Computer software 50 000 20 000 150%
Bad debts 295 000 50 000 490%
Advertising 120 000 60 000 100%
Salaries and 90 000 40 000 125%
wages
Insurance 200 000 100 000 100%
Depreciation 45 000 20 000 125%
Profit from operations 1 300 000 1 300 000 0%
Less finance charges 100 000 10 000 900%
Profit before tax 1 200 000 1 290 000 -7%
Taxation expense 440 000 645 000 -32%
Profit for the period 760 000 645 000 18%
Other comprehensive 0 0 0%
income
Total comprehensive income 760 000 645 000 18%
Edwards Stores
Statement of financial position % increase/
As at 31 December 20X2 (decrease)
20X2 20X1
C C
Assets
Non-current assets: 2 900 000 2 100 000 38%
Property, plant and equipment 1 800 000 900 000 100%
Investment at cost 1 100 000 1 300 000 -15%
Current assets: 3 008 000 1 345 000 124%
- Inventory 1 500 000 375 000 300%
- Accounts receivable 1 500 000 350 000 329%
- Cash 8 000 620 000 -99%
5 908 000 3 545 000 67%

Ordinary share capital 500 000 500 000 0%
10% Preference share capital 350 000 300 000 17%
Retained earnings 1 658 000 945 000 75%
Shareholders’ equity 2 508 000 1 745 000 44%
Non-current loan 2 000 000 800 000 150%
Debentures 600 000 600 000 0%
Deferred tax 400 000 300 000 33%
Current liabilities: Accounts 400 000 100 000 300%
payable
5 908 000 3 545 000 67%
Interpretation of the horizontal analysis:
The statement of financial position:
The following is a brief discussion of the most obvious interpretations of the Edward’s Stores
horizontal analysis of the statement of financial position.
1168 Chapter 28

Finance was increased by 67%, very little of which was raised through equity finance (17%
increase in preference share capital), with a massive increase of 150% in the relatively risky source
of loan finance. Extra financing was obtained indirectly through the 300% increase in accounts
payable, possibly indicating a continuing liquidity problem. Whereas the increase in accounts
payable may reinforce the opinion that the company is suffering cash flow problems, it may
indicate that it is making use of relatively cheap forms of finance and paying debts only when they
fall due. The disposal of 15% of the investments may also have been made in a bid to raise cash.
The analysis of the assets shows a 100% increase in property, plant and equipment, which
accounts for approximately 38% of the 67% (C2 363 000) increase in financing (900 000/ 2
363 000). This may indicate that the company is adopting a positive approach to the future and
increasing its operational capabilities in order to meet an expected increase in demand.
The tremendous increase in inventories (300%) may indicate either obsolete and slow-moving
inventories or stockpiling in expectation of a sudden increase in sales. Keeping a higher level of
inventory on hand involves higher storage costs and insurance costs and there is a higher risk of
theft. The risk of damage to inventory and obsolescence also increases. Another suggestion is that
the increase is due to a better quality and thus more expensive product which in turn may be the
cause of the 67% increase in sales (see horizontal statement of comprehensive income analysis).
It can be seen that debtors increased by an alarming 329%. This may be as a result of deteriorating
collection procedures or it may be that, in order to secure additional sales, the sales staff waived
the usual credit checks and offered extended credit terms. This may be the reason for the dramatic
increase of 490% in bad debts (see the horizontal statement of comprehensive income analysis).
An increase in accounts receivable that goes unchecked may cause liquidity problems, which may
result in the company finding itself unable to pay its creditors on time. This possibly explains the
dramatic 300% increase in accounts payable.
The 99% decrease in cash seems to confirm the apparent cash shortage.
The statement of comprehensive income:
The following is a brief discussion of the most obvious interpretations of the horizontal analysis of
statement of comprehensive income:
Sales increased by 67%, perhaps due to increased advertising (100% increase), but more probably
as a result of the extended credit terms and limited credit checks (suggested by the 329% increase
in accounts receivable and the 490% increase in bad debts).
The cost of sales increased by 100% which exceeded the increase of 67% in sales: this may
indicate that the inventory was of a better quality, and thus more expensive, with the higher quality
contributing to the increased sales, (more expensive inventory may account for the 300% increase
in inventories). Alternatively, in order to service additional sales, it may have been considered
prudent to maintain a higher level of inventory than normal. It should be noted that higher levels of
inventory frequently increase the cost of inventory and consequently, the cost of sales too:
bulk orders may be placed which, although usually reduces the price, may increase the costs
instead if the inventory requirements become too large for the company's usual supplier/s, and
it becomes necessary to use additional, more expensive suppliers.
if the company maintains a low level of inventory and as a result of the increasing demand,
finds itself frequently placing ‘rush orders’, the cost of inventory will increase.
Expenditure on insurance doubled, no doubt due to the increased levels of inventory and increase
in value of the non-current assets.
Depreciation increased by 125% due to the increase in property, plant and equipment.
Interest expense increased by a dramatic 900% due to the large increase in loans.
Salaries and wages increased by 125%, which may indicate that the store expected increased
volumes of sales and hired more staff, or that the store extended its trading hours in order to secure
more sales, in which case the increase may be the extra overtime pay.
The 150% increase in computer software may be due to replacement of old software, or may be
brand new software purchased as a result of the intention to process accounting records internally
rather than to use a computer bureau. The increase in non-current assets may therefore be partly
due to an increase in computers.
Despite the 67% increase in sales, the gross profit increased by only 33% and, worse still, the
profit before tax decreased by 7%. The profit after tax managed to increase by 18%, but this was as
a result of a 32% decrease in tax. This indicates that the operational efficiency is deteriorating.
Chapter 28 1169
Solution 1B: Using the vertical analysis
Edwards Stores 20X2 20X1 20X2 20X1

Statement of comprehensive income C C % %
Gross revenue 5 000 000 3 000 000 100% 100%

Cost of sales 3 000 000 1 500 000 60% 50%
Gross profit 2 000 000 1 500 000 40% 50%
Add interest 100 000 90 000
income
Gross income 2 100 000 1 590 000 100% 100%
Other expenses: 800 000 290 000 38,1% 18,2%
Computer software 50 000 20 000 2,4% 1,3%
Bad debts 295 000 50 000 14,0% 3,1%
Advertising 120 000 60 000 5,7% 3,8%
Salaries and 90 000 40 000 4,3% 2,5%
wages
Insurance 200 000 100 000 9,5% 6,3%
Depreciation 45 000 20 000 2,1% 1,3%
Profit before finance charges 1 300 000 1 300 000 61,9% 81,8%
Less finance charges 100 000 10 000 4,8% 0,6%
Profit before tax 1 200 000 1 290 000 57,1% 81,1%
Taxation expense 440 000 645 000 21,0% 40,6%
Profit for the period 760 000 645 000 36,2% 40,6%
Other comprehensive income for the period 0 0 0 0
Total comprehensive income for the period 760 000 645 000 36,2% 40,6%
Edwards Stores 20X2 20X1 20X2

Statement of financial position C C % 20X1
%
Assets
Non-current assets 2 900 000 2 100 000 49% 62%
Property, plant and equipment 1 800 000 900 000 30% 25%
Investment at cost 1 100 000 1 300 000 19% 37%
Current assets 3 008 000 1 345 000 51% 38%
- Inventory 1 500 000 375 000 25,4% 10,6%
- Accounts receivable 1 500 000 350 000 25,4% 9,9%
- Cash 8 000 620 000 0,2% 17,5%
5 908 000 3 545 000 100,0% 100,0%

Ordinary share capital 500 000 500 000 8% 14%
10% Preference share capital 350 000 300 000 6% 8%
Retained earnings 1 658 000 945 000 28% 27%
Shareholders equity 2 508 000 1 745 000 42% 49%
Long-term loan 2 000 000 800 000 34% 23%
Debentures 600 000 600 000 10% 17%
Deferred taxation 400 000 300 000 7% 8%
Current liabilities 400 000 100 000 7% 3%
5 908 000 3 545 000 100% 100%
1170 Chapter 28

Interpretation of the vertical analysis:
The statement of financial position:
The elements in the statement of financial position are analysed as a percentage of total financing
(equity and liabilities).
From the analysis above, it can be seen that whereas in 20X1 only 25% of total financing was
spent on property, plant and equipment, 30% has been allocated this year. Normally, with an
increase in property, plant and equipment, a resultant increase in profits is expected, yet the profits
have deteriorated since 20X1 (as evidenced by the horizontal analysis above).
The percentage spent on investments decreased from 37% to 19%. It is difficult to say from such
an analysis whether or not this was advantageous to the company. It will be necessary to calculate
the return on investment and compare it with the return on non-current assets and return on equity
(these calculations form part of the ratio analysis).
The investment in inventory has increased from 10,6% to 25,4%. This increase may be due to the
increase in demand evidenced by the 67% increase in sales (see the horizontal analysis of the
statement of comprehensive income). Conversely, it may indicate that the inventory is slow-
moving or obsolete.
The increase in accounts receivable from 9,9% to 25,4% may indicate that the company's debtors
collection policy is deteriorating or that extended credit terms were offered.
The retention of 17,5% of financing in the form of cash reserves has dropped to 0,2%, which may
indicate severe cash flow problems or may be an indication of a more risk seeking approach from
management. This should not always be seen as a fault, since as the saying goes: the higher the
risk, the higher the return.
The statement of comprehensive income:

The vertical analysis of the statement of comprehensive income above, includes a twofold analysis: it
first analyses cost of sales and gross profit as a percentage of sales and since there is 'other income', the
rest of the statement of comprehensive income has been analysed as a percentage of gross income
instead. There is, however, no specific approach that has to be followed when performing such an
analysis. The emphasis here is simply to perform an analysis that provides the user with information
that is useful to him. For instance, the analysis could have been done with each line item of expenses
shown as a percentage of total expenses, sales or, indeed gross income. The variations are endless.
The vertical analysis of a statement of comprehensive income assists in gauging the efficiency of
company operations. For example, for every C1 of sales, C0.60 was spent on the cost of the inventory
sold which is more than was spent last year (C0.50 per C1 of sales). This obviously means that the cost
effectiveness of operations has deteriorated somewhat since last year. Each line item can be analysed in
this way (i.e. as a percentage of sales). Since, however, other income has also been earned, each line
item has been calculated as a percentage of the total gross income instead of sales.
The more dramatic movements are commented upon below:
The increase in the cost of sales as a percentage of sales may indicate a poor buying policy (e.g.
increased rush orders), a more expensive supplier, a better quality product or may simply reflect
the effects of inflation.
There has been a very serious increase in bad debts with C0.14 out of every C1 of profit being lost
to bad debts whereas, in the prior year, only C0.031 was lost in this way. This seems to correlate
with the increase in debtors: debtors constituted 9,9% of total finance in 20X1 whereas 25,4% of
total finance in 20X2.
The cost of financing is taking a substantially bigger bite out of sales, with almost C0.05 out of
every C1 of sales being spent on financing versus only C0.006 in 20X1.
Similarly, the cost of insurance is now C0.095 out of every C1 of gross income versus only C0.063
in 20X1. This would seem due to the increased investment in inventories from 10,6% to 25,4 %
and a similar increase in property, plant and equipment from 25% to 30% (as revealed in the
vertical analysis of the statement of financial position).
There has been a significant decrease in tax, from almost C0.41 for every C1 of gross income to
C0.21 thereof in 20X2. Assuming that there are no permanent differences or other reconciling
items, this would mean that there was a change in tax rate. This resulted in the profit after tax
decreasing by only C0.043 per C1 of gross income (from C0.405 to C0.362) whereas, the profit
before tax actually decreased by C0.24 per C1 since 20X1
Chapter 28 1171

Conclusion:
Despite the 100% increase in property, plant and equipment, the profit before tax (a truer reflection
of the profitability of the company than the profit after tax, whose decrease was diluted by the
decrease in the tax rate), decreased by 7%. Whereas C0.81 per C1 was retained as profit (before tax)
in 20X1, only C0.57 per C1 of profit was retained in 20X2.
As far as the liquidity is concerned, it appears that the company suffered a cash flow shortage (partly
due to the increased investment in non-current assets) with the result that the company raised 67% in
finance during the year.
The increase in accounts receivable and accounts payable seem to indicate that there is a continuing
cash flow shortage with the collection of accounts receivable impacting adversely on the ability to
repay the creditors. Although there was an increased investment in current assets (from 38% to 51%
of total assets), the increase resulted from inventories and accounts receivable, with cash having
reduced by 99%. This would seem to confirm a cash flow problem.
The finance structure of the company seems to rely too heavily on risky loan finance than equity.
All in all, the company appears to have deteriorated since 20X1 and thus investment therein should
be avoided.
Comment: The interpretation of the analysis may differ from one user to another and reasons offered
for increases and decreases are suggestions only.
Please also note that when analysing the statement of comprehensive income references are still
made to the statement of financial position (and vice versa): the most important aspect of an analysis
and interpretation is to see the bigger picture and therefore different line items, financial statements
and techniques should be considered together rather than separately.
6. Ratio Analysis in More Detail
Understanding the calculation and analysis of ratios is best understood by way of example,
thus let us use the following financial statements as a worked example to explain each ratio.
Worked example: Ratio analysis
The following are the financial statements of Cashew-head Limited, a nuts retailer.
Cashew-head Limited
20X6 20X5
ASSETS C C
Property, plant and equipment 3 150 000 1 575 000
Investment at cost 1 925 000 2 275 000
Current assets 5 264 000 2 353 750
Inventory 2 625 000 656 250
Accounts receivable 2 625 000 612 500
Cash 14 000 1 085 000
10 339 000 6 203 750
Issued share capital and reserves 4 747 750 3 395 000
Non-current loan 3 500 000 1 400 000
Debentures 1 050 000 1 050 000
Deferred taxation 700 000 183 750
Capital employed 9 997 750 6 028 750
Current liabilities
Accounts payable 341 250 175 000
10 339 000 6 203 750
1172 Chapter 28
Worked example: Ratio analysis continued ...
Cashew-head Limited
share capital share earnings
C3.50 each capital
C C C C
Opening balances: 1 January 20X5 875 000 525 000 612 500 2 012 500
Less dividends declared:
Opening balances: 1 January 20X6 875 000 525 000 1 995 000 3 395 000
Less dividends declared:
Preference share issue 87 500 87 500
Closing balances: 31 December 20X6 875 000 612 500 3 260 250 4 747 750
Cashew-head Limited
20X6 20X5
C C
Revenue from sales 8 750 000 5 250 000
Cost of sales 5 250 000 2 625 000
Gross profit 3 500 000 2 625 000
Total other expenses 1 400 000 507 500
Profit before finance charges 2 100 000 2 117 500
Finance charges (all relating to no-current liabilities) 175 000 17 500
Taxation expense 577 500 630 000
Market price per share 1,25 1,00
6.1 Profitability Ratios
6.1.1 Gross Profit Percentage/margin

Gross profit %/margin:
The gross profit ratio can fluctuate for many reasons:
Changes in mark-up Gross profit x 100
Net sales 1
This could involve either a direct change to the
selling price or the offering of trade/ cash discount: the sales figure disclosed on the face
of the statement of comprehensive income is net of trade and cash discounts.
Stock thefts
Theft of inventory causes the closing stock to decrease and therefore the cost of sales to
increase in a manner that is out of proportion to the sales.
Chapter 28 1173
Incorrect inventory counts

Obviously, if either the opening or closing balance of inventory is incorrect, it will cause
the cost of sales to increase/decrease in a manner that is out of proportion to the sales.
Incorrect/ inconsistent valuation of inventory
Obviously, if either the opening or closing balance of inventory has been valued
incorrectly or inconsistently, the cost of sales will be distorted.
Example 2: Cashew-head Limited: gross profit percentage margin
20X6 20X5
Gross profit 100 3 500 000 100 2 625 000 x 100
x = x
Net sales 1 8 750 000 1 5 250 000 1
= 40% 50%
6.1.2 Net Profit Percentage/margin

Net profit percentage/ margin
The net profit figure used should be
Profit before finance charges and tax 100
before interest and tax so that the profit x
Net sales 1
from the business operations is not
influenced either by the entity’s financing
methods or the tax structure of the country in which it operates.
Ideally, any non-operating income e.g. investment income should also be excluded, since the
purpose of the ratio is to calculate that portion of every C1 of sales that is saved (i.e. not spent
through the operations of the business).
Items that would affect the net profit percentage include:

any change that affects the gross profit percentage (above) will obviously also affect the
net profit percentage;
changes to the operating expenditure (e.g. bad debts, cash discount, depreciation) and
other income (if included) will affect the net profit percentage.
It is slightly more difficult to ascertain the true reasons behind a change in net profit
percentage if the user is faced with a set of published financial statements. This is because
International Reporting Standards and other legislative requirements necessitate only limited
disclosure of the related items.
Although a reduction in operating expenses could naturally be expected to lead to increased
profitability, excessive reduction thereof could, in fact, leave the company operating
inefficiently and an inefficient operation will ultimately reduce profits anyway.
Example 3: Cashew-head Limited: net profit percentage margin
20X6 20X5
Profit before tax and interest 100 = 2 100 000 100 2 117 500 100
Net sales x 1 8 750 000 x 1 5 250 000 x 1
= 24% 40%
6.1.3 Return on capital employed

Return on capital employed
Capital employed’ constitutes share capital and
long-term finance. This ratio thus calculates the Profit before finance charges and tax x 100
average return belonging to both the suppliers of Average capital employed 1
capital and long- term finance.
1174 Chapter 28
For the sake of simplicity, the ratio is normally calculated with the ‘numerator’ being ‘profits
before tax’ rather than after tax. When reversing the interest expense, care must be taken not
to reverse any interest paid to the short-term suppliers of finance (i.e. the profits calculated
must be after payment of interest to the short-term financiers), since that interest does not
belong to the providers of long-term capital.
Illustration: Imagine that a company has profits before tax of C50 and that these profits are
calculated after deducting the interest expense of C50: C20 interest to short-term financiers
and C30 interest to long-term financiers. The profit before interest and tax is calculated as
follows:
C
Profits before taxation and interest (balancing) 100
Less interest paid to short-term financiers 20
Less interest paid to long-term financiers 30
Profits before taxation 50
The aim of this ratio is to indicate the earnings before tax (as a percentage return) belonging
to the providers of capital and long-term finance. Hence, not all of the C100 ‘profit before
interest and tax’ belongs to the aforementioned providers. Instead, C20 thereof belongs to the
short-term financiers. The interest that belongs to the long-term financiers needs to be
reversed (i.e. C50 + C30 = C80 belongs to the providers of capital and long-term finance).
Example 4: Cashew-head Limited: return on capital employed
Return on capital employed in 20X6 :
Profit before finance charges and tax 100 2 100 000 100
x = x
Average capital employed 1 (9 997 750 + 6 028 750) / 2 1
= 26,21%
6.1.4 Return on owners’ equity

This is an important ratio to the owners of Return on owners’ equity
the shares since they require a certain Profit after tax and preference dividends x 100
return relative to the risks involved with Average ordinary shareholders’ equity 1
the investment in the entity.
Since the object of this formula is to calculate the return owing to the ordinary shareholders,
the earnings should be calculated by deducting preference dividends and tax since both the
preference shareholders and the tax authorities have first rights to the profits: any profits
remaining belong to the ordinary shareholders. Ordinary dividends should not be deducted
since they belong to the ordinary shareholders.
Example 5: Cashew-head Limited: return on owners’ equity
Return on owner’s equity in 20X6:
Profit after tax & pref dividends x 100 1 347 500 – 61 250 x 100
Average ord shareholder’s equity 1 = (4 747 750 – 612 500 + 3 395 000 – 525 000 ) / 2 1
= 36,7%
6.1.5 Return on Assets

Return on assets
As with the return on capital employed,
the effects of financing should be Profit before finance charges and tax 100
removed. This ratio indicates the Average total assets x 1
effectiveness of management’s use of the
company assets entrusted to them.
Chapter 28 1175
Example 6: Cashew-head Limited: return on assets

Return on assets in 20X6:
Profit before finance charges & tax x 100 = 2 100 000 x 100
Average total assets 1 (10 339 000 + 6 203 750) / 2 1
= 25,4%
6.1.6 Earnings per ordinary share
This ratio is similar to the ‘return on

ordinary equity’ although the ‘earnings Earnings per ordinary share
per share’ is calculated as a value per
share whereas in the former case, Profit after tax less preference dividends 100
earnings are calculated as a percentage of Number of ordinary shares x 1
the value of capital.
‘Earnings per share’ is usually calculated for ordinary shares only since preference shares
generally do not share n earnings (unless participative), but rather in a fixed dividend only.
‘Earnings per share’ must be disclosed either on the face of the statement of comprehensive
income or in the notes thereto. IAS 33 governs the calculation and disclosure of ‘earnings per
share’.
Example 7: Cashew-head Limited: earnings per ordinary share
20X6 20X5
Profit after tax less preference dividends (1 347 500 – 61 250) (1 470 000 –52 500)
=
Number of ordinary shares (875 000 / 3,5) (875 000 / 3,5)
= 5,15 5,67
6.1.7 Dividends per share
Whilst the ‘earnings per share’ ratio Dividends per share

merely calculates how much has been
earned per share, this ratio calculates how
much has actually been declared to the Ordinary (or preference dividends 100
Number of ordinary (or preference) shares x 1
shareholders.
Example 8: Cashew-head Limited: dividends per ordinary share
20X6 20X5
Ordinary dividends 21 000 35 000
=
Number of ordinary shares (875 000 / 3,5) (875 000 / 3,5)
= 0,08 0,14
6.1.8 Ordinary dividend payout ratio
This ratio calculates the percentage of the Ordinary dividend payout ratio
earnings belonging to the ordinary
shareholder that are actually distributed to
Dividends per share Dividends
the ordinary shareholder. or
Earnings per share Earnings
1176 Chapter 28
Example 9: Cashew-head Limited: ordinary dividend payout ratio
20X6 20X5
Ordinary dividends per share 0,08 0,14
=
Earnings per ordinary shares 5,15 5,67
= 0,016 : 1 0,025 : 1
6.1.9 Price earnings ratio

Price earnings ratio
This ratio reflects how much investors are
willing to pay per C1 of reported profits.
Market price per share
Earnings per share
Theoretically, the greater the profits the
more they would be willing to pay.
There are, however, many other factors that play a part in determining the market price per
share, e.g. the company’s performance relative to other companies in the industry, inflation,
the risks relating to the investment in the company and expected future growth.
Example 10: Cashew-head Limited: price earnings ratio
20X6 20X5
Market price per ordinary share 1,25 1,00
=
Earnings per ordinary shares 5,15 5,67
= 0,24 : 1 0,18 : 1
6.1.10 Earnings yield Earnings yield
This calculates the earnings as a

Earnings per share 100
percentage of each C1 invested. x
Market price per share 1
Example 11: Cashew-head Limited: earnings yield
20X6 20X5
Earnings per ordinary share 100 = 5,15 100 5,67 100
Market price per ordinary share x 1 1,25 x 1 1,0 x 1
= 412% 567%
6.1.11 Dividend yield Dividend yield
This calculates the dividends as a

percentage of each C1 invested. A high Dividends per share 100
Market price per share x 1
dividend yield may be as a result of either
a relatively high payout or a share price
that is very low (perhaps indicating market sentiment that the company has a limited future).
Example 12: Cashew-head Limited: dividend yield
20X6 20X5
Dividend per ordinary share 100 = 0,084 x 100 100 0,14 x 100 100
Market price per ordinary share x 1 1,25 x 1 1,00 x 1
= 6,7% 14%
Chapter 28 1177
6.2 Liquidity ratios

Liquidity ratios indicate the ability of the company to repay its debts in the short-term.
6.2.1 Current ratio

Current ratio
The current ratio indicates the ability to Current assets : Current liabilities
repay the current liabilities out of the
current assets. Theoretically, the normal ratio is considered to be 2:1.
Example 13: Cashew-head Limited: current ratio
20X6 20X5
Current assets: Current liabilities = 5 264 000 : 341 250 2 353 750 : 175 000
= 15,4 : 1 13,45 : 1
6.2.2 Acid-test ratio
The acid-test ratio is a modified current ratio that takes into account the fact that inventory
may be a relatively difficult current asset to convert into cash.
Acid-test ratio
This ratio therefore reflects a more
Current assets - Inventories : Current liabilities
conservative view of the ability of the
company to repay its current liabilities
within a short period. Theoretically, the normal ratio is considered to be 1:1.
Example 14: Cashew-head Limited: acid-test ratio
20X6 20X5
Current assets - Inventories: Current liabilities = 5 264 000 – 2 625 000 : 2 353 750 – 656 250:
341 250 175 000
= 7,73 : 1 9,7 : 1
6.2.3 Working capital ratio

Working capital ratio
This ratio indicates the percentage of total Working capital :Total assets
assets that are relatively liquid. Working
capital is calculated as ‘current assets – current liabilities’.
Example 15: Cashew-head Limited: working capital ratio
20X6 20X5
Working capital: Total assets = 5 264 000 – 341 250 : 2 353 750 – 175 000:
10 339 000 6 203 750
= 0,48 : 1 0,35 : 1
6.2.4 Debtors collection period
This ratio gives an idea of the average Debtors collection period

period of time it takes between the date of
sale and the final receipt of cash. The Average debtors balance
period used may be given in days or Credit sales per day
months (in which case multiply by 12
instead of 365).
1178 Chapter 28
Example 16: Cashew-head Limited: debtors’ collection period

Debtors collection period in 20X6:
Average debtors balance x 365 = (2 625 000 + 612 500) / 2 x 365

Net credit sales 1 8 750 000 1
= 67,525 days*
*This is on the assumption that all sales are on credit
6.2.5 Debtors’ turnover

Debtors turnover
This ratio indicates the entity’s credit and Net credit sales
collection efficiency. Average debtors balance
OR
It is based on an inverse of the debtors 365
collection period. There are thus two Debtors collection period
ways of calculating this ratio – both give
the same answer of course.
Example 17: Cashew-head Limited: debtors’ turnover

Debtors turnover in 20X6:
Net credit sales = 8 750 000

Average debtors balance (2 625 000 + 612 500) / 2
= 5,41 times*
6.2.6 Days supply (or inventory) on hand

This ratio indicates how long the balance Days supply(or inventory) on hand
of stock on hand will last (i.e. the number
of days supply in average inventory) and Average inventory balance
therefore highlights over/ under Cost of sales/ day
investments in inventory
Example 18: Cashew-head Limited: days supply on hand

Days supply on hand in 20X6:
Average inventory balance x 365 = (2 625 000 + 612 500) / 2 x 365

Cost of sales 1 5 250 000 1
= 114,063 days*
6.2.7 Inventory turnover

Inventory turnover
This ratio indicates how fast inventory is
turned over (sold) - i.e. how liquid Cost of sales
inventory is. A low turnover may indicate Average inventory balance
over-stocking or obsolescence whereas a OR
high turnover may indicate under-
365
stocking. Days inventory on hand
Comparing this to the ‘days stock on

hand' ratio brings us to another way of calculating the inventory turnover.
Chapter 28 1179
Example 19: Cashew-head Limited: inventory turnover

Inventory turnover in 20X6:
Cost of sales = 5 250 000

Average inventory balance (2 625 000 + 656 250) / 2
= 3,2 times*
6.2.8 Creditors payment period
This ratio indicates how long we take to pay our Creditors payment period
trade creditors: a long period could indicate
Average creditors balance
cash flow problems or that we are making full Credit purchases/ day
use of relatively cheap finance (but beware the
cost of the loss of cash discounts) or it may indicate that credit terms have been extended.
Example 20: Cashew-head Limited: creditors’ payment period

Creditors’ payment period in 20X6:
Average creditors balance x 365 = (341 250 + 175 000) / 2 x 365

Credit purchases 1 (5 250 000 + 2 625 000 – 656 250) 1
= 13,05 days
6.2.9 Creditors’ turnover Creditors turnover
This ratio indicates how many times creditors Credit purchases

are paid during the period. Average creditors balance
Example 21: Cashew-head Limited: creditors turnover

Creditors turnover in 20X6:
Credit purchases = (5 250 000 + 2 625 000 – 656 250)

Average creditors balance (341 250 + 175 000) / 2
= 30 times
6.2.10 Business cycle days

Business cycle days
This ratio indicates how long cash is tied up in Days supply of inventory
the operating cycle and therefore helps budget + Debtors collection period
– Creditors repayment period
for cash requirements needed to operate the
business.
Example 22: Cashew-head Limited: business cycle
Business cycle in 20X6:
Days supply of inventory + debtors collection period – creditors repayment period = 114,063 + 67,525 – 13,05
= 168,538 days
6.3 Solvency/ structure ratios
The solvency or structure ratios indicate the ability to meet long-term obligations.
6.3.1. Equity ratio

Equity ratio
This ratio indicates how much of the asset Owner’s equity : Total assets
base is financed by owners thus also
indicating the strength of the company. Please remember that redeemable preference shares
could be argued to be debt rather than equity.
1180 Chapter 28
Example 23: Cashew-head Limited: equity ratio
20X6 20X5
Owner’s equity: total assets = 4 747 750 : 10 339 000 3 395 000 : 6 203 750
= 0,46 : 1 0,55 : 1
6.3.2. Debt ratio

Debt ratio
This ratio indicates how much of the asset
Total debt (current and non-current) :
base is financed by external parties. Total assets (current and non-current)
Example 24: Cashew-head Limited: debt ratio
20X6 20X5
Total debt: total assets = (10 339 000 – 4 747 750) : 10 339 000 (6 203 750 – 3 395 000) : 6 203 750
= 0,54 : 1 0,45 : 1
6.3.3. Solvency ratio

Solvency ratio
This is the inverse of the debt ratio. It
indicates how much of the liabilities are Total assets (current and non-current):
covered by assets - in essence, the capacity of Total debt (current and non-current)
the company to repay its debts in the long-term.
Example 25: Cashew-head Limited: solvency ratio
20X6 20X5
Total assets: total debt = 10 339 000 : (10 339 000 – 4 747 750) 6 203 750 : (6 203 750 – 3 395 000)
= 1,85 : 1 2,21 : 1
6.3.4. Debt to equity ratio

Debt to equity ratio
This ratio indicates the ratio in which the
Total debt (non-current and current):
company is financed by internal shareholders’ Shareholders' equity (ordinary, preference)
capital (equity) versus external third party capital
(debt). Debt is considered to be cheaper but riskier than equity finance.
Example 26: Cashew-head Limited: debt equity ratio
20X6 20X5
Total debt: shareholder’s equity = (10 339 000 – 4 747 750) : 4 747 750 (6 203 750 – 3 395 000): 3 395 000
= 1,18 : 1 0,83 : 1
6.3.5. Borrowing ratio

Borrowing ratio
This ratio is similar to the debt equity ratio except
that it only concentrates on the debt that costs the Interest-bearing debt:
company money. Shareholders' equity (ordinary, preference)
Example 27: Cashew-head Limited: borrowing ratio
20X6 20X5
Interest bearing debt: = (3 500 000 + 1 050 000 + 341 250) : (1 400 000 + 1 050 000 + 175 000):
Shareholders’ equity 4 747 750 3 395 000
= 1,03 : 1 0,77 : 1
Chapter 28 1181
7. Summary
Financial Analysis and

Interpretation
Statements of cash Ratio Analysis Common-sized financial

flows statements
This statement must be These ratios generally Horizontal analysis:
analysed to prevent cash concentrate on the This highlights increases
flow problems that could following areas: and decreases in the
ultimately lead to Profitability sources of finance
liquidity problems and Liquidity (equity and liabilities),
eventually, final Solvency assets, income and
liquidation expenses
Vertical analysis:
Each line item is analysed
as a percentage of a
base, then compared with
the prior year for
fluctuations
Profitability ratios Liquidity ratios Solvency ratios

These ratios analyse the These ratios measure the These ratios measure the
profits in the statement ability of the company to ability of the entity to
of comprehensive income repay its debts in the repay its debts in the
as well as the short-term. They usually long-term. They usually
profitability in relation focus on current assets deal with total assets and
to the related capital and current liabilities total liabilities
investments and sources
of finance presented in
the statement of
financial position
Gross profit percentage Current ratio Equity ratio

Net profit percentage Acid-test ratio Debt ratio
Return on capital Working capital ratio Solvency ratio
employed Debtors’ collection Debt equity ratio
Return on owner’s period Borrowing ratio
equity Debtors’ turnover
Return on assets Inventory on hand
Earnings per share Inventory turnover
Dividends per share Creditors’ payment
Dividend payout period
Price earnings Creditors’ turnover
Earnings yield Business cycle
Dividend yield
1182 Chapter 28

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Acknowledgements and thanks:

Sue Ludolph: SAICA Project Director: Accounting

Editing of layout and formatting: Sue Trollip

Contacting the authoress: Cathrynne Service Via Facebook:

Writing it would simply not have been possible without

Too numerous to mention, are the rest of my family and friends,

(‘counting mutants’ is a quirky reference to accountants in the comedy:

My own lifelong - and appalling - inability to accurately distinguish between debits

Dr. Roger Service

Bon voyage! And remember that with enthusiasm,

The ongoing international harmonisation and improvements projects have seen a

Gripping GAAP is designed for those who wish to:

4 IFRS 15 Revenue from contracts with customers 102

5 IAS 12 Taxation: various types and current income tax 204

6 IAS 12 Taxation: deferred taxation 247

7 IAS 16 Property, plant and equipment: cost model 340

8 IAS 16 Property, plant and equipment: revaluation model 393

9 IAS 38 Intangible assets 447

10 IAS 40 Investment property 489

11 IAS 36 Impairment of assets 527

13 IAS 2 Inventories 629

14 IAS 23 Borrowing costs 691

15 IAS 20 Government grants and government assistance 716

16 IAS 17 Leases: lessee accounting 752

17 IAS 17 Leases: lessor accounting 803

19 IAS 19 Employee benefits 878

20 IAS 21, IFRS 9, & Foreign currency transactions 922

26 IAS 8 Accounting policies, estimates and errors 1095

27 IAS 7 Statements of cash flows 1126

28 N/A Financial analysis and interpretation 1158

The Reporting Environment

If you’re studying towards being a SA Chartered Accountant, the SAICA’s

2. A Brief History of Accounting

2.1 Accounting is a language

Accounting is just another language, one Examples of typical users:

2.2 Accounting has evolved

2.3 The difference between the double-entry system and GAAP

2.4 The difference between GAAP and IFRS

Since the beginning of the industrial revolution,

The Daimler-Benz Story:

3. GAAP and IFRSs – The Process of Internationalisation

3.1 A brief history of the internationalisation of GAAP into IFRSs

The idea of this single global accounting language is not new!

3.2 International Financial Reporting Standards (IFRSs)

3.2.2 The meaning of the term: IFRSs

3.2.3 The meaning of the term: Standards Standards represent

by the IASB are prefixed with IFRS.

3.2.4 The meaning of the term: Interpretations

Interpretations are given the same authority as the standards. Interpretations

3.4 Compliance with IFRSs (adoption)

Apart from a country’s legislative requirements, IAS 1 Presentation of Financial Statements

3.4.3 The extent of compliance with IFRS around the world

3.5 Harmonisation versus Convergence

In this regard, two terms are commonly used:

3.6 Adoption versus Convergence

Adopt or converge? One country resisting the adoption of

3.7 Development of IFRSs (standard-setting)

3.7.2 Standards developed to date

3.7.3 Interpretations developed to date

3.7.4 Due Process

This due process is set-out in the Due Process Handbook.

3.7.4.2 Principles of Due Process

3.7.4.3 The Basic Development Cycle