2016

ADVANCED ACCOUNTING AND

FINANCIAL REPORTING
STUDY SUPPORT MATERIAL

ICAP
Advanced accounting and
financial reporting

First edition published by

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Advanced accounting and financial reporting

C
Contents
Page

Syllabus objective and learning outcomes

Chapter
1

Regulatory framework

Accounting and reporting concepts

25

Presentation of financial statements

(IAS 1, IAS 34, IAS 24, IFRS 8, IAS 10)

53

IAS 8: Accounting policies, changes in accounting estimates

and errors

81

IFRS 15: Revenue from contracts with customers

103

IAS 16: Property, plant and equipment

117

Non-current assets: sundry standards

(IAS 23, IAS 20 and IAS 40)

149

IAS 38: Intangible assets

173

IAS 36: Impairment of assets

195

10

IFRS 5: Non-current assets held for sale and discontinued

operations

213

11

IFRS 16: Leases

235

12

IAS 37: Provisions, contingent liabilities and contingent assets

292

13

IAS 19: Employee benefits

323

14

IFRS 2: Share based payments

349

15

Financial instruments: Recognition and measurement

395

16

Financial instruments: Presentation and disclosure

457

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Page

17

IFRS 13: Fair value measurement

475

18

IAS 12: Income taxes

493

19

Business combinations and consolidation

535

20

Consolidated statements of profit or loss and other

comprehensive income

577

21

Associates and joint ventures

589

22

Business combinations achieved in stages

607

23

Complex groups

625

24

Disposal of subsidiaries

659

25

Other group standards (IAS 27 and IFRS 12)

687

26

Foreign currency

697

27

IAS 7: Statements of cash flows

729

28

IAS 33: Earnings per share

771

29

Analysis and interpretation of financial statements

811

30

Sundry standards and interpretations

(IAS 2, IAS 41, IFRS 6, IFRS 14, IFRIC 12, SIC 7)

853

31

IFRS 1: First time adoption of IFRS

879

32

Specialised financial statements

891

33

International public sector accounting standards (IPSAS)

933

34

Accounting for hyperinflation

949

35

Islamic accounting standards

963

36

Ethical issues in financial reporting

977

Index

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

S
Syllabus objective
and learning outcomes
CERTIFIED FINANCE AND ACCOUNTING PROFESSIONAL
ADVANCED ACCOUNTING AND FINANCIAL REPORTING
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.
Learning Outcome
On the successful completion of this paper candidates will be able to:
1

prepare financial statements in accordance with the international pronouncements

and under the Companies Ordinance, 1984.

evaluate and analyse financial data in order to arrive at firm decisions on the
accounting treatment and reporting of the same.

exercise professional judgment and act in an ethical manner (that is in the best
interest of society and the profession).

prepare financial statements of specialized entities (including small and medium

sized entities in accordance with the Companies Ordinance, 1984 and the
applicable reporting framework, retirement benefit funds in accordance with
international pronouncements) and be able to demonstrate an understanding of
reporting requirements under the laws specific to insurance, banking companies
and mutual funds.

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Advanced accounting and financial reporting

Grid

Weighting

Presentation of financial statements including public

sector accounting

30-35

Financial reporting (including ethics)

50- 60

Specialized financial statements

10-15
Total

Contents
A

100

Chapter

Presentation of financial statements including public sector

accounting
1

Presentation of financial statements (IAS 1, IAS 7 and Companies

Ordinance 1984)

2, 3, 25

IAS 27: Separate financial statements

IFRS 10: Consolidated financial statements

IAS 28: Accounting for associates and joint ventures

20

IFRS 11: Joint arrangements

20

IFRS 12: Disclosure of interests in other entities

22

IAS 34: Interim financial reporting

IAS 29: Financial Reporting in Hyperinflationary Economies

33

IFRS 5: Non-current assets held for sale and discontinued

operations

10, 22

23
18, 19, 22

10 IFRS 8: Operating segments

11 Overview of IPSASs and the conceptual framework for general

purpose financial reporting by public sector entities

32

12 IPSAS 1 Presentation of financial statements

32

13 IPSAS Financial reporting under the cash basis of accounting (this

IPSAS has not been given any number).

32

Financial reporting and ethics

a

Financial reporting

The Conceptual Framework for the preparation and presentation of

financial statements

IFRS 1: First-time adoption of international financial reporting

standards

30

IFRS 2: Share-based payment

15

IFRS 3: Business combinations

18, 19, 21

IFRS 4: Insurance contracts

31

IFRS 6: Exploration for and evaluation of mineral resources

29

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Contents
B

Chapter

Financial reporting and ethics (continued)

a

Financial reporting (continued)

IFRS 7: Financial instruments: disclosures

17

IFRS 9: Financial Instruments

16

IFRS 13: Fair value measurement

2, 16

10 IFRS 14: Regulatory deferral accounts

29

11 IFRS 15: Revenue from contracts with customers

12 IAS 2: Inventories

29

13 IAS 8: Accounting policies, changes in accounting estimates and

errors

14 IAS 10: Events after the reporting date

15 IAS 11: Construction contracts

16 IAS 12: Income Taxes

13

17 IAS 16: Property, plant and equipment

18 IFRS 16: Leases

11

19 IAS 18: Revenue

20 IAS 19: Employee benefits

14

21 IAS 20: Accounting for government grants and disclosure of

government assistance

22 IAS 21: The effects of changes in foreign exchange rates

24

23 IAS 23: Borrowing costs

24 IAS 24: Related party disclosures

25 IAS 32: Financial instruments: Presentation

17

26 IAS 33: Earnings per share

26

27 IAS 36: Impairment of assets

28 IAS 37: Provisions, contingent liabilities and contingent assets

12

29 IAS 38: Intangible assets

30 IAS 39: Financial instruments: recognition and measurement

16

31 IAS 40: Investment property

32 IAS 41: Agriculture

29

33 IFRIC 1: Changes in existing decommissioning, restoration and

similar liabilities

34 IFRIC 2: Members shares in co-operative entities and similar

instruments

17

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Contents
B

Chapter

Financial reporting and ethics (continued)

a

Financial reporting (continued)

35 IFRIC 4: Determining whether an arrangement contains a lease

11

36 IFRIC 5: Rights to interests arising from decommissioning, restoration

and environmental rehabilitation funds

12

37 IFRIC 6: Liabilities arising from participating in a specific market

waste electrical and electronic equipment

12

38 IFRIC 7: Applying the restatement approach under IAS 29 financial

reporting in hyperinflationary economies

33

39 IFRIC 10: Interim financial reporting and impairment

40 IFRIC 12: Service concession arrangements

29

41 IFRIC 13: Customer loyalty programmes

42 IFRIC 14: IAS 19 The limit on a defined benefit asset, minimum

funding requirements and their interaction

14

43 IFRIC 15: Agreements for the construction of real estate

44 IFRIC 16: Hedges of a net investment in a foreign operation

16

45 IFRIC 17: Distributions of non-cash assets to owners

17

46 IFRIC 18: Transfers of assets from customers

47 IFRIC 19: Extinguishing financial liabilities with equity instruments

17

48 IFRIC 20: Stripping costs in the production phase of a surface mine

49 IFRIC 21: Levies

21

50 SIC 7: Introduction of the euro

29

51 SIC 10: Government assistance no specific relation to operating

activities

52 SIC 15: Operating leases incentives

11

53 SIC 25: Income taxes changes in the tax status of an enterprise or

its shareholders

13

54 SIC 27: Evaluating the substance of transactions in the legal form of a

lease

11

55 SIC 29: Disclosure service concession arrangements

29

56 SIC 31: Revenue barter transactions involving advertising services

57 SIC 32: Intangible Assets web site costs

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Contents
B

Chapter

Financial reporting and ethics (continued)

b

Ethics

Professional misconduct under the Chartered Accountants Ordinance

1961

35

Code of Ethics issued by the Institute of Chartered Accountants of

Pakistan

35

Specialised financial statements

1

Small and medium sized entities

31

Banks

31

Mutual funds

31

Insurance companies

31

IAS 26: Accounting and reporting by retirement benefit plans

31

Overview of Islamic accounting standard issued by ICAP

34

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

Regulatory framework
Contents
1 Regulatory framework for accounting in Pakistan
2 Companies Ordinance 1984: Fourth Schedule
3 Companies Ordinance 1984: Fifth Schedule

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with international

pronouncements and under the Companies Ordinance, 1984.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A1

Presentation of financial statements (Companies Ordinance 1984)

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REGULATORY FRAMEWORK FOR ACCOUNTING IN PAKISTAN

Section overview

Accounting regulation in Pakistan

Companies Ordinance 1984: Introduction to accounting requirements

Companies Ordinance 1984: Introduction to the fourth and fifth schedules

Applicability of accounting standards in Pakistan

Accounting standards: Three tier approach

International Financial Reporting Standards

1.1 Accounting regulation in Pakistan

The objective of financial statements is to provide information about the financial
position (balance sheet), financial performance (profit and loss) and cash flows of
an entity that is useful to a wide range of users in making economic decisions.
The Securities and Exchange Commission of Pakistan
The Securities and Exchange Commission of Pakistan (SECP) was established
by the Securities and Exchange Commission of Pakistan Act, 1997 and became
operational in 1999.
It is the corporate and capital market regulatory authority in Pakistan. Its stated
mission is To develop a fair, efficient and transparent regulatory framework,
based on international legal standards and best practices, for the protection of
investors and mitigation of systemic risk aimed at fostering growth of a robust
corporate sector and broad based capital market in Pakistan (SECP website).
One of the roles of the SECP is to decide on accounting rules that must be
applied by companies in Pakistan.
Companies must prepare financial statements in accordance with accounting
standards approved as applicable and notified in the official gazette by the
Securities and Exchange Commission of Pakistan (SECP) and in accordance
with rules in the Companies Ordinance 1984.
The Institute of Chartered Accountants in Pakistan (ICAP)
ICAP regulates the Chartered Accountancy profession. It is the body responsible
for recommending accounting standards for notification by the Securities and
Exchange Commission of Pakistan. The process is explained later.

1.2 Companies Ordinance 1984: Introduction to accounting requirements

The Companies Ordinance 1984 is the primary source of company law in
Pakistan. Amongst other things it establishes the requirements for financial
reporting by all companies in Pakistan.
General requirements
Every company must prepare annual accounts (financial statements) that provide
a true and fair view on the performance and activities of the company during the
year.
The financial statements comprise:

a balance sheet (statement of financial position): a structured

representation of the financial position of an entity;

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an income statement (statement of comprehensive income): a structured

representation of the financial performance of an entity.

a statement of changes in equity;

a cash flow statement;

notes to the accounts which contain a summary of significant accounting
policies and other information that sets out explanations of figures in the
main statements and provides supplementary information.

Section 234
Section 234 requires that every balance sheet (statement of financial position)
must give a true and fair view of the state of affairs of the company as at the end
of its financial year, and every profit and loss account or income and expenditure
account of a company must give a true and fair view of the profit and loss of the
company for the financial year.
All items of expenditure must be recognised in the profit or loss account unless it
may be fairly charged over several years. In such cases the whole amount must
be stated with the reasons why only part is charged against the income of the
financial year.
Other requirements
Assets and liabilities must be classified under headings appropriate to the
company's business.
The period reported on in the accounts is called the financial year.

1.3 Companies Ordinance 1984: Introduction to the fourth and fifth schedules
The Companies Ordinance 1984 contains a series of appendices called
schedules which set out detailed requirements in certain areas.
The fourth schedule to the Companies Ordinance 1984
This schedule sets out the detailed requirements that must be complied with in
respect of the balance sheet and profit and loss account of a listed company. It
also applies to private and non-listed public companies that are a subsidiary of a
listed company.
The schedule specifies that listed companies must follow International Financial
Reporting Standards as notified for this purpose in the Official Gazette.
The fifth schedule to the Companies Ordinance 1984
This schedule applies to the balance sheets and profit and loss accounts of all
other companies.
This schedule defines and applies to public interest companies, medium sized
companies and small sized companies. These categories determine which
accounting standards are followed. The three categories are defined in the next
section.

1.4 Applicability of accounting standards in Pakistan

Listed companies are subject to the requirements of the fourth schedule which
specifies the use of International Financial Reporting Standards as notified for
this purpose in the Official Gazette.

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The requirements of the fifth schedule that apply to other companies are more
complicated. The fifth schedule identifies different classes of companies and then
specifies the standards which must be applied by each class. The classes are as
follows:

Public interest companies which are non-listed companies which are either
x

A public sector company as defined in the Public Sector Companies

(Corporate Governance) Rules 2013; or

A public utility or similar company carrying on the business of

essential public service; or

A company that holds assets in a fiduciary capacity for a broad group

of outsiders (this class includes banks, insurance companies, pension
funds and mutual funds). (Note that accounting rules in addition to
those set out in the fourth and fifth schedules might apply to such
companies. This is covered in a later chapter).

Large sized companies which are non-listed companies which have:

x

paid-up capital of Rs. 200 million or more: or

turnover of Rs. 1 billion or more.

Medium sized companies which are non-listed companies which are not:
x

a public interest company; or

a large sized company; or

small sized company (other than a non-listed public company).

Small sized companies which are non-listed companies (other than a nonlisted public company) which have:
x

paid-up capital not exceeding Rs. 25 million: or

turnover not exceeding Rs. 100 million.

Accounting standards apply to these classes as follows.

Class

Criteria

Public interest companies

IFRS as approved and notified by SECP

Large sized companies

IFRS as approved and notified by SECP

Medium sized companies

IFRS for Small and Medium Entities as adopted in

Pakistan by council of ICAP (or IFRS as approved
and notified by SECP if they elect to do so).

Small sized companies

Revised Accounting and Financial Reporting

Standards for Small-Sized Entities (AFRS for
SSEs) as approved by the council of ICAP (or
IFRS as approved and notified by SECP if they
elect to do so).

All other companies including foreign companies which do not fall into any of the
above categories must follow Full IFRS as approved and notified by SECP.
The SECP may upon application made to it, grant an exemption to any company
or class of company from compliance with all or any of the requirements of the
standards.

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The SECP encourages medium sized companies and small sized companies to
follow IFRS as approved and notified by SECP.
Specific rules apply to companies formed under section 42 of the Companies
Ordinance (associations not for profit) and section 43 of the Companies
Ordinance (companies limited by guarantee). This guidance is not in the syllabus
but IFRS as approved and notified by SECP would apply to many of these
companies.

1.5 Accounting standards: Three tier approach

As can be seen from the above, the regulatory framework in Pakistan uses a
three tier approach to specify which accounting standards must be followed by an
organisation.
Tier 1: Publically accountable entities
This includes:

Any entity that has filed, or is in the process of filing, its financial statements
with the Securities and Exchange Commission of Pakistan.

Public interest companies;

Large sized companies.

Any entity in this category must apply IFRS as approved as applicable and
notified in the official gazette by the Securities and Exchange Commission of
Pakistan.
For clarity:

A listed company must follow the fourth schedule and apply IFRS (as
specified and notified by the SECP).

Unlisted public interest companies and large sized companies must follow
the fifth schedule and apply IFRS (as specified and notified by the
SECP).

If there is a conflict between IFRS and any SECP guidance or decision the SECP
view must be applied.
Tier 2: Medium Sized Companies
Any company in this category must apply the IFRS for SMEs as adopted in
Pakistan by council of ICAP and follow the requirements of the fifth schedule.
Tier 3: Small Sized Companies
Any company in this category must apply the Revised Accounting and
Financial Reporting Standards for Small-Sized Entities (a single document
drafted and issued by ICAP) and follow the requirements of the fifth schedule.
The AFRS is not examinable.

1.6 International Financial Reporting Standards

The International Accounting Standards Committee (IASC) was established
in 1973 to develop international accounting standards with the aim of
harmonising accounting procedures throughout the world.
The first International Accounting Standards (IASs) were issued in 1975. The
work of the IASC was supported by another body called the Standing
Interpretation Committee. This body issued interpretations of rules in standards

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when there was divergence in practice. These interpretations were called

Standing Interpretation Committee Pronouncements or SICs.
In 2001 the constitution of the IASC was changed leading to the replacement of
the IASC and the SIC by new bodies called the International Accounting
Standards Board (IASB) and the International Financial Reporting
Interpretations Committee (IFRIC).
The IASB adopted all IASs and SICs that were extant at the time but said that
standards written from that time were to be called International Financial
Reporting Standards (IFRS). Interpretations are known as IFRICs.
The term IFRS is also used to refer to the whole body of rules (i.e., IAS and IFRS
in total).
Thus IFRS is made up as follows:
Published by the IASC
(up to 2001)

Published by the IASB

(from 2001)

Accounting standards

IASs

IFRSs

Interpretations

SICs

IFRICs

Note that many IASs and SICs have been replaced or amended by the IASB
since 2001.
International accounting standards cannot be applied in any country without the
approval of the national regulators in that country. All jurisdictions have some
kind of formal approval process which is followed before IFRS can be applied in
that jurisdiction.
Adoption process for IFRS in Pakistan
The previous sections refer to the approval of IFRS by the SECP and notification
of that approval in the Official Gazette
Adoption of an IFRS involves the following steps:

As a first step the IFRS/IAS is considered by ICAPs Accounting

Standards Committee (ASC), which identifies any issues that may arise
on adoption.

The ASC refers the matter to the Professional Standards and Technical
Advisory Committee (PSTAC) of ICAP. This committee determines how
the adoption and implementation of the standard can be facilitated. It
considers issues like how long any transition period should be and whether
adoption of the standard would requires changes in regulations.

If the PSTAC identifies the need for changes to regulations it refers the
matter to the Securities and Exchange Commission of Pakistan (SECP)
(and/or the State Bank of Pakistan (SBP) for matters affecting banks and
other financial institutions). This process is managed by the Coordination
Committees of ICAP and SECP (SBP).

After the satisfactory resolution of issues the PSTAC and the Council
reconsider the matter of adoption.

ICAP recommends the adoption to the SECP (SBP) by decision of the

Council. The decision to adopt the standard rests with the SECP and SBP.

IFRSs are adopted by the Securities and Exchange Commission of

Pakistan by notification in the Official Gazette. When notified, the
standards have the authority of the law.
A full list of all IFRSs is given in the preliminaries section of this text.

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COMPANIES ORDINANCE 1984: FOURTH SCHEDULE

Section overview

Fixed assets (non-current assets)

Long term investments

Long term loans and advances

Long term deposits and prepayments

Current assets
Share capital and reserves

Non-current liabilities

Current liabilities

Contingencies and commitments

Profit and loss account

Other disclosures
These requirements must be followed in addition to those in IFRS.

2.1 Fixed assets (non-current assets)

Fixed assets (other than investments) must be classified as follows:

property, plant and equipment:

x

land (distinguishing between freehold and leasehold);

buildings (distinguishing between building on freehold land and those

on leasehold land);

plant and machinery;

furniture and fittings;

vehicles;

office equipment;

capital work in progress;

development property; and

others (to be specified)

intangible:
x

goodwill;

brand names;

computer software;

licences and franchises;

patents, copyright, trademarks and designs;

intangible assets under development; and

others (to be specified).

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2.2 Long term investments

The aggregate amount (under separate sub-headings) in respect of the following:

investments in related parties; and

other investments.

The investments must be shown under the heading long term investments,
indicating separately:

at cost;

using the equity method;

held to maturity investments, which are not due to mature within next
twelve months; and

available for sale investments which are not intended to be sold within the
next 12 months.

This section introduces several terms which require further explanation. They are
covered in more detail in certain international accounting. However, the
Companies Ordinance 1984 is in your syllabus and refers to these. Therefore,
they will be explained briefly.
Related parties
A related party is an entity or person with the ability to control the company or
exercise significant influence over the company in making financial and operating
decisions or an entity over which the company has ability to control or exercise
significant influence.
IAS 24 Related Party Disclosures includes a list of related parties and specifies
disclosures.
The equity method
The equity method is a method of accounting where an investment is initially
recognised at cost and the carrying amount is increased or decreased to
recognise the investors share of the profit or loss of the investee after the date of
acquisition.
IAS 28: Investments in Associates and Joint Ventures specifies the use of the
equity method in accounting for associates and joint ventures.
Held to maturity investments
This is a type of asset defined in IAS 39: Financial Instruments: Recognition and
Measurement.
Held to maturity investments are financial assets with fixed or determinable
payments and fixed maturity that an entity has the positive intention and ability to
hold to maturity.
They are measured at amortised cost. The amortised cost of a financial asset is
the amount invested initially plus interest recognised at the effective rate less any
cash received in respect of the asset.
IAS 39 is not in your syllabus.

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Available for sale investment

This is also a type of asset defined in IAS 39: Financial Instruments: Recognition
and Measurement.
An available for sale investment is one that is not a loan or receivable, nor held to
maturity nor held for trading purposes.
IAS 39 requires that available for sale investments are remeasured to fair value
at each reporting date. Any difference is recognised as other comprehensive
income (see chapter 2) and accumulated as a separate reserve in equity.
IAS 39 is not in your syllabus.

2.3 Long term loans and advances

The following must be shown (under separate sub-headings) distinguishing
between considered good and considered bad or doubtful.

Loans and advances to related parties and disclosing:

x

Details of each borrower (name, amount, terms and details of security

held if any);

Maximum amount outstanding since the later of the date of

incorporation or the date of the previous balance sheet.

Other loans and advances disclosing in respect of amounts to those other

than suppliers the name of the borrower and the terms of repayment if the
amount is material with particulars of security.

Illustration: Long term loans and advances

A disclosure note might look like this.
Statement of financial position (e
extract)
Non-current assets

2013
Rs.

2012
Rs.

237,900

158,750

2013

2012

Rs.

Rs.

To employees secured, considered good

197,026

167,952

To supplier unsecured, considered good

98,736

28,734

295,762

196,686

(57,862)

(37,936)

237,900

158,750

Loans and advances

Note to the accounts:

Less current portion shown under current assets

Loans to employees are interest free loans for the purpose of cars. They
are repayable within 3 years and are secured on the vehicles. The
maximum amount of the loans during the year was Rs. 201,345 (2012:
174,321).
The loan to supplier is an unsecured loan given to the TZ Electric Company
to fund the development of electrical supply infrastructure at our Lahore
depot. The loan is repayable in equal instalments over. Mark-up is charged
at 2% per annum.

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2.4 Long term deposits and prepayments

Long-term deposits and long-term prepayments must be stated separately.
Any material item must be disclosed separately.

2.5 Current assets

Current assets must be classified in a way appropriate to the company's affairs,
including the following:

stores, spare parts and loose tools distinguishing each from the other
where practicable;

stock-in-trade, distinguishing between appropriate classifications (for

example, raw materials and components, work in progress, finished
products etc.).

trade debts (other than loans and advances) showing separately:

debts considered good and debts considered doubtful or bad must be

separately stated;

debts considered good must be distinguished between secured and

unsecured;

the aggregate amount due from directors, chief executive and

executives; and

the aggregate amount due from related parties with the names of
those related parties.

loans and advances due for repayment within a period of twelve months
from the reporting date showing separately:
x

loans and advances considered good and those considered doubtful

or bad;

the aggregate amount due from directors, chief executive and

executives;

the aggregate amount due from related parties with the names of
those related parties;

trade deposits and short term prepayments and current account balances
with statutory authorities;

interest accrued;

other receivables specifying separately the materials items;

financial assets other than any included above showing separately:

x

the aggregate amount due from directors, chief executive and

executives;

the aggregate amount due from related parties with the names of
those related parties;

tax refunds due from the Government, showing separately different types of
tax;

cash and bank balances, distinguishing between current and deposit

accounts.

Any provision made for a fall in value of any current asset is shown as a
deduction from the gross amount of that asset.

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Definition
Executive: An employee, other than the chief executive and directors, whose basic
salary exceeds five hundred thousand rupees in a financial year.

Illustration: Stock in trade

A disclosure note might look like this.
Statement of financial position (extract)
Current assets
Stock in trade

2013
Rs.
547,132

Note to the accounts:

2012
Rs.
523,890

2013

2012

Rs.

Rs.

Raw materials

139,950

153,856

Work in progress

178,434

163,433

Finished goods

179,100

162,121

51,962

48,261

549,446
(2,314)

527,671
(3,781)

547,132

523,890

Goods purchased for sale

Less: Provision for slow moving items

Illustration: Trade debts

A disclosure note might look like this.
Statement of financial position (extract)
Current assets
Trade debts

2013
Rs.
493,657

Note to the accounts:

Considered good secured
Considered good unsecured
Considered doubtful unsecured
Less: Provision for doubtful debts

2012
Rs.
472,010

2013

2012

Rs.

Rs.

19,247

15,652

474,410

456,358

10,192

8,763

503,849

480,773

(10,192)

(8,763)

493,657

472,010

The considered good unsecured trade debts include Rs. 47, 438 (2012
Rs. 26,342) from X Limited, a related party.

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2.6 Share capital and reserves

Share capital and reserves must be classified under the following sub-heads:

issued, subscribed and paid up capital, distinguishing in respect of each

class between:
x

shares allotted for consideration paid in cash;

shares allotted for consideration other than cash; and

shares allotted as bonus shares; and

reserves (distinguishing between capital reserves and revenue reserves).

Definition
Capital reserve: A reserve not regarded free for distribution by way of dividend.
(Includes capital redemption reserve, capital repurchase reserve account, share
premium account, profit prior to incorporation).
Revenue reserve: A reserve that is normally regarded as available for distribution.

Illustration: Share capital

A disclosure note might look like this.
Statement of financial position (extract)
Issued subscribed and paid-up capital
(Ordinary shares of Rs. 10 each)
Note to the accounts:

Authorised share
capital (Ordinary
shares of Rs. 10
each)
Issued subscribed
and paid-up capital
(Ordinary shares of
Rs. 10 each)
Fully paid in cash
Fully paid for
consideration other
than cash
Bonus issue

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2013

2012

Rs. 000

Rs. 000

41,800

38,000

2013

2012

2013

2012

Rs. 000

Rs. 000

Number of
shares

Number
of shares

50,000

50,000

5,000,000

5,000,000

35,000

35,000

3,500,000

3,500,000

3,000

3,000

300,000

300,000

3,800

nil

380,000

nil

41,800

38,000

4,180,000

3,800,000

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2.7 Non-current liabilities

Non-current liabilities must be classified under the following sub-headings:

long term financing;

debentures;

liabilities against assets subject to finance lease;

long term murabaha;

long term deposits; and

deferred liabilities.

Long term loans must be classified as secured and unsecured, and the following
must be shown separately under each class:

loans from banking companies and other financial institutions, other than
those as specified below;

loans from related parties; and

other loans.

Long-term deposits must be classified according to their nature.

2.8 Current liabilities

Current liabilities and provisions must be classified under the following subheadings:

trade and other payables, which shall be classified as:

x

creditors;

murabaha;

accrued liabilities;

advance payments;

payable to employee retirement benefit funds;

unpaid and unclaimed dividend; and

others ( to be specified, if material);

interest, profit, return or mark-up accrued on loans and other payables;

short term borrowings which shall be classified as:

x

short-term borrowings, distinguishing between secured and

unsecured and between loans taken from:

banking companies and other financial institutions other than

related parties;

related parties; and

others;

short-term running finance, distinguishing between secured and

unsecured;

current portion of long term borrowings;

current portion of long term murabaha; and

provision for taxation, showing separately income tax and other taxes.

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Illustration: Trade and other payables

A disclosure note might look like this.
Statement of financial position (extract)
Current liabilities
Trade and other payables
Note to the accounts:

2013
Rs.
316,715

2012
Rs.
268,803

2013

2012

Rs.

Rs.

Trade creditors
Accrued liabilities

275,102
13,610

228,869
14,599

Advance payments

23,457

22,222

4,546

3,113

316,715

268,803

Others

2.9 Contingencies and commitments

The following must be shown separately as a footnote to the balance-sheet:

the aggregate amount of any guarantees given by the company on behalf

of any related party and where practicable, the general nature of the
guarantee;

where practicable the aggregate amount or estimated amount, if it is

material, of contracts for capital expenditure, so far as not provided for or a
statement that such an estimate cannot be made; and

any other commitment, if the amount is material, indicating the general

nature of the commitment.

2.10 Profit and loss account

The profit and loss account must disclose separately the manufacturing, trading
and operating results.
A manufacturing concern must show the cost of goods manufactured.
The profit and loss account must disclose all material items of income and
expenses including the following:

The turnover (sales) showing the gross sales figure with trade discount and
sales tax as a deduction.

Expenses, classified according to their function under the following subheads (along with additional information on their nature):
x

cost of sales;

distribution cost;

administrative expenses;

other operating expenses; and

finance cost.

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Other operating income:

x

income from financial assets;

income from investments in and debts, loans, advances and

receivables to each related party; and

income from assets other than financial assets.

Finance cost must show separately the amount of interest on borrowings

from related parties (if any).

Other information:
x

debts written off as irrecoverable distinguishing between trade debts,

loans, advances and other receivables; and

provisions for doubtful or bad debts distinguishing between trade

debts, loans, advances and other receivables.

In each case the company must disclose:

debts due by directors, chief executive, and executives of the

company and any of them severally or jointly with any other
person; and

debts due by other related parties.

The aggregate amount of auditors remuneration, showing separately fees,

expenses and other remuneration for services rendered as auditors and for
services rendered in any other capacity and stating the nature of such other
services. (Amounts must be shown separately for joint auditors).

If a donation is made and any director or his spouse has interest in the
donee, the company must disclose the names of such directors, their
interest in the donee and the names and address of all donees.

Illustration: Turnover
A disclosure note might look like this.
Profit and loss account (exxtract)
Turnover

2013
Rs.
578,554

Note to the accounts:

Gross sales

2012
Rs.
533,991

2013

2012

Rs.

Rs.

673,669

611,670

Sales tax

(83,839)

(74,566)

Trade discounts

(11,276)

(3,113)

578,554

533,991

Less:

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Payments to senior management

A company must disclose the aggregate amount charged in the financial
statements in respect of the directors, chief executive and executives by the
company as fees, remuneration, allowances, commission, perquisites or benefits
or in any other form or manner and for any services rendered.
The company must give full particulars of the aggregate amounts separately for
the directors, chief executive and executives together with the number of such
directors and executives, under appropriate headings such as:

fees;

managerial remuneration;

commission or bonus, indicating their nature;

reimbursable expenses which are in the nature of a perquisite or benefit;

pension, gratuities, company's contribution to provident, superannuation

and other staff funds, compensation for loss of office and in connection with
retirement from office;

other perquisites and benefits in cash or in kind stating their nature and,
where practicable, their approximate money values; and

the amounts, if material, by which any items shown above are affected by
any change in an accounting policy.

Illustration: Remuneration of chief executive, directors and executives

Note to the accounts

Chief
executive
Rs.000
1,650

Executive
directors
Rs.000
5,478

Executives
Rs.000

11,225
2,000

33,675
6,000


323,280
12,000

Retirement benefits

2,000

4,800

37,900

Housing

8,666

Transport

2,345


6,734


26,778

27,886

56,687

399,958

Fees
Managerial remuneration
Bonus

Number of persons

48

Sale of fixed assets

For sale of fixed assets where the book value of the asset or assets exceeds in
aggregate fifty thousand rupees, a company must disclose particulars of the
assets and in aggregate:

cost or valuation, as the case may be;

the book value;

the sale price and the mode of disposal (e.g. by tender or negotiation); and

particulars of the purchaser.

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2.11 Other disclosures

A company must disclose the following:

The general nature of any credit facilities available to the company under
any contract (other than trade credit) and not used as at the date of the
balance sheet.

Any penalty imposed under any law by any authority.

The fact of any reduction, enhancement or waiver of a penalty.

Where any property or asset, acquired with the funds of the company, is not held
in the name of the company, or is not in the possession and control of the
company, this fact must be disclosed together with a description and value of the
property or asset and the person in whose name and possession or control it is.
Note: In the exam, you may be required to make any or all of these disclosures
therefore their knowledge and presentation is expected at this level.

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COMPANIES ORDINANCE 1984: FIFTH SCHEDULE

Section overview

Sundry requirements
Fixed assets (non-current assets)

Long term investments

Long term loans and advances

Long term deposits and prepayments

Current assets

Share capital and reserves

Non-current liabilities

Current liabilities
Contingencies and commitments

Profit and loss account

Other disclosures

3.1 Sundry requirements

The figures in the financial statements may be rounded to the thousands of
rupees.
Financial statements must disclose:

all material information necessary to make the financial years statements

clear and understandable;

any change in an accounting policy that has a material effect in the current
year or may have a material effect in the subsequent year together with
reasons for the change and the financial effect of the change, if material.

3.2 Fixed assets (non-current assets)

Fixed assets (other than investments) must be classified as follows:

property, plant and equipment:

x

land (distinguishing between free-hold and leasehold);

buildings (distinguishing between building on free-hold land and those

on leasehold land);

plant and machinery;

furniture and fittings;

vehicles;

office equipment

capital work in progress:

development property; and

others (to be specified)

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intangible:
x

goodwill;

brand names;

computer software;

licences and franchises;

patents, copyright, trademarks and designs; and

others (to be specified).

3.3 Long term investments

The aggregate amount (under separate sub-headings) in respect of the following:

investments in related parties; and

other investments.

A company that is not a small sized company must also disclose investments
under the heading long term investments, indicating separately:

held to maturity investments, which are not due to mature within next
twelve months; and

available for sale investments which are not intended to be sold within the
next 12 months.

market value of listed securities and book value of unlisted securities as per
their latest available financial statements.

3.4 Long term loans and advances

The following must be shown (under separate sub-headings) distinguishing
between considered good and considered bad or doubtful.

Loans and advances to related parties and disclosing:

Other loans and advances.

Any provision made for bad or doubtful loans and advances is shown as a
deduction under each sub-heading above.
Information on terms and conditions, securities obtained and any other material
information must be disclosed.

3.5 Long term deposits and prepayments

Long-term deposits and long-term prepayments must be stated separately.

3.6 Current assets

Current assets must be classified in a way appropriate to the company's affairs,
including the following:

stores, spare parts and loose tools distinguishing each from the other
where practicable;

stock-in-trade, distinguishing between appropriate classifications (for

example, raw materials and components, work in progress, finished
products etc.).

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trade debts (other than loans and advances) showing separately:

x

debts considered good and debts considered doubtful or bad must be

separately stated;

debts considered good must be distinguished between secured and

unsecured;

the aggregate amount due from directors, chief executive and

executives (does not apply to small sized companies); and

the aggregate amount due from related parties with the names of
those related parties (does not apply to small sized companies).

loans and advances due for repayment within a period of twelve months
from the reporting date showing separately:
x

loans and advances considered good and those considered doubtful

or bad;

the aggregate amount due from directors, chief executive and

executives (does not apply to small sized companies);

the aggregate amount due from related parties with the names of
those related parties (does not apply to small sized companies);

trade deposits and short term prepayments and current account balances
with statutory authorities;

interest accrued;

other receivables specifying separately the materials items;

financial assets other than any included above showing separately:

x

the aggregate amount due from directors, chief executive and

executives (does not apply to small sized companies);

the aggregate amount due from related parties with the names of
those related parties (does not apply to small sized companies);

tax refunds due from the Government, showing separately different types of
tax;

cash and bank balances, distinguishing between current and deposit

accounts.

Any provision made for a fall in value of any current asset is shown as a
deduction from the gross amount of that asset.

3.7 Share capital and reserves

Share capital and reserve must be classified under the following sub-heads:

issued, subscribed and paid up capital, distinguishing in respect of each

class between:
x

shares allotted for consideration paid in cash;

shares allotted for consideration other than cash; and

shares allotted as bonus shares; and

reserves by distinguishing between capital reserves and revenue reserves.

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3.8 Non-current liabilities

A company which is not a small company must classify non-current liabilities
under the following sub-headings:

long term financing;

debentures;

liabilities against assets subject to finance lease;

long term murabaha;

long term deposits; and

deferred liabilities.

Long term loans must be classified as secured and unsecured, and the following
must be shown separately under each class:

loans from banking companies and other financial institutions, other than
those as specified below;

loans from related parties; and

other loans.

Long-term deposits must be classified according to their nature.

3.9 Current liabilities

Current liabilities and provisions must be classified under the following subheadings:

trade and other payables, which shall be classified as:

x

creditors;

murabaha;

accrued liabilities;

advance payments;

payable to employee retirement benefit funds;

unpaid and unclaimed dividend; and

others ( to be specified, if material);

interest, profit, return or mark-up accrued on loans and other payables;

short term borrowings which shall be classified as:

x

short-term borrowings, distinguishing between secured and

unsecured and between loans taken from:

banking companies and other financial institutions other than

related parties;

related parties; and

others;

short-term running finance, distinguishing between secured and

unsecured;

current portion of long term borrowings;

current portion of long term murabaha; and

provision for taxation, showing separately income tax and other taxes.

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3.10 Contingencies and commitments

The following must be shown separately as a footnote to the balance-sheet:

the aggregate amount of any guarantees given by the company on behalf

of any related party and where practicable, the general nature of the
guarantee;

where practicable the aggregate amount or estimated amount, if it is

material, of contracts for capital expenditure, so far as not provided for or a
statement that such an estimate cannot be made; and

any other commitment, if the amount is material, indicating the general

nature of the commitment.

3.11 Profit and loss account

The profit and loss account must disclose separately the manufacturing, trading
and operating results.
A manufacturing concern must show the cost of goods manufactured.
The profit and loss account must disclose all material items of income and
expenses including the following:

The turnover (sales) showing the gross sales figure with trade discount and
sales tax as a deduction.

Expenses, classified according to their function under the following subheads (along with additional information on their nature):

cost of sales;

distribution cost;

administrative expenses;

other operating expenses; and

finance cost.

Other operating income:

x

income from financial assets;

income from investments in and debts, loans, advances and

receivables to each related party; and

income from assets other than financial assets.

Finance cost must show separately the amount of interest on borrowings

from related parties (if any). This does not apply to a small sized company.

Other information:
x

debts written off as irrecoverable distinguishing between trade debts,

loans, advances and other receivables; and

provisions for doubtful or bad debts distinguishing between trade

debts, loans, advances and other receivables.

In each case the company must disclose:

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debts due by directors, chief executive, and executives of the

company and any of them severally or jointly with any other
person; and

debts due by other related parties.

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Number of employees at the year-end and the average number of

employees during the year.

Payments to senior management

This does not apply to a small sized company.
A company must disclose the aggregate amount charged in the financial
statements in respect of the directors, chief executive and executives by the
company as fees, remuneration, allowances, commission, perquisites or benefits
or in any other form or manner and for any services rendered.
The company must give full particulars of the aggregate amounts separately for
the directors, chief executive and executives together with the number of such
directors and executives, under appropriate headings such as:

fees;

managerial remuneration;

commission or bonus, indicating their nature;

reimbursable expenses which are in the nature of a perquisite or benefit;

pension, gratuities, company's contribution to provident, superannuation

and other staff funds, compensation for loss of office and in connection with
retirement from office;

other perquisites and benefits in cash or in kind stating their nature and,
where practicable, their approximate money values; and

the amounts, if material, by which any items shown above are affected by
any change in an accounting policy.

3.12 Other disclosures

A company must disclose the following:

The general nature of any credit facilities available to the company under
any contract (other than trade credit) and not used as at the date of the
balance sheet.

Any penalty imposed under any law by any authority.

The fact of any reduction, enhancement or waiver of a penalty.

Where any property or asset, acquired with the funds of the company, is not held
in the name of the company, or is not in the possession and control of the
company, this fact must be disclosed together with a description and value of the
property or asset and the person in whose name and possession or control it is.
If any loan or advance has been granted on terms softer than those generally
prevalent in trade or any relief allowed in matters of interest, repayment, security
or documentation, details with reasons for this must be disclosed along with the
nature of interest of the company or its directors or other officers.
Note: In the exam, you may be required to make any or all of these disclosures
therefore their knowledge and presentation is expected at this level.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

Accounting and reporting concepts

Contents
1

A conceptual framework for financial reporting

The IASB Conceptual Framework

Qualitative characteristics of useful financial

information

The elements of financial statements

Recognition in the financial statements

Accounting concepts

Measurement and capital maintenance

Fair presentation

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 1

The Conceptual Framework for the preparation and presentation of financial

statements

B (a) 9

IFRS 13: Fair value measurement

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A CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Section overview

The meaning of GAAP

The meaning of a conceptual framework

The purpose of a conceptual framework

The alternative to a conceptual framework

1.1 The meaning of GAAP

The preparation and presentation of financial statements is based on a large
number of concepts, principles and detailed rules. Some of these are contained
in law, and others are in financial reporting standards. Many of the most
fundamental concepts are not contained in any law or regulation or standard, but
are simply accepted accounting principles and conventions.
All the concepts, principles, conventions, laws, rules and regulations that are
used to prepare and present financial statements are known as Generally
Accepted Accounting Principles or GAAP.
Generally accepted accounting principles vary from country to country, because
each country has its own legal and regulatory system. The way in which
businesses operate also differs from country to country. (For example, there is
US GAAP, UK GAAP and Pakistan GAAP).
Many countries have now adopted International Financial Reporting Standards or
IFRSs, sometimes called international accounting standards. It is now fairly
common to refer to the totality of the rules as IFRS or IAS.

1.2 The meaning of a conceptual framework

A conceptual framework is a system of concepts and principles that underpin the
preparation of financial statements. These concepts and principles should be
consistent with one another.
The International Accounting Standards Committee (the predecessor of the
IASB) issued a conceptual framework document in 1989. This was called the
Framework for the Preparation and Presentation of Financial Statements and
was adopted by the IASB. It is comprised of the following sections:

The objective of financial statements (now replaced see below)

Underlying assumptions of financial statements

Qualitative characteristics of financial statements (now replaced see

below)

The elements of financial statements

Recognition of the elements of financial statements

Measurement of the elements of financial statements

Concepts of capital and capital maintenance.

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The IASB has been working closely with FASB (the US standard setter) on a
wide range of projects with the aim of converging IFRS and US GAAP. One of
the projects has had the aim of producing a conceptual framework common to
each GAAP.
The new conceptual framework is being developed on a chapter by chapter
basis. Each chapter is being released as an exposure draft and then, subject to
comments received, released as the final version. To date, two chapters have
been finalised and these replace the sections on The objective of financial
statements and Qualitative characteristics of financial statements from the
original document.
To avoid confusion the IASB has published a new document called The
conceptual framework for financial reporting which includes the new chapters
and those retained from the original framework.
The new document is made up of the following sections:

Chapter 1 The objective of general purpose financial statements.

Chapter 2 The reporting entity (to be added currently in release as an

exposure draft).

Chapter 3 Qualitative characteristics of financial information.

Chapter 4 The Framework (1989): The remaining text (These sections

are unchanged as of yet).
x

Underlying assumptions of financial statements.

The elements of financial statements.

Recognition of the elements of financial statements.

Measurement of the elements of financial statements.

Concepts of capital and capital maintenance.

The original document was known as The Framework. This text will describe the
new document as The Conceptual Framework. Note that the changes are not
fundamental in terms of their impact on IFRS.

1.3 The purpose of a conceptual framework

Most preparers and users of financial statements recognise that there is a need
for a formal conceptual framework and that this can be useful in a number of
ways.
Where there is a formal conceptual framework for accounting, accounting
practice and accounting standards are based on this framework.
Lack of a formal framework often means that standards are developed randomly
or only to deal with particular problems. The result is that standards are
inconsistent with each other or with legislation.
Lack of a conceptual framework may also mean that accounting standards fail to
address important issues. For example, until the IASB developed its Framework,
there was no proper definition of terms such as asset, liability, income and
expenses.
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The business environment is becoming increasingly complex. It is unlikely that

accounting standards can cover all possible transactions. Where an entity enters
into an unusual transaction and there is no relevant accounting standard, it can
refer to the framework and apply the principles in it.
It can also be argued that a conceptual framework strengthens the credibility of
financial reporting and the accounting profession in general.

1.4 The alternative to a conceptual framework

The alternative to a system based on a conceptual framework is a system based
on detailed rules.
Accounting standards based on detailed rules are open to abuse. Creative
accounting is the name given to techniques which enable management to give a
biased impression (usually favourable) of the companys performance while still
complying with accounting standards and other regulations. During the 1980s
there were a number of scandals in which investors were misled by the financial
statements of apparently healthy companies which then collapsed. This was one
of the original reasons why the IASB and other standard setters developed their
conceptual frameworks. Principles are normally much harder to evade than rules.
Another disadvantage of a rule-based system is that standard setters are more
likely to be influenced by vested interests such as large companies or a
particular business sector. The existence of a conceptual framework is an
important safeguard against this kind of political pressure.
Despite these problems, some preparers and regulators still appear to favour rule
based standards. Standards based on principles may require management to
use its judgement (and to risk making a mistake), while rules simply need to be
followed. This can be important where management can face legal action if an
investor makes a poor decision based on the financial statements.
The use of a conceptual framework can lead to standards that are theoretical and
complex. They may give the right answer but be very difficult for the ordinary
preparer to understand and apply. However, a system of extremely detailed rules
can also be very difficult to apply.

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THE IASB CONCEPTUAL FRAMEWORK

Section overview

Introduction

Underlying assumption

Users and their information needs

Objective of general purpose financial statements

2.1 Introduction
Financial reports are based on estimates, judgements and models rather than
exact depictions. The Conceptual Framework establishes the concepts that
underlie those estimates, judgements and models.
The Conceptual Framework deals with:

the objective of financial reporting;

the qualitative characteristics of useful financial information;

the definition, recognition and measurement of the elements from which

financial statements are constructed; and

concepts of capital and capital maintenance.

The Conceptual Framework sets out the concepts that underlie the preparation
and presentation of financial statements for external users. Its purpose is:

to assist the IASB in the development of future IFRSs and in its review of
existing IFRSs;

to assist the IASB in promoting harmonisation of regulations, accounting

standards and procedures relating to the presentation of financial
statements by providing a basis for reducing the number of alternative
accounting treatments permitted by IFRSs;

to assist national standard-setting bodies in developing national standards;

to assist preparers of financial statements in applying IFRSs and in dealing

with topics that have yet to form the subject of an IFRS;

to assist auditors in forming an opinion on whether financial statements

comply with IFRSs;

to assist users of financial statements in interpreting the information

contained in financial statements prepared in compliance with IFRSs; and

to provide those who are interested in the work of the IASB with information
about its approach to the formulation of IFRSs.

This Conceptual Framework is not an IFRS and nothing in the Conceptual

Framework overrides any specific IFRS.

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On very rare occasions there may be a conflict between the Conceptual

Framework and an IFRS. In those cases, the requirements of the IFRS prevail
over those of the Conceptual Framework.

2.2 Underlying assumption

The going concern basis of accounting is the assumption in preparing the
financial statements that the entity will continue to operate for the foreseeable
future, and does not intend to go into liquidation and will not be forced into
liquidation. The going concern assumption is particularly relevant for the
valuation of assets.
This is found in chapter 4 of The Conceptual Framework.

2.3 Users and their information needs

Many existing and potential investors, lenders and other creditors cannot require
reporting entities to provide information directly to them and must rely on general
purpose financial reports for much of the financial information they need. These
are the primary users to whom general purpose financial reports are directed.

General purpose financial reports cannot provide all the information needed
and users also need to consider pertinent information from other sources.

General purpose financial reports do not show the value of a reporting

entity; but they provide information to help users estimate a value.

Individual primary users have different information needs. The aim of IFRSs
is to provide information that will meet the needs of the maximum number
of primary users.

Other users

Regulators and members of the public other than investors, lenders and
other creditors may also find general purpose financial reports useful but
these reports are not primarily directed to these groups.

A companys management is interested in financial information but the

management does not need to rely on general purpose financial reports.

2.4 Objective of general purpose financial statements

The objective of general purpose financial reporting forms the foundation of the
Conceptual Framework. Other aspects of the Conceptual Framework flow
logically from the objective.
The objective
The objective of general purpose financial reporting is to provide financial
information about the reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions about providing
resources to the entity.
Those decisions involve buying, selling or holding equity and debt instruments,
and providing or settling loans and other forms of credit.

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In order to make these decisions the users need information to help them
assess the prospects for future net cash inflows to an entity.

In order to assess an entitys prospects for future net cash inflows, users
need information about:
x

the resources of the entity;

claims against the entity; and

how efficiently and effectively the entitys management have

discharged their responsibilities to use the entitys resources. (This
information is also useful for decisions by those who have the right to
vote on or otherwise influence management performance).

Information provided
General purpose financial statements provide information about:

the financial position of the entity which is information about economic

resources and the claims against them; and

changes in its financial position which could be due to:

x

financial performance; and/or

other events or transactions (e.g. share issues).

Economic resources and claims

Information about the nature and amounts of economic resources and claims can
help users to:

identify the financial strengths and weaknesses of a reporting entity;

to assess a reporting entitys liquidity and solvency and its needs for
additional financing;

Information about priorities and payment requirements of existing claims helps

users to predict how future cash flows will be distributed among those with a
claim against the reporting entity.
Changes in economic resources and claims Financial performance
Accrual accounting depicts the effects of transactions and other events and
circumstances on a reporting entitys economic resources and claims in the
periods in which those effects occur, even if the resulting cash receipts and
payments occur in a different period.
This is important because such information provides a better basis for assessing
the entitys past and future performance than information solely about cash
receipts and payments during that period.
Importance of information about a reporting entitys financial performance:

It helps users to understand the return generated from its economic

resources. This in turn provides an indication of how well management has
discharged its responsibilities to make efficient and effective use of these
resources.

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It shows the capacity of a reporting entity to generate net cash inflows

through its operations rather than by obtaining additional resources directly
from investors and creditors.

It gives an indication of the extent to which events such as changes in

market prices or interest rates affect its ability to generate net cash inflows.

Information about the variability and components of return is also important,

especially in assessing the uncertainty of future cash flows.

Information about past financial performance is helpful in predicting the

entitys future returns on its economic resources.

Another aspect of performance is management of cash flow. Information about a

reporting entitys cash flows during a period helps users to assess the entitys
ability to generate future net cash inflows. It indicates how the reporting entity
obtains and spends cash, including information about its borrowing and
repayment of debt, cash dividends or other cash distributions to investors, and
other factors that may affect the entitys liquidity or solvency. Information about
cash flows helps users understand a reporting entitys operations, evaluate its
financing and investing activities, assess its liquidity or solvency and interpret
other information about financial performance.
Changes in economic resources and claims Other events and transactions
Information about this type of change is necessary to give users a complete
understanding of why the reporting entitys economic resources and claims
changed and the implications of those changes for its future financial
performance.
Objectives of financial statements: summary
The objectives of financial statements are met by:

the main financial statements (statement of financial position, statement of

profit or loss and other comprehensive income (or statement of profit or
loss and statement of other comprehensive income), statement of cash
flows, and statement of changes in equity), and

supporting notes to the accounts, which provide additional details.

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QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL

INFORMATION
Section overview

Introduction

Relevance

Faithful representation

Enhancing qualitative characteristics

Cost constraint on useful information

3.1 Introduction
This is covered by chapter 3 of The IASB Conceptual Framework.
Information must have certain characteristics in order for it to be useful for
decision making. The IASB Conceptual Framework describes:

fundamental qualitative characteristics; and

enhancing qualitative characteristics

Fundamental qualitative characteristics:

relevance; and

faithful representation

The qualitative characteristics that enhance the usefulness of information that is

relevant and a faithful representation are:

comparability;

verifiability

timeliness; and

understandability

If financial information is to be useful, it must be relevant and faithfully represent

what it purports to represent. The usefulness of financial information is
enhanced if it is comparable, verifiable, timely and understandable.
Emphasis
Information must be both relevant and faithfully represented if it is to be useful.
The enhancing qualitative characteristics cannot make information useful if that
information is irrelevant or not faithfully represented.

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3.2 Relevance
Information must be relevant to the decision-making needs of users. Information
is relevant if it can be used for predictive and/or confirmatory purposes.

It has predictive value if it helps users to predict what might happen in the
future.

It has confirmatory value if it helps users to confirm the assessments and

predictions they have made in the past.

The relevance of information is affected by its materiality.

Information is material if omitting it or misstating it could influence decisions that
users make on the basis of financial information about a specific reporting entity.

Materiality is an entity-specific aspect of relevance based on the nature or

magnitude (or both) of the items to which the information relates in the
context of an individual entitys financial report.

Therefore, it is not possible for the IASB to specify a uniform quantitative

threshold for materiality or predetermine what could be material in a
particular situation.

3.3 Faithful representation

Financial reports represent economic phenomena (economic resources, claims
against the reporting entity and the effects of transactions and other events and
conditions that change those resources and claims) by depicting them in words
and numbers.
To be useful, financial information must not only represent relevant phenomena,
but it must also faithfully represent the phenomena that it purports to represent.
A perfectly faithful representation would have three characteristics. It would be:

complete the depiction includes all information necessary for a user to

understand the phenomenon being depicted, including all necessary
descriptions and explanations.

neutral the depiction is without bias in the selection or presentation of

financial information; and

free from error where there are no errors or omissions in the description
of the phenomenon, and the process used to produce the reported
information has been selected and applied with no errors in the process.

3.4 Enhancing qualitative characteristics

Comparability
Comparability is the qualitative characteristic that enables users to identify and
understand similarities in, and differences among, items
Information about a reporting entity is more useful if it can be compared with
similar information about other entities and with similar information about the
same entity for another period or another date.

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Consistency is related to comparability but is not the same. Consistency refers to

the use of the same methods for the same items, either from period to period
within a reporting entity or in a single period across entities. Consistency helps to
achieve the goal of comparability.
Verifiability
This quality helps assure users that information faithfully represents the
economic phenomena it purports to represent.

Verifiability means that different knowledgeable and independent observers

could reach consensus that a particular depiction is a faithful
representation.

Quantified information need not be a single point estimate to be verifiable.

A range of possible amounts and the related probabilities can also be
verified.

Verification can be direct or indirect.

Direct verification means verification through direct observation, e.g. by

counting cash.

Indirect verification means checking the inputs to a model, formula or other

technique and recalculating the outputs using the same methodology. For
example, the carrying amount of inventory might be verified by checking the
inputs (quantities and costs) and recalculating the closing inventory using
the same assumption (e.g. FIFO).

Timeliness
This means having information available to decision-makers in time to be capable
of influencing their decisions.
Understandability
Information is made understandable by classifying, characterising and presenting
it in a clear and concise manner.
Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyse the information
diligently.

3.5 Cost constraint on useful information

Reporting financial information that is relevant and faithfully represents what it
purports to represent helps users to make decisions with more confidence. This
results in more efficient functioning of capital markets and a lower cost of capital
for the economy as a whole. An individual investor, lender or other creditor also
receives benefits by making more informed decisions. However, it is not possible
for general purpose financial reports to provide all the information that every user
finds relevant.
The benefits obtained from financial information should exceed the cost of
obtaining and providing it. Information should not be provided if the cost is not
worth the benefit.
Since it is difficult to measure the benefits of financial information, the setters of
accounting standards must use their judgement in deciding whether certain items
of information should be provided in the financial statements (and if so, in how
much detail).

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THE ELEMENTS OF FINANCIAL STATEMENTS

Section overview

Assets

Liabilities

Equity

Income

Expenses

The IASB Framework discusses the five elements of financial statements:

for reporting financial position: assets, liabilities and equity

for reporting financial performance: income and expenses.

4.1 Assets
An asset is defined as:

a resource controlled by the entity;

as a result of past events; and

from which future economic benefits are expected to flow to the entity.

Resource controlled by the entity

Control is the ability to obtain economic benefits from the asset, and to restrict
the ability of others to obtain the same benefits from the same item.
An entity usually uses assets to produce goods or services to meet the needs of
its customers, and because customers are willing to pay for the goods and
services, this contributes to the cash flow of the entity. Cash itself is an asset
because of its command over other resources.
Many assets have a physical form, but this is not an essential requirement for the
existence of an asset.
The result of past events
Assets result from past transactions or other past events. An asset is not created
by any transaction that is expected to occur in the future but has not yet
happened. For example, an intention to buy inventory does not create an asset.
Expected future economic benefits
An asset should be expected to provide future economic benefits to the entity.
Providing future economic benefits can be defined as contributing, directly or
indirectly, to the flow of cash (and cash equivalents) into the entity.

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4.2 Liabilities
A liability is defined as:

a present obligation of an entity

arising from past events

the settlement of which is expected to result in an outflow of resources that

embody economic benefits.

Present obligation
A liability is an obligation that already exists. An obligation may be legally
enforceable as a result of a binding contract or a statutory requirement, such as a
legal obligation to pay a supplier for goods purchased.
Obligations may also arise from normal business practice, or a desire to maintain
good customer relations or the desire to act in a fair way. For example, an entity
might undertake to rectify faulty goods for customers, even if these are now
outside their warranty period. This undertaking creates an obligation, even
though it is not legally enforceable by the customers of the entity.
Past transactions or events
A liability arises out of a past transaction or event. For example, a trade payable
arises out of the past purchase of goods or services, and an obligation to repay a
bank loan arises out of past borrowing.
Future outflow of economic resources
The settlement of a liability should result in an outflow of resources that embody
economic benefits. This usually involves the payment of cash or transfer of other
assets. A liability is measured by the value of these resources that will be paid or
transferred.
Some liabilities can be measured only with a substantial amount of estimation.
These may be called provisions.

4.3 Equity
Equity is the residual interest in an entity after the value of all its liabilities has
been deducted from the value of all its assets. It is a balance sheet value of the
entitys net assets. It does not represent in any way the market value of the
equity.
Equity may be sub-classified in the statement of financial position, into share
capital, retained profits and other reserves that represent capital maintenance
adjustments.

4.4 Income
Income is defined as increases in economic benefits during the accounting period
in the form of inflows or enhancements of assets or decreases of liabilities that
result in increases in equity, other than those relating to contributions from equity
participants.

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Financial performance is measured by profit or loss and gains or losses

recognised in other comprehensive income. Profit is measured as income less
expenses.
The concept of income includes both revenue and gains.

Revenue is income arising in the course of the ordinary activities of the

entity. It includes sales revenue, fee income, royalties income and income
from investments (interest and dividends). Revenue is recognised in the
statement of profit or loss.

Gains represent other items that meet the definition of income. Gains may
be recognised in the statements of profit or loss or in the statement of other
comprehensive income. For example:
x

Income includes gains on the disposal of non-current assets. These

are recognised in the statement of profit or loss.

Income also includes unrealised gains which occur whenever an

asset is revalued upwards, but is not disposed of. For example, an
unrealised gain occurs when a property owned by the entity is
revalued upwards. Unrealised gains might be recognised in the
statement of profit or loss (e.g. revaluation gains on property
accounted for under IAS 40) or in the statement of other
comprehensive income (e.g. revaluation gains on property accounted
for under the IAS 16 fair value model).

4.5 Expenses
Expenses are decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity
participants.
Expenses include:

Expenses arising in the normal course of activities, such as the cost of

sales and other operating costs, including depreciation of non-current
assets. Expenses result in the outflow of assets (such as cash or finished
goods inventory) or the depletion of assets (for example, the depreciation of
non-current assets).

Losses include for example, the loss on disposal of a non-current asset,

and losses arising from damage due to fire or flooding. Losses are usually
reported as net of related income.

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RECOGNITION IN THE FINANCIAL STATEMENTS

Section overview

Probability of future economic benefit flowing in or out

Reliability of measurement

Recognition of assets, liabilities, income and expenses

Assessment of the Framework

The IASB Framework states that an element (asset, liability, equity, income or
expense) should be recognised in the statement of financial position or in profit and
loss (the statement of profit or loss) when it:

meets the definition of an element, and also

satisfies certain criteria for recognition.

Items that fail to meet the criteria for recognition should not be included in the financial
statements. However, some if these items may have to be disclosed as additional
details in a note to the financial statements.
The criteria for recognition are as follows:

It must be probable that the future economic benefit associated with the item will
flow either into or out of the entity.

The item should have a cost or value that can be measured reliably.

5.1 Probability of future economic benefit flowing in or out

The concept of probability relates to the degree of certainty or uncertainty that the
future economic benefit associated with the item will flow into or out of the entity.
The degree of certainty or uncertainty should be assessed on the basis of the
evidence available at the time the financial statements are prepared.
For example, if it is considered fairly certain that a trade receivable will be paid at
a future date, it is appropriate to recognise the receivable as an asset in the
statement of financial position. However, there is probably a reasonable degree
of certainty that some trade receivables will become bad debts and the
economic benefit will not flow into the entity. It would then be appropriate to
recognise an expense for the expected reduction in economic benefits (as an
allowance for irrecoverable debts).

5.2 Reliability of measurement

An item should be recognised in the financial statements only if it has a cost or
value that can be measured with reliability.
In many cases, the value of an item has to be estimated because its value is not
known with certainty. Using reasonable estimates is an essential part of
preparing financial statements, and provided that the estimates are reasonable, it
is appropriate to recognise items in the financial statements.

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However, if it is not possible to make a reasonable estimate, the item should be

excluded from the statement of financial position and statement of profit or loss
and other comprehensive income.
An item that cannot be estimated with reliability at one point in time might be
estimated with greater certainty at a later time, when it would then be appropriate
to include it in the financial statements.

5.3 Recognition of assets, liabilities, income and expenses

Recognition of assets
An asset is recognised in the statement of financial position when there is an
increase in future economic benefits relating to an increase in an asset (or a
reduction in a liability) which can be measured reliably.
An asset should not be recognised when expenses have been incurred but it is
unlikely that any future economic benefits will flow to the entity. Instead, the item
should be treated as an expense, and the cost of the asset should be written off.
Recognition of liabilities
A liability is recognised when it is probable that an outflow of resources that
embody economic benefits will result from the settlement of a present obligation,
and the amount of the obligation can be measured reliably.
Recognition of income
Income is recognised in the statement of profit when an increase in future
economic benefits arises from an increase in an asset (or a reduction in a
liability) and this can be measured reliably.
Recognition of expenses
Expenses are recognised in the statement of profit or loss when a decrease in
future economic benefits arises from a decrease in an asset or an increase in a
liability, which can be measured reliably.
Note that an expense is recognised at the same time as an increase in a liability
(for example, trade payables) or a reduction in an asset (for example, cash).
Expenses are recognised in the statement of profit or loss by means of a direct
association between items of income and the expenses incurred in creating that
income.

Matching of costs and income involves the simultaneous recognition of

revenues and related expenses.

When economic benefits arise over several accounting periods, and the
association with income can only be decided in broad terms, expenses
should be recognised in profit and loss (the statement of profit or loss) of
each accounting period on the basis of systematic and rational
allocation procedures. For example, depreciation charges for a noncurrent asset are allocated between accounting periods on a systematic
and rational basis, by means of an appropriate depreciation policy and
depreciation method.

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When an item of expenditure is not expected to provide any future

economic benefits, it should be recognised immediately as an expense in
the statement of profit or loss. When the future economic benefits
associated with an asset are no longer expected to arise, the value of the
asset is written off, and the write-off is treated as an expense.

An expense may also be recognised when a liability arises without the

recognition of any matching asset. For example, a liability might arise when
an entity recognises that it will have to make a payment to settle a legal
dispute. The cost of the future liability is treated as an expense in the period
when the liability is recognised.

5.4 Assessment of the Framework

In theory, IASs and IFRSs are based on the IASB Framework. In practice, the
standards are a mixture of principles and rules.
Many standards (for example, the main standards dealing with non-current
assets) reflect the fundamental principles in the Framework and are consistent
with each other. This improves the quality of financial reporting as there are fewer
options available and the standards are based on the definitions in the
Framework.
However, some of the more recent standards (for example, the standards on
financial instruments) have been heavily influenced by US accounting practice.
These standards are complex and tend to contain many detailed rules and
definitions.
It can be argued that the success of the IASBs Framework is that recent
accounting standards have been successful in providing consistent accounting
rules. The application of the definitions in the Framework and the recognition and
measurement criteria should mean that any accounting issue not covered by a
standard can be dealt with.
The development of the new Conceptual Framework with FASB should further
improve reporting in the future.

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ACCOUNTING CONCEPTS
Section overview

Consistency of presentation

Materiality and aggregation

Offsetting

In addition to the accounting concepts in the IASB Framework, some other accounting
concepts are used in financial reporting. These concepts, together with the underlying
assumptions of going concern and accruals, are explained in IAS 1 Presentation of
financial statements.

6.1 Consistency of presentation

Consistency of presentation is needed if financial information is to be
comparable. IAS 1 states that there should be consistency in the presentation
and classification of items in the financial statements from one year to the next.
There are just two exceptions to the requirement for consistency:

Consistency is not required when it is apparent, following a significant

change in the entitys operations or a review of its financial statements, that
a different presentation or classification would be more appropriate.

Consistency is not appropriate if a new accounting standard (or the

interpretation of a Standard by IFRIC) requires a change in the presentation
of information.

6.2 Materiality and aggregation

IAS 1 also states that each material class of similar items should be presented
separately in the financial statements.
In addition, items of a dissimilar nature should not be aggregated together in the
financial statements (combined as a single item and in a single total), unless their
value is immaterial.

6.3 Offsetting
IAS 1 states that:

Assets and liabilities should not be offset against each other.

Similarly incomes and expenses should not be offset against each other.

Instead they should be reported separately.

The exceptions to this rule are when:

offsetting is required or permitted by an accounting standard or the

Interpretation of a standard

offsetting reflects the economic substance of a transaction. An example

specified in IAS 1 is reporting of a gain or loss on disposal of a non-current
asset at sale value minus the carrying value of the asset and the related
selling expenses.

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MEASUREMENT AND CAPITAL MAINTENANCE

Section overview

Measurements of elements of financial statements

Fair value

Capital maintenance concepts

7.1 Measurements of elements of financial statements

The Conceptual Framework allows that several measurement bases are used for
the elements in financial statements. These include:

Historical cost. Assets are measured at the amount of cash paid, or at the
fair value of the consideration given to acquire them. Liabilities are
measured at:
x

the amount of proceeds received in exchange for the obligation (for

example, bank loan or a bank overdraft), or

the amount of cash that will be paid to satisfy the liability.

Current cost or current value is the basis used in current value

accounting/current cost accounting. Assets are measured at the amount
that would be paid to purchase the same or a similar asset currently.
Liabilities are measured at the amount that would be required to settle the
obligation currently.

Realisable value (or settlement value). This method of measurement is

relevant when an entity is not a going concern, and is faced with liquidation
(and a forced sale of its assets). Assets are measured at the amount that
could be obtained by selling them. Liabilities are measured at the amount
that would be required to settle them currently.

Present value. Assets might be measured at the value of the future net
cash inflows that the item is expected to generate, discounted to a present
value. Similarly, a liability might be measured at the discounted present
value of the expected cash outflows that will be made to settle the liability.

Historical cost is the most commonly used measurement basis. However, the
other bases of measurement are often used to modify historical cost. For
example, inventories are measured at the lower of cost and net realisable value.
Deferred income is measured at present value. Some non-current assets may be
valued at current value.
The Framework does not favour one measurement base over the others.

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7.2 Fair value

Fair value is a possible basis for the valuation of assets in the financial
statements. Although it is not described in the IASB Conceptual Framework,
many IASs and IFRSs require it to be used instead of historical cost or as an
alternative to historical cost. For example, IAS 39 requires many types of
investment to be measured at fair value.
Fair value may be used in financial statements in the following circumstances:

After its initial recognition at acquisition, a non-current asset may be revalued to its fair value.

Inventory is measured in the statement of financial position at the lower of

cost or net realisable value. Net realisable value (NRV) is the selling price
of the inventory item in the ordinary course of business, less the estimated
further costs to completion and the expected selling costs. NRV may or
may not be the same as fair value.

Revenue should be measured in the statement of profit or loss at the fair

value of the consideration received or receivable (IAS 18).

Fair value is often approximately the same as current value, but sometimes fair
value and current value can be very different.
Problems with the use of fair value
Fair value is easy to understand and less complicated to apply than value to the
business/current value. Arguably, it is also more reliable than value to the
business, because market value is more easily verified than (for example)
economic value. However, it has some serious disadvantages:

There may not be an active market for some kinds of asset. Where there is
no active market, estimates have to be used and these may not be reliable.

It anticipates sales and profits which may never happen (the entity may
have no plans to sell the asset).

Market values can move up and down quite rapidly. This may distort trends
in the financial statements and make it difficult for users to assess an
entitys performance over time.

A notable example of this problem occurred during 2007 and 2008 with the
collapse of the market for certain types of asset-backed securities (mortgagerelated securities known as CDOs). Many banks, particularly in the US and
Europe, announced huge losses, largely due to the requirement to write down
their investments in these financial instruments to fair value, even though fair
value was difficult to assess.
Despite these problems, it looks increasingly likely that the IASB will require
greater use of fair value in future.

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7.3 Capital maintenance concepts

The Conceptual Framework states that there are two concepts of capital:

A financial concept of capital;

A physical concept of capital.

Different systems of accounts used different capital maintenance concepts. The

choice of capital maintenance has a profound effect on the measurement of
profit.
Consider the basic accounting equation.
Formula:: Accounting equation
Assets
A

= Liabilities

+ Equity

or

Assets
A

 Liabilities

Equity

Net assets
Like any other equation, changes on one side of the accounting equation are
matched by changes in the other side. Therefore, Profit or loss for a period can
be calculated from the difference between the opening and closing net assets
after adjusting for any distributions during the period.
Formula: Profit
Change in equity = Closing equity  Opening equity
Increase in equity = Profit + capital introduced  distributions
Profit = Increase in equity  capital introduced + distributions
This shows that the value ascribed to opening equity is crucial in the
measurement of profit.
Financial capital maintenance
With the financial concept of capital maintenance, a profit is not earned during
a period unless the financial value of equity at the end of the period exceeds the
financial value of equity at the beginning of the period (after adjusting for equity
capital raised or distributed).
Historical cost accounting is based on the concept of money financial capital
maintenance. Under this concept, an entity makes a profit when its closing
equity exceeds its opening equity measured as the number of units of currency at
the start of the period. Note that this is a separate issue from asset valuation.
Assets could be revalued during the period but this would have no effect on the
opening capital position.
An alternative view of financial capital maintenance is used in constant
purchasing power accounting. This system is based on the concept of real
financial capital maintenance. Under this concept, an entity makes a profit
when its closing equity exceeds opening equity remeasured to maintain its
purchasing power.

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This requires the opening equity to be uplifted by the general inflation rate. This is
achieved by a simple double entry.
Illustration: Adjustment to maintain opening equity
Debit
Statement of profit or loss

Credit

Inflation reserve

Physical capital maintenance

A physical concept of capital is that the capital of an entity is represented by its
productive capacity or operating capability. Where a physical concept of capital is
used, the main concern of users of the financial statements is with the
maintenance of the operating capability of the entity.
With a physical concept of capital maintenance, a profit is not earned during a
period unless (excluding new equity capital raised during the period and adding
back any distribution of dividends to shareholders) the operating capability of the
business is greater at the end of the period than at the beginning of the period.
This requires the opening equity to be uplifted by the specific rates of inflation
that apply to the individual components of the net assets of the company. Again,
this is achieved by the same simple double entry.
The following example should help you to understand this.

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Example: Capital maintenance concepts

X Limited commenced business on 1 January with a single item of inventory
which cost Rs.10,000.
During the year it sold the item for Rs. 14,000 (cash).
During the year general inflation was 5% but the inflation specific to the item was
10%.
Profit is calculated under each concept in the following ways.
Capital maintenance concept
Financial
(money terms)

Financial
(real terms)

Physical

Rs.

Rs.

Rs.

Statement of profit or loss

Revenue
Cost of sale

14,000

14,000

14,000

(10,000)

(10,000)

(10,000)

Inflation adjustment
(inflation rate applied to
opening equity):
5% u Rs.10,000

(500)

10% u Rs.10,000

(1,000)
4,000

Statement of financial
position

Rs.

Net assets

3,500

Rs.

3,000

Rs.

14,000

14,000

14,000

10,000

10,000

10,000

500

1,000

10,000

10,500

11,000

4,000

3,500

3,000

14,000

14,000

14,000

Equity:
Opening equity
Before adjustment
Inflation reserve (see
above)
After adjustment
Retained profit (profit for the
year)

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Commentary on the example

Under historical cost accounting, the profit is Rs. 4,000. If the business paid this
out as a dividend it would have Rs. 10,000 left.
Rs. 10,000 is the opening equity expressed as a number of units of currency.
This means that the company would have maintained its equity expressed as a
number of units of currency. However, inflation in the period has caused the
purchasing power of the currency to decline. This means that Rs. 10,000 no
longer has the same purchasing power that it had a year ago. The company has
not maintained its capital in real terms.
To maintain its opening equity in real terms the company would have to ensure
that it had the same purchasing power at the year-end as it had at the start.
Inflation was 5% so the company would need Rs. 10,500 at the year-end in order
to have the same purchasing power as it had at the start of the year. The
company can achieve this by transferring Rs. 500 from profit and loss into an
inflation reserve. Profit would then be reported as Rs. 3,500.
If the business paid out Rs. 3,500 as a dividend it would have Rs. 10,500 left.
This is not enough to buy the same asset that it had at the start of the year. The
asset has been subject to specific inflation of 10% therefore the company would
need Rs. 11,000 at the year-end in order to buy the same asset.
This means that the company would not have the same capacity to operate as it
had a year ago.
To maintain its opening equity in physical terms the company would have to
ensure that it had the same ability to operate at the year-end as it had at the
start. In other words it would need to have Rs. 11,000. The company can achieve
this by transferring Rs. 1,000 from profit and loss into an inflation reserve. Profit
would then be reported as Rs. 3,000.
Comparing the two concepts
Neither the IASB Conceptual Framework nor accounting standards require the
use of a specific capital maintenance concept. In practice, almost all entities use
money financial capital maintenance, but both concepts can provide useful
information.
Financial capital maintenance is likely to be the most relevant to investors as they
are interested in maximising the return on their investment and therefore its
purchasing power.
Physical capital maintenance is likely to be most relevant to management and
employees as they are interested in assessing an entitys ability to maintain its
operating capacity. This is particularly true for manufacturing businesses, where
management may need information about the ability of the business to continue
to produce the same or a greater volume of goods.

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FAIR PRESENTATION
Section overview

What is meant by fair presentation (or a true and fair view)?

Fair presentation and compliance with IFRSs

Where fair presentation conflicts with an accounting standard

8.1 What is meant by fair presentation (or a true and fair view)?
Financial statements are often described as showing a true and fair view or
presenting fairly the financial position and performance of an entity, and
changes in its financial position. In some countries (for example, the UK) this is
the central requirement of financial reporting.
Under international GAAP (specifically IAS 1) financial statements are required
to present fairly the financial position, financial performance and cash flows of the
entity.
The Framework does not deal directly with this issue. However, it does state that
if an entity complies with international accounting standards, and if its financial
information has the desirable qualitative characteristics of information, then its
financial statements should convey what is generally understood as a true and
fair view of such information.
IAS 1 states that: Fair presentation requires the 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 IASB Framework.
The use of the term faithful representation means more than that the amounts in
the financial statements should be materially correct. It implies that information
should present clearly the transactions and other events that it is intended to
represent. To provide a faithful representation, financial information must account
for transactions and other events in a way that reflects their substance and
economic reality (in other words, their true commercial impact) rather than their
legal form. If there is a difference between economic substance and legal form,
the financial information should represent the economic substance.
Faithful representation also implies that the amounts in the financial statements
should be classified and presented, and disclosures made in such a way that
important information is not obscured and users are not misled.

8.2 Fair presentation and compliance with IFRSs

The application of IFRSs, with additional disclosure when necessary, is
presumed to result in financial statements that achieve a fair presentation. IAS 1
states that:

When the financial statements of an entity comply fully with International

Financial Reporting Standards, this fact should be disclosed.

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An entity should not claim to comply with IFRSs unless it complies with all
the requirements of every applicable Standard.

IAS 1 appears to equate fair presentation with compliance with accounting

standards.
In some situations fair presentation may require more than this. It is important to
apply the spirit (or general intention) behind an accounting standard as well as
the strict letter (what the standard actually says).
The requirement to present fairly also applies to transactions which are not
covered by any specific accounting standard. It is worth noting that there is no
IFRS that covers complex transactions and arrangements which have been
deliberately structured so that their economic substance is different from their
legal form.
IAS 1 states that a fair presentation requires an entity:

to select and apply accounting policies in accordance with IAS 8

Accounting policies, changes in accounting estimates and errors. IAS 8
explains how an entity should develop an appropriate accounting policy
where there is no standard.

to present information in a manner that provides relevant, reliable,

comparable and understandable information

to provide additional disclosures where these are necessary to enable

users to understand the impact of particular transactions and other events
on the entitys financial performance and financial position (even where
these are not required by IFRSs).

8.3 Where fair presentation conflicts with an accounting standard

IAS 1 acknowledges that in extremely rare circumstances, compliance with a
standard or an Interpretation may produce financial statements that are so
misleading that they do not provide useful information and no longer give a fair
presentation.
An entity can then depart from the requirements of the standard or Interpretation.
It must disclose:

that management has concluded that the financial statements present fairly
the entitys financial position, financial performance and cash flows;

that it has complied with applicable standards and Interpretations, except

that it has departed from a particular requirement to achieve a fair
presentation;

the title of the standard or Interpretation from which the entity has departed,
the nature of the departure, including the treatment that the standard or
Interpretation would require, the reason why that treatment would be
misleading, and the treatment adopted; and

for each period presented, the financial impact of the departure on each
item in the financial statements that would have been reported in complying
with the requirement.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

Presentation of
financial statements
Contents
1 IAS 1: Presentation of financial statements
2 ED/2014/1: Disclosure initiative
3 IAS 34: Interim financial reporting
4 IAS 24: Related party disclosures
5 IFRS 8: Operating segments
6 IAS 10: Events after the reporting period

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with international

pronouncements and under the Companies Ordinance, 1984.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A1

Presentation of financial statements (IAS 1, IAS 7 and Companies Ordinance

1984)

A7

IAS 34: Interim financial reporting

A 10

IFRS 8: Operating segments

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 14

IAS 10: Events after the reporting date

B (a) 24

IAS 24: Related party disclosures

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IAS 1: PRESENTATION OF FINANCIAL STATEMENTS

Section overview

Form and content

Statement of financial position

Statement of profit or loss and other comprehensive income

Statement of changes in equity (SOCIE)

Notes to the financial statements

1.1 Form and content

IAS 1: Presentation of Financial Statements sets out the rules on the form and
content of financial statements.
A complete set of financial statements consists of:

a statement of financial position as at the end of the period;

a statement of comprehensive income for the period (made up of a

statement of profit or loss and a statement of other comprehensive
income);

a statement of changes in equity for the period;

a statement of cash flows (this is dealt with in a later chapter); and

notes to these statements, consisting of a summary of significant

accounting policies used by the entity and other explanatory notes;

comparative information in respect of the previous period (as specified);

and

a statement of financial position as at the beginning of the preceding period

when an entity applies an accounting policy retrospectively or
retrospectively restates or reclassifies items (as specified).

1.2 Statement of financial position

Current and non-current assets and liabilities
IAS 1 requires an entity to present current and non-current assets, and current
and non-current liabilities, as separate classifications on the face of its statement
of financial position unless a liquidity presentation provides more relevant and
reliable information. In such cases, all assets and liabilities must be presented
broadly in order of liquidity.
Some items may be presented using a current/non-current distinction and others
in order of liquidity if this provides information that is more relevant and reliable.
Whichever method of presentation is adopted an entity must disclose the amount
expected to be recovered or settled after more than twelve months for each asset
and liability line item that combines current and non-current amounts.
Information to be presented on the face of the statement of financial position
IAS 1 provides a list of items that, as a minimum, must be shown on the face of
the statement of financial position as a line item (in other words, on a separate
line in the statement):

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Additional line items should be included in the statement of financial position

when presenting them separately and is relevant to an understanding of the
entitys financial position.
Some of the line items in the statement of financial position should be subclassified into different categories, giving details of how the total figure is made
up. This sub-classification may be presented either:

as additional lines on the face of the statement of financial position (adding

up to the total amount for the item as a whole); or

in notes to the financial statements.

Note: In Pakistan, the fourth/fifth schedules to the Companies Ordinance 1984

are followed.

1.3 Statement of profit or loss and other comprehensive income

A single statement or two statements
The statement provides information about the performance of an entity in a
period. It consists of two parts:

a statement of profit or loss a list of income and expenses which result in

a profit or loss for the period; and

a statement of other comprehensive income a list of other gains and

losses that have arisen in the period.

IAS 1 allows an entity to present the two sections in a single statement or in two
separate statements.
IAS 1 provides a list of items that, as a minimum, must be shown on the face of
the statement of profit or loss and other comprehensive income.
Additional line items should be presented on the face of the statement of
comprehensive income when it is relevant to an understanding of the entitys
financial performance.
Information to be shown on the face of the statement of comprehensive income (or
the statement of profit or loss, if separate) or in the notes
The following information may be shown either on the face of the statement of
comprehensive income or in a note to the financial statements:

material items of income and expense

an analysis of expenses, providing either:

x

expenses analysed by their nature, or

expenses analysed by the function that has incurred them.

Information to be presented in the other comprehensive income section

The other comprehensive income section must present line items for amounts of
other comprehensive income in the period, classified by nature (including share
of the other comprehensive income of associates and joint ventures accounted
for using the equity method) and grouped into those that, in accordance with
other IFRSs:

will not be reclassified subsequently to profit or loss:

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revaluation surpluses on property, plant and equipment (IAS 16) (but

remember in Pakistan such changes are not recognised in OCI as per
Companies Ordinance 1984);

revaluation surpluses on intangible assets (IAS 38) (but remember in

Pakistan such changes are not recognised in OCI as per Companies
Ordinance 1984);

remeasurements of defined benefit pension schemes (IAS 19); and

will be reclassified subsequently to profit or loss when specific conditions

are met, including:
x

gains and losses on retranslation of foreign operations (IAS 21);

gains and losses recognised on remeasurement of available for sale

financial assets (IAS 39); and

gains and losses recognised on the effective element of cash flow

hedges (IAS 39)

Example: Reclassification adjustments

Year 1:
A company buys a foreign subsidiary at the start of year 1.
At the end of year 1 the financial statements of the subsidiary are retranslated
resulting in an exchange loss of Rs. 100,000.
Debit
Other comprehensive income
Net assets of S

Credit

100,000
100,000

This debit is transferred to a separate balance in equity.

Year 2:
The company sells the subsidiary at the start of year 2.
The loss previously recognised in OCI must now be recognised in P&L. The double
entry to achieve this is:
Debit
Credit
Profit or loss
Other comprehensive income

100,000
100,000

This credit in OCI in turn is transferred to the separate balance in equity

where it nets the debit that was taken there in year 1 back to zero.

1.4 Statement of changes in equity (SOCIE)

A SOCIE shows the amount at the beginning of the period, changes during the
period, and the amount at the end of the period for each component of equity.
For each component of equity, the SOCIE should show changes resulting from:

profit (gain) or loss for the period;

each item of other comprehensive income;

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transactions with owners in their capacity as owners.

x

new issues of shares;

payments of dividends;

repurchases and cancellation of its own shares by the company; and

charges in respect of equity-settled share based payment

transactions.

Transactions with owners in their capacity as owners are not gains or losses so
are not shown in the statement of comprehensive income but they do affect
equity. The SOCIE highlights such transactions.

1.5 Notes to the financial statements

Notes contain information in addition to that presented in the statement of
financial position, statement of comprehensive income, statement of changes in
equity and statement of cash flows.
Notes provide narrative descriptions of items in those statements and information
about items that do not qualify for recognition in those statements. They also
explain how totals in those statements are formed.
Disclosure of accounting policies
An entity must disclose the following in the summary of significant accounting
policies:

the measurement basis (or bases) used in preparing the financial

statements; and

the other accounting policies used that are relevant to an understanding of

the financial statements.

the judgements (apart from those involving estimations) made by

management in applying the accounting policies that have the most
significant effect on the amounts of items recognised in the financial
statements. For example:
x

whether financial assets are held-to-maturity investments;

when substantially all the significant risks and rewards of ownership

of financial assets and lease assets are transferred to other entities;

whether, in substance, particular sales of goods are financing

arrangements and therefore do not give rise to revenue; and

whether the substance of the relationship between the entity and a

special purpose entity indicates that the entity controls the special
purpose entity.

Which policies?
Management must disclose those policies that would assist users in
understanding how transactions, other events and conditions are reflected in the
reported financial performance and financial position.
If an IFRS allows a choice of policy, disclosure of the policy selected is especially
useful.
Some standards specifically require disclosure of particular accounting policies.
For example, IAS 16 requires disclosure of the measurement bases used for
classes of property, plant and equipment.

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It is also appropriate to disclose an accounting policy not specifically required by

IFRSs, but selected and applied in accordance with IAS 8.
Key measurement assumptions
An entity must disclose information regarding key assumptions about the future,
and other key sources of measurement uncertainty, that have a significant risk of
causing a material adjustment to the carrying amounts of assets and liabilities
within the next financial year.
In respect of those assets and liabilities, the notes must include details of:

their nature; and

their carrying amount as at the reporting date.

Examples of key assumptions disclosed are:

future interest rates;

future changes in salaries;

future changes in prices affecting other costs; and,

useful lives.

Examples of the types of disclosures made are:

the nature of the assumption or other measurement uncertainty;

the sensitivity of carrying amounts to the methods, assumptions and

estimates underlying their calculation, including the reasons for the
sensitivity;

the expected resolution of an uncertainty and the range of reasonably

possible outcomes within the next financial year in respect of the carrying
amounts of the assets and liabilities affected; and

an explanation of changes made to past assumptions concerning those

assets and liabilities, if the uncertainty remains unresolved.

Capital disclosures
An entity must disclose information to enable users to evaluate its objectives,
policies and processes for managing capital.
An entity must disclose the following:

qualitative information including:

x

a description of what it manages as capital;

the nature of any externally imposed capital requirements and how

they are incorporated into the management of capital;

how it is meeting its objectives for managing capital;

summary quantitative data about what it manages as capital; and

whether any externally imposed capital requirements have been complied

with and if not the consequences of such non-compliance.

These disclosures must be based on information provided internally to key

management personnel.

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ED/2014/1: DISCLOSURE INITIATIVE

Section overview

Introduction
Materiality

Information to be presented in the SOFP or the SOPL & OCI

Notes

Disclosure of accounting policies

2.1 Introduction
The objective of this project is to make narrow-focus amendments to IAS 1
Presentation of Financial Statements to address some of the concerns expressed
about existing presentation and disclosure requirements, and to ensure that
entities are able to use judgement when preparing financial statements
The proposed amendments relate to:

materiality and aggregation;

statement of financial position and statement of profit or loss and other

comprehensive income;

notes structure; and

disclosure of accounting policies.

2.2 Materiality
The proposed amendments clarify the materiality requirements in IAS 1 and
include an emphasis on the potentially detrimental effect of overwhelming useful
information with immaterial information.

Entities must not aggregate or disaggregate information in a manner that

obscures useful information;

the materiality requirements apply to the statement(s) of profit or loss and

other comprehensive income, statement of financial position, statement of
cash flows and statements of changes in equity and to the notes; and

An entity need not provide a specific disclosure required by an IFRS in the

financial statements, including in the notes, if the information resulting from
that disclosure is not material. When a standard requires a specific
disclosure, an entity must assess whether all of that information needs to
be presented or disclosed, or whether some of the information is immaterial
and presenting or disclosing it would reduce the understandability of its
financial statements by detracting from the material information.

2.3 Information to be presented in the SOFP or the SOPL & OCI

IAS 1 includes a list of line items that should be shown in the statement of
financial position and a list of line items that should be shown the statement of
profit or loss. The ED proposes to add the following paragraph below each list.
These line items must be disaggregated when such presentation is relevant to
an understanding of the entitys financial position.

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IAS 1 requires that an entity should present additional line items, headings and
subtotals in the statement of financial position when such presentation is relevant
to an understanding of the entitys financial position. There is a similar
requirement for the statement of profit or loss.
The ED proposes to add a requirement that when an entity presents subtotals in
accordance with these paragraphs, those subtotals must:

be made up of items recognised and measured in accordance with IFRS;

be presented and labelled in a manner that makes what constitutes the

subtotal understandable; and

be consistent from period to period.

In addition any extra subtotal in the statement of profit or loss cannot be

displayed with more prominence that the subtotals and totals already required by
IAS 1.

2.4 Notes
IAS 1 contains a requirement that notes must be presented in a systematic
manner.
The ED clarifies that entities have flexibility as to the order in which they present
the notes, but also emphasise that understandability and comparability should be
considered by an entity when deciding that order. The ED proposes to provide
additional guidance which allows the entity to consider:

sequence of notes based on importance;

inter-related disclosures and grouping of notes;

sequence of notes compared to the primary financial statements sequence;

and

whether accounting policy descriptions should be in a separate section, or

as part of other notes

2.5 Disclosure of accounting policies

The ED proposes the removal of potentially unhelpful guidance in IAS 1 for
identifying a significant accounting policy.
This is a minor change and is not discussed further.

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IAS 34: INTERIM FINANCIAL REPORTING

Section overview

Scope of IAS 34
Form and content of interim financial statements

Periods for which interim financial statements must be presented

Recognition and measurement

Use of estimates in interim financial statements

3.1 Scope of IAS 34

IAS 1 requires that financial statements should be produced at least annually.
Many companies are required by national regulations to produce accounts on a
half-yearly basis or sometimes on a quarterly basis. For example, the Listing
Regulations of Pakistan requires listed companies whose shares are traded on
the Pakistan Stock Exchange to present financial statements on quarterly, half
yearly and annual basis.
IAS 34 Interim financial reporting does not specify the frequency of interim
reporting: this is a matter for national regulations, which may vary between
countries. IAS 34 focuses on providing guidance on the form and content of
these interim accounts.
It encourages publicly-traded companies to prepare interim accounts and to file
them with the national authority no later than 60 days after the end of the interim
period.

3.2 Form and content of interim financial statements

IAS 34 requires that, as a minimum, an interim financial report should include:

a condensed statement of financial position

a condensed statement of profit or loss and other comprehensive income,

presented as either a condensed single statement or a condensed separate
statement of profit or loss followed by a condensed statement of other
comprehensive income

a condensed statement of changes in equity

a condensed statement of cash flows, and

selected explanatory notes.

In the statement that presents the components of profit or loss an entity should
present the basic and diluted EPS for the period.
An entity could provide a full set of financial statements or additional selected
information if it wishes to do so. If it chooses to produce a full set of financial
statements for its interim accounts, the entity must comply with IAS 1.
The interim statements are designed to provide an update on the performance
and position of the entity. It should focus on new activities, events, and
circumstances that have occurred since the previous annual financial statements
were issued. They should not duplicate information that has already been
reported in the past.

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3.3 Periods for which interim financial statements must be presented

Interim reports must include the following financial statements (condensed or
complete):

a statement of financial position at the end of the current interim period and
a comparative balance sheet at the end of the previous financial year.

statements of profit or loss and other comprehensive income for the current
interim period and cumulatively for the current financial year to date.

comparative statements of profit or loss and other comprehensive income

for the comparable interim period last year, and the comparable cumulative
period last year.

a statement of changes in equity for the current financial year to date, with
a comparative statement for the comparable year-to-date period in the
previous year.

a statement of cash flows cumulatively for the current financial year to date,
with a comparative statement for the comparable year-to-date period in the
previous year.

Example: Periods for which interim financial statements must be presented

X plc publishes interim financial reports quarterly.
The entity's financial year ends 31 December (calendar year).
The statements that must be presented in the quarterly interim report as of 30
June 2015:

Statement of financial position

31st
December
2014

30th June
2015

30th June
2014
-

Statement of profit or loss and

other comprehensive income


6 months ending
3 months ending

Statement of cash flows

6 months ending
3 months ending

Statement of changes in equity

6 months ending
3 months ending

Note: the profit and loss statement will have four columns.

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3.4 Recognition and measurement

An entity should use the same accounting policies in the interim accounts that it
uses in the annual financial statements.
Measurement for interim purposes should be made on a year-to-date basis. For
example, suppose that a company uses quarterly reporting and in the first quarter
of the year, it writes down some inventory to zero. If it is then able to sell the
inventory in the next quarter, the results for the six-month period require no writedown of inventory, and the write-down of inventory should be reversed for the
purpose of preparing the interim accounts for the first six months of the year.
An appendix to IAS 34 gives some guidance on applying the general recognition
and measurement rules from the IASB Conceptual Framework to the interim
accounts. Some examples are given below.
Intangible assets
The guidance in IAS 34 states that an entity should follow the normal recognition
criteria when accounting for intangible assets. Development costs that have been
incurred by the interim date but do not meet the recognition criteria should be
expensed. It is not appropriate to capitalise them as an intangible asset in the
belief that the criteria will be met by the end of the annual reporting period.
Tax
Interim period income tax expense is accrued using the tax rate that would be
applicable to expected total annual earnings, that is, the estimated average
annual effective income tax rate applied to the pre-tax income of the interim
period.
The following examples illustrate the application of the foregoing principle.
Example: Interim period income tax expense
An entity publishes interim financial reports quarterly.
It expects to earn Rs. 10,000 pre-tax each quarter and operates in a jurisdiction
with a tax rate of 20% on the first 20,000 of annual earnings and 30% on all
additional earnings.
Actual earnings match expectations.
The following table shows the amount of income tax expense that is reported in
each quarter:

Tax expense

1st
Quarter

2nd
Quarter

3rd
Quarter

4th
Quarter

Annual
total

2,500

2,500

2,500

2,500

10,000

Rs. 10,000 of tax is expected to be payable for the full year on Rs.
40,000 of pre-tax income.

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Example: Interim period income tax expense

An entity publishes interim financial reports quarterly.
The entity earns 15,000 pre-tax profit in the first quarter but expects to incur
losses of 5,000 in each of the three remaining quarters (thus having zero income
for the year), and operates in a jurisdiction in which its estimated average annual
income tax rate is expected to be 20%.
The following table shows the amount of income tax expense that is reported in
each quarter:

Tax expense

1st
Quarter

2nd
Quarter

3rd
Quarter

4th
Quarter

Annual
total

3,000

(1,000)

(1,000)

(1,000)

nil

3.5 Use of estimates in interim financial statements

The interim financial statements should be reliable and relevant. However IAS 34
recognises that the preparation of interim accounts will generally rely more
heavily on estimates than the annual financial statements. An appendix of IAS 34
provides examples.
Pensions
A company is not expected to obtain an actuarial valuation of its pension
liabilities at the interim date. The guidance suggests that the most recent
valuation should be rolled forward and used in the interim accounts.
Provisions
The calculation of some provisions requires the assistance of an expert. IAS 34
recognises that this would be too costly and time-consuming for the interim
accounts. IAS 34 therefore states that the figure included in the annual financial
statements for the previous year should be updated without reference to an
expert.
Inventories
A full count of inventory may not be necessary at the interim reporting date. It
may be sufficient to make estimates based on sales margins to establish a
valuation for the interim accounts.

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IAS 24: RELATED PARTY DISCLOSURES

Section overview

Impact on the financial statements

The objective of IAS 24

Definitions

Disclosure requirements

4.1 Impact on the financial statements

A user of financial statements will normally expect the financial statements to
reflect transactions that have taken place on normal commercial terms (at arms
length). The user of the financial statements would want to be informed if:

Transactions have taken place that were not at arms length; or

There are parties that could enforce transactions on the entity that are not
on an arms length basis.

For example, in a group of companies, an entity might sell goods to its parent or
fellow-subsidiaries on more favourable terms than it would sell to other
customers.
In this situation, the financial performance or financial position reported by the
financial statements would be misleading. In each situation there is a special
relationship between the parties to the business transactions. This is referred to
as a related party relationship.

4.2 The objective of IAS 24

The objective of IAS 24 is to ensure that an entitys financial statements contain
sufficient disclosures to draw attention to the possibility that the entitys financial
position, or profit or loss may have been affected by:

the existence of related parties; and

transactions and outstanding balances with related parties.

IAS 24 is a disclosure standard. It does not require the redrafting of financial

statements. Such redrafting would be difficult as without the related party
relationship the transactions might never have taken place, and even if they had,
it may not be possible to determine at what amount.
Specified disclosures are required of:

related party relationships; and

related party transactions.

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4.3 Definitions
IAS 24 provides a lengthy definition of a related party and also a definition of a
related party transaction.
Related party
Definition: Related party
A related party is a person or entity that is related to the entity that is preparing its
financial statements (the reporting entity).
a)

b)

A person or a close member of that persons family is related to a reporting

entity if that person:
i) has control or joint control over the reporting entity;
ii)

has significant influence over the reporting entity; or

iii)

is a member of the key management personnel of the reporting

entity or of a parent of the reporting entity.

An entity is related to a reporting entity if any of the following conditions

applies:
i)

ii)

iii)
iv)
v)

vi)
vii)

viii)

The entity and the reporting entity are members of the same group
(which means that each parent, subsidiary and fellow subsidiary is
related to the others).
One entity is an associate or joint venture of the other entity (or an
associate or joint venture of a member of a group of which the other
entity is a member).
Both entities are joint ventures of the same third party.
One entity is a joint venture of a third entity and the other entity is an
associate of the third entity.
The entity is a post-employment benefit plan for the benefit of
employees of either the reporting entity or an entity related to the
reporting entity. If the reporting entity is itself such a plan, the
sponsoring employers are also related to the reporting entity.
The entity is controlled or jointly controlled by a person identified in
(a).
A person identified in (a)(i) has significant influence over the entity or
is a member of the key management personnel of the entity (or of a
parent of the entity).
The entity, or any member of a group of which it is a part, provides
key management personnel services to the reporting entity of to the
parent of the reporting entity.

A parent entity is related to its subsidiary entities (because it controls them) and
its associated entities (because it exerts significant influence over them). Fellow
subsidiaries are also related parties, because they are under the common control
of the parent.
In considering each possible related party relationship the entity must look to the
substance of the arrangement, and not merely its legal form. Although two
entities that have the same individual on their board of directors would not meet
any of the above conditions for a related party, a related party relationship would
nevertheless exist if influence can be shown.

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Some examples are given by IAS 24 of likely exemptions, where a related party
relationship would usually not exist. However, the substance of the relationship
should always be considered in each case.
Examples of entities that are usually not related parties are:

Two venturers that simply share joint control over a joint venture

Providers of finance (such as a lending bank or a bondholder)

Trade unions

Public utilities

Government departments and agencies

Customers, suppliers, franchisors, distributors or other agents with whom

the entity transacts a significant volume of business.

Close family members

Definition: Close family members
Close family members are those family members who may be expected to
influence, or be influenced by that individual.
Close family members include:

an individuals partner, children and dependants; and

children or dependants of the individuals partner.

Related party transactions

Definition: Related party transaction
A related party transaction is a transfer of resources, services or obligations
between a reporting entity and a related party, regardless of whether a price is
charged.
The following examples of related party transactions are given in IAS 24. (These
are related party transactions when they take place between related parties.)

Purchases or sales of goods

Purchases or sales of property and other assets

Rendering or receiving of services

Leases

Transfer of research and development costs

Finance arrangements (such as loans or contribution to equity)

Provision of guarantees

Settlement of liabilities on behalf of the entity or by the entity on behalf of

another party.

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Example: Related party transactions

In the following examples, identify related party relationships between all parties
and state any additional factors to consider in order to form a conclusion:
(a)

W Plc holds a controlling interest in X Ltd and Y Ltd. Z Ltd is a wholly owned
subsidiary of X Ltd.

(b)

Mr Z holds 75% of the voting capital of A Ltd and 40% of the voting capital
of B Ltd.

(c)

H and W (who are husband and wife) are the directors and majority
shareholders of Q Ltd. The company makes purchases from P Ltd, a
company jointly controlled by W and their daughter, D. D is a director of P
Ltd but holds no share in Q Ltd.

Answer
(a)

W Plc
W PLC is related to both X Ltd and Y Ltd (both subsidiaries) because of its
controlling interest.
X Ltd and Y Ltd are related because they are under the common control of
W PLC.
Z Ltd is related to X Ltd because of its subsidiary status.
Z Ltd is also related to W PLC as he is indirectly controlled by W PLC
through W PLCs holding of X Ltd.

(b)

Mr Z
Mr Z is related to A Ltd because of the subsidiary status of A Ltd.
As an associate of Mr Z, B Ltd is also a related party
A Ltd and B Ltd are not related. Although they are both owned by Mr Z,
there is no common control because Mr Z only has a 40% stake in B Ltd.

(c)

Q Ltd
H and W are both related to Q Ltd, because they are key management of
the entity
D could be considered to be close family to H and W, but this is only true if
it can be shown that she is influenced by them in business dealings (and
there is insufficient information in this example to ascertain whether this is
true).
P Ltd is related to Q Ltd as it is jointly controlled by a member of the key
management of Q Ltd. Therefore any business dealings between the two
entities will need to be disclosed.

4.4 Disclosure requirements

IAS 24 requires disclosure in the notes to the financial statements of the
following, whether or not transactions have taken place between those related
parties:

the name of the entitys parent

if different, the name of the ultimate controlling party

Where transactions have taken place between the related parties, irrespective of
whether a price was charged, the following should be disclosed:

The nature of the related party relationship

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The amount of the transactions

In respect of outstanding balances

the amount

their terms and conditions

any guarantees given or received

any provision for doubtful/irrecoverable debts

The expense recognised in the period in respect of irrecoverable debts due

from related parties.

The above disclosures should be given separately for each of the following
categories of related party:

The parent

Entities with joint control or significant influence over the entity

Subsidiaries

Associates

Joint ventures in which the entity is a venturer

Key management personnel of the entity or its parent

Other related parties

In addition, IAS 24 requires disclosure of compensation to key management

personnel, in total, and for each of the following categories:

Short-term employee benefits

Post-employment benefits

Other long-term benefits

Termination benefits

Share-based payments.

Illustration: Disclosure note

An example of a note to the financial statements for related party transactions of
a large quoted company is shown below:
Trading transactions

Associates
Joint ventures

Sales to
related
parties

Purchases
from related
parties

Amounts
owed by
related
parties

Amounts
owed to
related
parties

Rs. m
57

Rs. m
48
14

Rs. m
12

Rs. m
17
-

Non-trading transactions

Associates
Joint ventures

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related parties
Rs.m
33

70

Loans from
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Rs.m
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Chapter 3: Presentation of financial statements

IFRS 8: OPERATING SEGMENTS

Section overview

Introduction

Operating segments

5.1 Introduction
Many companies operate in several different industries (or product markets) or
diversify their operations across several geographical locations. A consequence
of diversification is that companies are exposed to different rates of profitability,
different growth prospects and different amounts of risk for each separate
segment of their operations.
Objective of IFRS 8
IFRS 8 requires quoted companies to disclose information about their different
operating segments, in order to allow users of the financial statements to gain a
better understanding of the companys financial position and performance.
Users are able to use the information about the main segments of the companys
operations to carry out ratio analysis, identify trends and make predictions about
the future. Without segment information, good performance in some segments
may hide very poor performance in another segment, and the user of the
financial statements will not see the true position of the company.
Scope of IFRS 8
Segment reporting is required for any entity whose debt or equity is quoted on a
public securities market (stock market) and also entities that are in the process of
becoming quoted. If an entity includes some segment information in the annual
report that doesnt comply with IFRS 8, it cannot call it segmental information.

5.2 Operating segments

IFRS 8 defines an operating segment as a component of an entity:

that engages in business activities from which it earns revenues and incurs
expenses

whose operating results are regularly reviewed by the entitys chief

operating decision maker to make decisions about resources to be
allocated to the segment and assess its performance, and

for which discrete financial information is available.

Not every part of an entity is necessarily an operating segment. For example a

corporate head office may not earn revenue and would not be an operating
segment.
The standard requires a segment to have its results reviewed by the chief
operating decision maker. The reason for this part of the definition of an
operating segment is to ensure that an entity reports segments that are used by
management of the entity to monitor the business.

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Aggregation of segments
Two or more operating segments may be aggregated into a single operating
segment if they have similar economic characteristics, and the segments are
similar in each of the following respects:

The nature of the products and services

The nature of the production process

The type or class of customer for their products and services

The methods used to distribute their products or provide their services, and

If applicable, the nature of the regulatory environment, for example,

banking insurance or public utilities.

Quantitative thresholds
An entity must report separately information about an operating segment that
meets any of the following quantitative thresholds:

Its reported revenue, including external sales and intersegment sales is

10% or more of the combined internal and external revenue of all operating
segments

Its reported profit is 10% or more of the greater of the combined profit of all
segments that did not report a loss and the combined reporting loss of all
segments that reported a loss

Its assets are 10% or more of the combined assets of all operating
segments

Reportable segments
An entity must report separately information about each operating segment that:

Has been identified in accordance with the definition of an operating

segment shown above

Or is aggregated with another segment

Or exceeds the quantitative thresholds.

If the total external revenue reported by operating segments constitutes less than
75% of the entitys total revenue, then additional operating segments must be
identified as reporting segments, even if they do not meet the criteria, until 75%
of revenue is included in reportable segments.

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Example:
The following information relates to a quoted company with five divisions of
operation:

Division 1
Division 2
Division 3
Division 4
Division 5

Profit

Loss

Rs.m
10
25

Rs.m

Rs.m

Rs.m

Rs.m

Rs.m

40
35
40
110

40

Which of the divisions are reportable segments under IFRS 8 Operating

segments?

Answer
Since Profit figure is higher, we will take 10% of that amount.

Division 1
Division 2
Division 3
Division 4
Division 5

Profit

Loss

Rs.m
10
25

Rs.m

40
35
40
110

Greater of the two

Reportable
segment (results >
Rs. 11m
No
Yes
Yes
Yes
Yes

40

110

Materiality threshold (10%)

11

Note: Division 3 is reportable as the loss of Rs. 40m is greater than Rs.
11m (ignoring the sign).

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Example:
The following information relates to Oakwood, a quoted company with five
divisions of operation:
Wood
sales
Rs.m
Revenue from
external
customers
Inter segment
revenue
Reported profit
Total assets

Furniture
sales
Rs.m

Veneer
sales
Rs.m

Waste
sales
Rs.m

Other
sales
Rs.m

Total
Rs.m

220

256

62

55

57

650

38

48

54
4,900

45
4,100

12
200

9
400

10
600

130
10,200

Which of the business divisions are reportable segments under IFRS 8 Operating
segments?

Answer
IFRS 8 states that a segment is reportable if it meets any of the following criteria:
1.

its internal and external revenue is more than 10% of the total entity internal
and external revenue.

2.

its reported profit is 10% or more of the greater of the combined profit of all
segments that did not report a loss.

3.

its assets are 10% or more of the combined assets of all operating
segments.

From the table above, only the Wood and Furniture department sales have more
than 10% of revenue, assets and profit and meet the requirements for an
operating segment. The other three divisions do not meet the criteria: none of
them pass the 10% test for assets, profit or revenue.
Additionally IFRS 8 states that if total external revenue reported by operating
segments constitutes less than 75% of the entitys revenue then additional
operating segments must be identified as reporting segments, until 75% of
revenue is included in reportable segments
The total external revenue of Wood and Furniture is Rs.476m and the total entity
revenue is Rs.650m, which means that the revenue covered by reporting these
two segments is only 73%. This does not meet the criteria so we must add
another operating segment to be able to report on 75% of revenue. It doesnt
matter that any of the other entities do not meet the original segment criteria.
In this case, we can add on any of the other segments to achieve the 75% target.
If we add in Veneer sales, this gives total sales of Rs.538m, which is 83% of the
sales revenue of Rs.650m. This is satisfactory for the segmental report.

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Disclosure
IFRS 8 states that an entity must disclose information so that users of the
financial statements can evaluate the nature and financial effects of the business
activities in which it engages and the economic environments in which it
operates.
The information that is to be disclosed is:

A measure of profit or loss for each reportable segment

A measure of total assets liabilities for each reportable segment if such an

amount is reported regularly to the chief operating decision maker

Information about the following items if they are specified and included in
the measure of segment profit that is reported to the chief operating
decision maker:

revenues from external customers

revenues from transactions with other operating segments of the

same entity

interest revenue

interest expense

depreciation and amortisation

material items of income and expense in accordance with IAS 1

the entitys interest in the profit or loss of associates and joint

ventures accounted for by the equity method

income tax expense or income

material non-cash items other than depreciation and amortisation.

the amount of investment in associates and joint ventures accounted for by

the equity method and the amounts of additions to non-current assets
(excluding financial instruments, deferred tax assets, post-employment
benefit assets and rights arising under insurance contracts), providing
these amounts are included in segment assets.

Additionally, the following reconciliations are required:

Reconciliation of the totals of segment revenues to the entitys revenue;

Reconciliation of the total of reported segment profits or losses to the

entitys profit before tax and discontinued operations;

Reconciliation of the total of the assets of the reportable segments to the

entitys assets;

Reconciliation of the total of the liabilities of the reportable segments to the

entitys liabilities (but only if segment liabilities are reported); and

Reconciliation of the total of the assets of the other material items to the
entitys corresponding items.

Also, the factors used to identify the entitys reportable segments, including the
basis of organisation, (i.e. whether the entity is organised around different
products and services or geographical area), and the types of products and
service from which the reportable segments derive their income must all be
disclosed.

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Measurement
IFRS 8 requires that the amount of each segment item reported shall be the
measure reported to the chief operating decision maker for the purposes of
making decisions about allocating resources to the segment and assessing its
performance. This is based on the internal structure of how division of the entity
report their results to the chief operating decision maker. Any adjustments and
eliminations made in preparing an entitys financial statements shall be included
in determining segment results only if they are included in the measure of the
segments results used by the chief operating decision maker.
The minimum amount the entity must disclose is:

The basis of accounting for any transactions between reportable segments

The nature of any differences between the measurement of the reportable

segments profit or loss before tax and the entitys profit or loss, for
example, the allocation of centrally incurred costs.

The nature of any differences between the measurement of the reportable

segments assets and the assets of the entity.

The nature of any differences between the measurement of the reportable

segments liabilities and the liabilities of the entity.

The nature of any changes from prior periods in measurement methods

used to determine segment profit or loss and the effect on profit or loss
from those changes.

The nature of asymmetrical allocations to reportable segments. For

example, a reportable segment may be charged the depreciation expense
for a particular asset but the depreciable asset might not have been
allocated to the segment.

Entity wide disclosures

The reporting entity must also make the following disclosures in the financial
statements, even if it only has one reportable segment:

Revenue from external customers for each product and service or each
group of similar products and services.

Revenue from external customers attributed to the entitys country of

domicile and attributed to all foreign countries in total where revenue is
made.

Non-current assets located in the country of domicile and located in all

foreign countries in total where the entity holds assets

If revenue from any customer is more than 10% of total revenue then it
must be disclosed along with the total of revenues from these customers
and the identity of the segment reporting the revenue.

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IAS 10: EVENTS AFTER THE REPORTING PERIOD

Section overview

Purpose of IAS 10
Accounting for adjusting events after the reporting period

Disclosures for non-adjusting events after the reporting period

Dividends

The going concern assumption

6.1 Purpose of IAS 10

IAS 10 Events after the reporting period has two main objectives:

to specify when a company should adjust its financial statements for events
that occur after the end of the reporting period, but before the financial
statements are authorised for issue, and

to specify the disclosures that should be given about events that have
occurred after the end of the reporting period but before the financial
statements were authorised for issue.

IAS 10 also includes a requirement that the financial statements should disclose
when the statements were authorised for issue, and who gave the authorisation.
IAS 10 sets out the following key definitions.
Definitions
Events after the reporting period: Those events, favourable and unfavourable that
occur between the end of the reporting period and the date the financial
statements are authorised for issue.
Adjusting events: Events that provide evidence of conditions that already existed as
at the end of the reporting period.
Non-adjusting events: Events that have occurred due to conditions arising after the
end of the reporting period.

6.2 Accounting for adjusting events after the reporting period

IAS 10 states that if a company obtains information about an adjusting event after
the reporting period, it should adjust the financial statements to allow for this new
information.
IAS 10 gives the following examples of adjusting events.

The settlement of a court case after the end of the reporting period,
confirming that the company had a present obligation as at the end of the
reporting period as a consequence of the case.

The receipt of information after the reporting period indicating that an asset
was impaired as at the end of the reporting period.

The discovery of fraud or errors showing that the financial statements are
incorrect.

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6.3 Disclosures for non-adjusting events after the reporting period

Non-adjusting events after the reporting period are treated differently. A nonadjusting event relates to conditions that did not exist at the end of the reporting
period, therefore the financial statements must not be updated to include the
effects of the event. IAS 10 states quite firmly: A company shall not adjust the
amounts recognised in the financial statements to reflect non-adjusting events
after the reporting period.
However, IAS 10 goes on to say that if a non-adjusting event is material, a failure
by the company to provide a disclosure about it could influence the economic
decisions taken by users of the financial statements. For material non-adjusting
events IAS 10 therefore requires disclosure of:

the nature of the event; and

an estimate of its financial effect or a statement that such an estimate

cannot be made.

IAS 10 gives the following examples of non-adjusting events:

A fall in value of an asset after the end of the reporting period, such as a
large fall in the market value of some investments owned by the company,
between the end of the reporting period and the date the financial
statements are authorised for issue.

The acquisition or disposal of a major subsidiary.

The formal announcement of a plan to discontinue a major operation.

Announcing or commencing the implementation of a major restructuring.

The destruction of a major plant by a fire after the end of the reporting
period.

6.4 Dividends
IAS 10 also contains specific provisions about proposed dividends and the going
concern presumption on which financial statements are normally based.
If equity dividends are declared after the reporting period, they should not be
recognised, because they did not exist as an obligation at the end of the reporting
period.
Dividends proposed after the reporting period (but before the financial statements
are approved) should be disclosed in a note to the financial statements, in
accordance with IAS 1.

6.5 The going concern assumption

There is one important exception to the normal rule that the financial statements
reflect conditions as at the end of the reporting period.
A deterioration in operating results and financial position after the end of the
reporting period may indicate that the going concern presumption is no longer
appropriate.
There are a large number of circumstances that could lead to going concern
problems. For example:

The financial difficulty of a major customer leading to their inability to pay

their debt to the agreed schedule if at all.

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An event leading to the net realisable value of lines of inventory falling to

less than cost.

An event leading to a crucial non-current asset falling out of use. This might
cause difficulties in supplying customers and fulfilling contracts.

A change in market conditions leading to a loss in value of major

investments.

Shortages of important supplies

The emergence of a highly effective competitor.

If it becomes clear that the company cannot be considered to be a going

concern, the financial statements will need to disclose this and the basis for
preparing them will change to the break-up basis.
This means that values will have to be adjusted to the amounts expected to be
realised through sale.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

IAS 8: Accounting policies,

changes in accounting
estimates and errors
Contents
1 Accounting policies
2 Accounting estimates
3 Errors

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 13

IAS 8: Accounting policies, changes in accounting estimates and errors

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ACCOUNTING POLICIES
Section overview

Introduction to IAS 8
Accounting policies

Selection of accounting policies

Changes in accounting policies

Retrospective application of a change in accounting policy

Limitation on retrospective application

Disclosure of a change in accounting policy

Judgements- IAS8

1.1 Introduction to IAS 8

The aim of IAS 8: Accounting policies, changes in accounting estimates and
errors is to enhance comparability of the entitys financial statements to previous
periods and to the financial statements of other entities.
It does this by prescribing:

the criteria for selecting accounting policies; and,

the accounting treatment and disclosure of:

x

changes in accounting policies;

changes in accounting estimates; and

errors.

Much of IAS 8 is concerned with how changes or corrections should be reported

in the financial statements.

1.2 Accounting policies

Definition: Accounting policies
Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements.
IFRSs set out accounting policies that result in financial statements containing
relevant and reliable information about the transactions, other events and
conditions to which they apply. Those policies need not be applied when the
effect of applying them is immaterial.
Definition: Material
Omissions or misstatements of items are material if they could, individually or
collectively, influence the economic decisions that users make on the basis of the
financial statements. Materiality depends on the size and nature of the omission or
misstatement judged in the surrounding circumstances. The size or nature of the
item, or a combination of both, could be the determining factor.

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1.3 Selection of accounting policies

Selection of accounting policies Areas covered by IFRS
If an IFRS (or an Interpretation) applies to an item in the financial statements, the
accounting policy or policies applied to that item must be determined by applying
the Standard or Interpretation and any relevant implementation guidance issued.
Selection of accounting policies Area not covered by IFRS
If there is no rule in IFRS that specifically applies to an item in the financial
statements, management must use its judgement to develop and apply an
accounting policy that results in information that is:

relevant to the decision-making needs of users; and

reliable in that the financial statements:

represent faithfully the results and financial position of the entity;

reflect the economic substance of transactions and other events, and not
merely the legal form;

are neutral, i.e. free from bias;

are prudent; and

are complete in all material respects.

In making the judgement management must consider the following sources in

descending order:

the requirements and guidance in IFRS dealing with similar and related
issues;

the definitions, recognition criteria and measurement concepts for assets,

liabilities, income and expenses set out in the Framework.

Management may also consider the most recent pronouncements of other

standard-setting bodies that use a similar conceptual framework to the extent that
these do not conflict with the above sources.
Consistency of accounting policies
An entity must apply consistent accounting policies over the periods to deal with
similar transactions, and other events and circumstances, unless IFRS
specifically requires or permits categorisation of items for which different policies
may be appropriate.
Illustration: Consistency
IAS 16: Property, plant and equipment allows the use of the cost model or the
revaluation model for measurement after recognition.
This is an example of where IFRS permits categorisation of items for which
different policies may be appropriate.
If chosen, each model must be applied to an entire class of assets. Each model
must be applied consistently within each class that has been identified.

1.4 Changes in accounting policies

Users of financial statements need to be able to compare financial statements of
an entity over time, so that they can identify trends in its financial performance or
financial position. Frequent changes in accounting policies are therefore
undesirable because they make comparisons with previous periods more difficult.

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The same accounting policies must be applied within each period and from one
period to the next unless a change in accounting policy meets one of the
following criteria. A change in accounting policy is permitted only if the change is:

required by IFRS; or

results in the financial statements providing reliable and more relevant

financial information.

A new or revised standard usually include specific transitional provisions to

explain how the change required by the new rules should be introduced.
In the absence of specific transitional provisions, a change in policy should be
applied retrospectively. This is explained shortly.
Determining when there is a change in accounting policy
A change in accounting policy can be established as follows. The accounting
policies chosen by an entity should reflect transactions and events through:

recognition (e.g. capitalising or writing off certain types of expenditure)

measurement (e.g. measuring non-current assets at cost or valuation)

presentation (e.g. classification of costs as cost of sales or administrative

expenses)

If at least one of these criteria is changed, then there is a change in accounting

policy.
Illustration: Determining when there is a change in accounting policy
IAS 23 requires the capitalisation of borrowing costs directly attributable to the
acquisition, construction or production of a qualifying asset.
Previously, IAS 23 allowed companies to expense or capitalise borrowing costs.
The revision to IAS 23 led to a change in accounting policy for some companies as
it affected:

recognition the interest cost previously recognised as an expense had to be

recognised as an asset; and

presentation the interest cost previously presented in the statement of

comprehensive income had to be presented in the statement of financial
position.

IAS 8 specifies that the application of a new accounting policy to transactions or

events that did not occur previously or differ in substance from those that
occurred previously, is not a change of accounting policy. It is simply the
application of a suitable accounting policy to a new type of transaction.
The initial application of a policy to revalue assets in accordance with IAS 16
Property, Plant and Equipment or IAS 38 Intangible Assets is a change in an
accounting policy. However, it is accounted for in accordance guidance in those
standards rather than in accordance with IAS 8.

1.5 Retrospective application of a change in accounting policy

When a change in accounting policy is required, and there are no transitional
provisions relating to the introduction of a new accounting standard, the change
in policy should be applied retrospectively.

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Definition: Retrospective application

Retrospective application is applying a new accounting policy to transactions, other
events and conditions as if that policy had always been applied.
The entity should adjust the opening balance for each item of equity affected by
the change, for the earliest prior period presented, and the other comparative
amounts for each prior period presented, as if the new accounting policy had
always been applied.
IAS 1: Presentation of Financial Statements requires a statement of financial
position at the beginning of the earliest comparative period when a new
accounting policy is applied retrospectively.
Illustration: Retrospective application
A company presents comparatives for the previous year only.
During the year ended 31 December 2015 it changes an accounting policy and this
change must be applied retrospectively.
If there were no change in accounting policy the company would present
statements of financial position as at December 2015 and December 2014 only.
However, because there is a change in accounting policy the company must also
present a statement of financial position as at 1 January 2014 (the beginning of
the earliest comparative period).
The change in accounting policy is applied retrospectively. This means that the
change should be applied to the balances at as at 1 January 2014 as if the new
accounting policy had always been applied.
Similarly, any other comparative amounts in previous periods should be adjusted
as if the new accounting policy had always been applied.
If this is impracticable, retrospective application should be applied from the
earliest date that is practicable.

1.6 Limitation on retrospective application

It might be impracticable to retrospectively apply the change in accounting policy.
This could be because the information necessary for the application of the
change in accounting policy to earlier periods is not available because it had not
been collected then.
Definition: Impracticable
Applying a requirement is impracticable when the entity cannot apply it after
making every reasonable effort to do so. For a particular prior period, it is
impracticable to apply a change in an accounting policy retrospectively or to make
a retrospective restatement to correct an error if:
(a) the effects of the retrospective application or retrospective restatement are
not determinable;
(b) the retrospective application or retrospective restatement requires
assumptions about what management's intent would have been in that
period; or
(c)
the retrospective application or retrospective restatement requires
significant estimates of amounts and it is impossible to distinguish
objectively information about those estimates that:

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(i)
(ii)

provides evidence of circumstances that existed on the date(s) as at

which those amounts are to be recognised, measured or disclosed; and
would have been available when the financial statements for that prior
period were authorised for issue from other information.

There are different degrees of impracticability.

Period specific effect
It might be impracticable to determine the effect of changing an accounting policy
on comparative information for one or more prior periods presented. For
example, it might be impracticable to determine the impact on profit for the prior
year.
In this case entity must apply the new accounting policy to the carrying amounts
of assets and liabilities (and therefore equity) as at the beginning of the earliest
period for which retrospective application is practicable. This may be the current
period.
Cumulative effect
It might be impracticable to determine the cumulative effect, at the beginning of
the current period, of applying a new accounting policy to all prior periods,
In this case a company must adjust the comparative information to apply the new
accounting policy prospectively from the earliest date practicable.
When the cumulative effect of applying the policy to all prior periods cannot be
determined, a company must apply the new policy prospectively from the start of
the earliest period practicable. This means that it would disregard the portion of
the cumulative adjustment to assets, liabilities and equity arising before that date.
Definition: Prospective application
Prospective application of a change in accounting policy and of recognising the
effect of a change in an accounting estimate, respectively, are:
(a)

applying the new accounting policy to transactions, other events and

conditions occurring after the date as at which the policy is changed; and

(b)

recognising the effect of the change in the accounting estimate in the

current and future periods affected by the change.

1.7 Disclosure of a change in accounting policy

When a change in accounting policy has an effect on the current period or any
prior period (or would have an affected that period except that it is impracticable
to determine the amount of the adjustment) or might have an effect on future
periods the following must be disclosed:
Disclosure:

Change due
to IFRS

The title of the Standard or Interpretation

The nature of the change in accounting policy

A description of any transitional provisions

The reason why the new accounting policy

provides reliable and more relevant information

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Disclosure:

Change due
to IFRS

Voluntary
change

For the current and previous period(s), to the

extent practicable, the amount of the adjustment
to each item in the financial statements.

To the extent practicable, the adjustment

relating to accounting periods before those
presented in the financial statements

If retrospective application is impracticable, an

explanation of how the accounting policy change
has been applied

1.8 Judgements IAS 8

IAS 8: Areas of judgement and estimate

Application of this standard requires different judgements and estimates to

be made which would have an impact on figures reported in the financial
statements.

These include the following:

Development of an accounting policy for events, transactions or balances

that are not specifically covered by an IFRS

Categorising items for the purpose of applying policies consistently to like

items

Whether or not a voluntary change in accounting policy provides reliable

and more relevant information

Impracticability arguments

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ACCOUNTING ESTIMATES
Section overview

Accounting estimates
Changes in accounting estimates

Disclosures

2.1 Accounting estimates

An accounting estimate is made for an item in the financial statements when the
item cannot be measured with precision, and there is some uncertainty about it.
An estimate is therefore based, to some extent, on managements judgement.
Management estimates might be required, for example, for the following items:

bad debts;

inventory obsolescence;

the fair value of financial assets or liabilities;

the useful lives of non-current assets;

the most appropriate depreciation pattern (depreciation method, for

example straight line or reducing balance) for a category of non-current
assets;

measurement of warranty provisions.

The use of reasonable estimates is an essential part of the preparation of

financial statements and does not undermine their reliability.
Accounting policy vs accounting estimate
It is important to distinguish between an accounting policy and an accounting
estimate.
Sometimes it can be difficult to distinguish between changes in accounting policy
from changes in accounting estimate. In such cases any change is treated as a
change in accounting estimate.
Illustration: Accounting policy vs accounting estimate
Accounting policy: Depreciating plant and equipment over its useful life
Accounting estimate: How to apply the policy. For example whether to use the
straight line method of depreciation or the reducing balance method is a choice of
accounting estimate.
A change in the measurement basis applied is a change in an accounting policy,
and is not a change in an accounting estimate.
Illustration: Accounting policy vs accounting estimate
IAS 16: Property, plant and equipment allows the use of the cost model or the
revaluation model for measurement after recognition.
This is a choice of accounting policy.

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2.2 Changes in accounting estimates

Definition: Change in accounting estimate
A change in accounting estimate is an adjustment of the carrying amount of an
asset or a liability, or the amount of the periodic consumption of an asset, that
results from the assessment of the present status of, and expected future benefits
and obligations associated with, assets and liabilities. Changes in accounting
estimates result from new information or new developments and, accordingly, are
not corrections of errors.
A change in accounting estimate may be needed if changes occur in the
circumstances on which the estimate was based, or if new information becomes
available. A change in estimate is not the result of discovering an error in the
way an item has been accounted for in the past and it is not a correction of an
error.
IAS 8 requires a change in an accounting policy to be accounted for
retrospectively whereas a change in an accounting estimate is normally
recognised from the current period.
The effect of a change in accounting estimate should be recognised
prospectively, by including it:

in profit or loss for the period in which the change is made, if the change
affects that period only, or

in profit or loss for the period of change and future periods, if the change
affects both.

To the extent that a change in estimate results in a change in assets and

liabilities, it should be recognised by adjusting the carrying amount of the affected
assets or liabilities in the period of change.
Example: Change in accounting estimate
A non-current asset was purchased for Rs. 200,000 two years ago, when its
expected economic life was ten years and its expected residual value was nil. The
asset is being depreciated by the straight-line method.
A review of the non-current assets at the end of year 2 revealed that due to
technological change, the useful life of the asset is only six years in total, and the
asset therefore has a remaining useful life of four years.
The original depreciation charge was Rs.20,000 per year (Rs.200,000/10 years) and at
the beginning of Year 2, its carrying value was Rs.180,000 (Rs.200,000 Rs.20,000).
The change in the estimate occurs in Year 2. The change in estimate should be
applied prospectively, for years 2 onwards (years 2 6). From the beginning of year
2, the asset has a revised useful remaining life of five years.
The annual charge for depreciation for year 2 (the current year) and for the future
years 3 6 will be changed from Rs.20,000 to Rs.36,000 ( Rs.180,000/5 years).

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2.3 Disclosures
The following information must be disclosed:

The nature and amount of a change in an accounting estimate that has an

effect in the current period or is expected to have an effect in future
periods, except for the effect on future periods when it is impracticable to
estimate that effect.

The fact that the effect in future periods is not disclosed because estimating
it is impracticable (if this is the case).

Example: Change in accounting estimate

Company ABC acquired equipment on Jan 1. 2014 costing Rs 100,000.
The initial estimate of the useful life of the equipment was 5 years.
The estimate of the useful life was revised to 4 years at the start of 2016.
Required
Draft the disclosure note required in the financial statements for the year ended
31 December 2016

Answer
Disclosure: Profit after tax
Profit before tax is stated after taking the following into account:
Depreciation
Original Estimate

2016
100,000

change in estimate

50,000
150,000

2015
100,000
100,000

Change in estimate
The estimated economic useful life of the plant and machinery was
changed from 5 years to 4 years. The increase / (decrease) in profits
caused by the change is as follows:
2016
Current years profits:
Future profits:

(50,000)
50,000

The total effect on profit zero.

The reason is that it is only the timing of the recognition of the
depreciation that has changed. The full, original cost of the asset will be
expensed irrespective of the estimated useful life.

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Answer (continued)
Working

Rs.

Cost at Jan 1, 2014

Accumulated depreciation up to 31 Dec 2015

500,000
(200,000)

Carrying amount at 31st December 2015

Remaining useful life (New estimate of 4 years less the
two years already used)

300,000

Depreciation in the year ended

31st

December 2016

Carrying amount at 31st December 2016

(Rs. 300,000 b/f less Rs. 150,000)

2 years
150,000
150,000

Practice question

Example: Change in accounting estimate

Company ABC acquired equipment on Jan 1. 2014 costing Rs 100,000.
The initial estimate of the useful life of the equipment was 5 years with a nil
residual value.
The estimate of residual value was revised to Rs. 90,000 at the start of 2016.
Required
Draft the disclosure note required in the financial statements for the year ended
31 December 2016

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ERRORS
Section overview

Errors
The correction of prior period errors

Limitation on retrospective restatement

Disclosure of prior period errors

3.1 Errors
Errors might happen in preparing financial statements. If they are discovered
quickly, they are corrected before the finalised financial statements are
published. When this happens, the correction of the error is of no significance for
the purpose of financial reporting.
A problem arises, however, when an error is discovered that relates to a prior
accounting period. For example, in preparing the financial statements for Year 3,
an error may be discovered affecting the financial statements for Year 2, or even
Year 1.
Definition: Prior period errors
Prior period errors are omissions from, and misstatements in, the entity's financial
statements for one or more prior periods arising from a failure to use, or misuse of,
reliable information that:
(a)

was available when financial statements for those periods were authorised
for issue; and

(b)

could reasonably be expected to have been obtained and taken into account
in the preparation and presentation of those financial statements.

Such errors include the effects of mathematical mistakes, mistakes in applying

accounting policies, oversights or misinterpretations of facts, and fraud.

3.2 The Correction of prior period errors

All material prior period errors should be corrected retrospectively in the first set
of financial statements following the discovery of the error.
Comparative amounts for the previous period should be re-stated at their
corrected amount.
If the error occurred before the previous year, the opening balances of assets,
liabilities and equity for the previous period should be re-stated at their corrected
amount unless that is impracticable.
The correction of a prior period error is excluded from profit or loss in the period
when the error was discovered.

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Illustration: Correction of prior period errors

In preparing its financial statements for 31 December 2015 Company A discovers
an error affecting the 31 December 2014 financial statements.
The error should be corrected in the 31 December 2015 financial statements by restating the comparative figures for 31 December 2014 at their correct amount.
If the error had occurred in 31 December 2013, the comparative opening balances
for the beginning of 31 December 2014 should be re-stated at their correct
amount.
The reported profit for 31 December 2015 is not affected.
Example:: Correction of prior period errors
Kasur Transport Company (KTC) is preparing its financial statements for 2015.
The draft statement of changes in equity is as follows:
Share
capital

Share
premium

Retained
earnings

Total

Rs.000

Rs.000

Rs.000

Rs.000

500

50

90

640

150

150

500

50

240

790

(100)

(100)

385

385

525

1,075

Balance at 31/12/13
Profit for the year
Balance at 31/12/14
2015
Dividends
Profit for the year
Balance at 31/12/15

500

50

KTC has now discovered an error in its inventory valuation. Inventory was
overstated by Rs. 70,000 at 31 December 2015 and by Rs. 60,000 at 31
December 2014. The rate of tax on profits was 30% in both 2014 and 2015.
The error in 2015 is corrected against the current year profit.
The error in 2014 is corrected against the prior year profit. (Note that the 2014
closing inventory is the opening inventory in 2015 so the 2014 adjustment will
impact both periods statements comprehensive income.
Profit adjustments:

2015

2014

Rs.000

Rs.000

Profit (2015 draft and 2014 actual)

385

150

Deduct error in closing inventory

(70)

(60)

Add error in opening inventory

60

Tax at 30%

Adjusted profit

(10)

(60)

18

(7)

(42)

378

108

The statement of changes in equity as published in 2015 becomes:

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Share
capital

Share
premium

Retained
earnings

Total

Rs.000

Rs.000

Rs.000

Rs.000

Balance at 31/12/13

500

50

90

640

108

108

500

50

198

748

(100)

(100)

378

378

476

1,026

Profit for the year (restated)

Balance at 31/12/14
2015
Dividends
Profit for the year
Balance at 31/12/15

500

50

3.3 Limitation on retrospective restatement

A prior period error must be corrected by retrospective restatement except to the
extent that it is impracticable to determine either the period-specific effects or the
cumulative effect of the error.
Period specific effect
It might be impracticable to determine the effect of correcting an error in
comparative information for one or more prior periods presented. For example, it
might be impracticable to determine the impact on profit for the prior year.
In this case a company must restate the carrying amounts of assets and liabilities
(and therefore equity) as at the beginning of the earliest period for which
retrospective restatement is practicable. This may be the current period.
Cumulative effect
It might be impracticable to determine the cumulative effect, at the beginning of
the current period, of correcting an error in all prior periods,
In this case a company must correct the error prospectively from the earliest date
practicable.

3.4 Disclosure of prior period errors

The following information must be disclosed:

the nature of the prior period error;

for each period presented in the financial statements, and to the extent
practicable, the amount of the correction for each financial statement item
and the change to basic and fully diluted earnings per share;

the amount of the correction at the beginning of the earliest prior period in
the statements (typically, the start of the previous year);

if retrospective re-statement is not practicable for a prior period, an

explanation of how and when the error has been corrected.

IAS 8 therefore requires that a note to the financial statements should disclose
details of the prior year error, and the effect that the correction has had on line
items in the prior year.

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Example: Disclosure of prior period errors

Returning to the above example the following note would be needed to the
financial statements for the year to 31 December 2015 to explain the
adjustments made to figures previously published for the year to 31 December
2014.
Note about statement of comprehensive income.
Rs.000
(Increase) in cost of goods sold

(60)

Decrease in tax

18

(Decrease) in profit

(42)

Note about statement of financial position

Rs.000

(Decrease) in closing inventory

(60)

Decrease in tax payable

18

(Decrease) in equity

(42)

Practice questions

Example:: Correction of prior period errors

A company processed depreciation of machines as Rs. 70,000 in 2015 instead of
as Rs. 170,000.
The following extracts from the draft financial statements for 2016 are before
correction of this.
Draft statement of financial position as at 31 December 2016 (extracts)
2016
2015
2014
Assets
Property, plant and equipment 400,000
500,000
300,000
Liabilities and equity
Retained earnings
360,000
205,000
42,000
Deferred tax
100,000
120,000
100,000
Draft statement of changes in equity for the year ended 31 December 2016
(extracts)
Retained
earnings
Rs.
Balance: 1 January 2015
42,000
Profit for the year
163,000
Balance: January 2016
205,000
Profit for the year
155,000
Balance: December 2016
360,000
Draft Statement of comprehensive income for the year ended 31 December
2016 (extracts)
2016
2015
Rs.
Rs.
Profit before tax
200,000
245,000
Taxation
45,000
82,000
Profit for the year
155,000
163,000
The normal tax rate is 30%.

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Required:
Correct this error and draft the relevant disclosures for the year ended 31st
December 2016.
Practice question

Extracts of the draft financial statements of a company are as follows:

Draft statement of financial position as at 31 December 2016 (extracts)
2016

2015

2014

600,000

650,000

300,000

85,000

25,000

Deferred tax

100,000

120,000

90,000

Current tax payable

250,000

80,000

70,000

Assets
Plant
Equity and liabilities
Retained earnings

Draft statement of changes in equity for the year ended 31 December 2016
(extracts)
Retained
earnings
Rs.
Balance: 1 January 2015

(24,600)

Profit for the year

49,600

Balance: January 2016

25,000

Profit for the year

60,000

Balance: December 2016

85,000

Draft Statement of comprehensive income for the year ended 31 December

2016 (extracts)
2015
2014
Rs.
100,000

Rs.
80,000

Taxation

40,000

30,400

Profit for the year

60,000

49,600

Profit before tax

During the year it was discovered that the purchase of plant on 1 January 2013
had been written off as a repair expense, (cost: Rs. 120,000). This error affected
the tax calculations and forms submitted.
The company writes off depreciation at 25% pa straight-line (not reduced for part
of the year). The wear and tear allowed by the tax authorities is the same. The tax
rate has been 30% for the past 8 years.
Required:
Correct this error and draft the relevant disclosures for the year ended
31st December 2016.

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SOLUTIONS TO PRACTICE QUESTIONS

Solutions

Disclosure: Profit after tax

Profit before tax is stated after taking the following into account:
Depreciation

2016

2015

Original Estimate

100,000

100,000

change in estimate

(30,000)
70,000

100,000

Change in estimate
The estimated residual value of the plant and machinery was changed from nil
to Rs. 90,000.
The increase / (decrease) in profits caused by the change is as follows:
2016
Current years profits:

30,000

Future profits:

60,000

The total effect on profit is an increase in profit of Rs 90 000 (Rs 30 000 in the
current year and Rs 60 000 in future years).
The reason for the net increase in profit owing to the change in estimate is
that the residual value was changed. The residual value increased from Rs 0
to Rs 90 000.
This means that instead of expensing the whole cost of Rs 500 000 as
depreciation over the life of the asset, only Rs 410 000 will now be expensed
as depreciation.
Working

Rs.

Cost at Jan 1, 2014

500,000

Accumulated depreciation up to 31 Dec 2015

Carrying amount at

31st

(200,000)

December 2015

300,000

Introduction of residual value

(90,000)

Depreciable amount

210,000

Remaining useful life

Depreciation in the year ended

3 years
31st

December 2016

Carrying amount at 31st December 2016

(Rs. 300,000 b/f less Rs. 150,000)

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Solutions

Retained earnings

2016

2015

As previously reported

205,000

42,000

Correction of Errors

(70,000)

Balance at 1st January 2015 (restated)

135,000

42,000

Revised comprehensive income

155,000

93,000

Balance at 1st January 2015 (restated)

290,000

135,000
2015
(restated)

Statement of comprehensive income

2016

Profit before tax as previously stated

200,000

245,000

Correction of error


200,000

(100,000)

(45,000)

(82,000)
30,000

Profit before tax (245-100)

Tax expense as previously stated
Adjustment

145,000

Tax expense (82-30)


(45,000)

Profit after tax

155,000

93,000

Debit

Credit

Journal entry in 2016

Retained earnings

70,000

Deferred tax liability

30,000

Accumulated depreciation

(52,000)

100,000

Correction of error
During year 2015, depreciation was incorrectly recorded as Rs 70,000
instead of Rs 170,000.
Effect on statement of comprehensive income

2015

Increase in expenses
Depreciation

100,000

Tax expense (30% u 100,000)

(30,000)

Net decrease in profits

70,000

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Solution (continued)

Effect on statement of financial position

2015

2014

Decrease in assets
Machines

(100,000)

(30,000)
(70,000)

(100,000)

Decrease in liabilities and equity

Deferred tax liability
Retained earnings

Sttatement of financial position - extracts

2016

2015

2014

As previously stated

400,000

500,000

300,000

Adjustment

(100,000)

(100,000)

Restated

300,000

400,000


300,000

As previously stated

360,000

205,000

42,000

Adjustment

(70,000)

(70,000)

Restated

290,000

135,000

42,000

As previously stated

100,000

120,000

100,000

Adjustment

(30,000)

(30,000)

Restated

70,000

90,000

100,000

Property, plant and equipment

Retained earnings

Deferred taxation

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Solution

Retained earnings

2016

2015

As previously reported

25,000

(24,600)

Correction of error

21,000

42,000

Balance at 1st January 2014 (restated)

46,000

17,400

Revised comprehensive income

39,000

28,600

Balance at 1st January 2014 (restated)

85,000

46,000

Statement of comprehensive income

2016

2015
(restated)

Profit before tax as previously stated

100,000

80,000

Correction of error

(30,000)

(30,000)

Profit before tax (245-100)

70,000

50,000

Tax expense as previously stated

Adjustment

(40,000)
9,000

(30,400)
9,000

Tax expense (82-30)

(31,000)

(21,400)

Profit after tax

39,000

28,600

Journal entry in 2016

Rectification of prior year error

Debit

Plant

Credit

120,000

Accumulated depreciation

90,000

Retained earnings

21,000

Tax payable

9,000

Current year adjustment

Debit

Depreciation

Credit

30,000

Accumulated depreciation

30,000

Effect on statement of comprehensive income

2016

Increase in expenses
Depreciation

30,000

Tax expense (30% u 100,000)

(9,000)

Net decrease in profits

21,000

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Solution (continued)

Effect on statement of financial position

2015

2014

Increase in assets
Plant (W1)

30,000

60,000

Current tax payable (W2)

9,000

18,000

Retained earnings (W1)

21,000

42,000

Increase in liabilities and equity

30,000

60,000

2016

2015

2014

As previously stated

600,000

650,000

300,000

Adjustment (W1)


600,000

30,000

60,000

680,000

360,000

85,000

25,000

(24,600)

21,000

42,000

85,000

46,000

17,400

As previously stated
Adjustment (W2)

250,000


80,000
9,000

70,000
18,000

Restated

250,000

89,000

88,000

Statement of financial position - extracts

Property, plant and equipment

Restated
Retained earnings
As previously stated
Adjustment (W2)
Restated
Current taxation

Workings: adjustments
W1: Adjustment to property, plant and equipment by year-e
end
Adjustment add back incorrectly
expensed asset
Adjustment subsequent
depreciation on asset

2015

2014

2013

120,000

120,000

120,000

(90,000)

(60,000)

(30,000

30,000

60,000

90,000

W2: Adjustment to retained earnings by year end

Net adjustment to PP and E

30,000

60,000

90,000

Tax at 30%

(9,000)

(18,000)

(27,000)

21,000

42,000

63,000

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

IFRS 15: Revenue from contracts

with customers
Contents
1 IFRS 15: Revenue from contracts with customers
2 IFRS 15: The five step model
3 Other aspects of IFRS 15

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 11

IFRS 15: Revenue from contracts with customers

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IFRS 15: REVENUE FROM CONTRACTS WITH CUSTOMERS

Section overview

Introduction
Core principle and the five step model

1.1 Introduction
The IASB issued IFRS 15: Revenue from contracts with customers in May 2014.
IFRS 15 is the end product of a major joint project between the IASB and the US
Financial Accounting Standards Board and replaces IAS 18, IAS 11, IFRIC 13,
IFRIC 15, IFRIC 18 and SIC 31.
IFRS 15 will have an impact on all entities that enter into contracts with
customers with few exceptions. Entities will need to reassess their revenue
recognition policies and may need to revise them. The timing and amount of
revenue recognised may not change for simple contracts for a single deliverable
but will change for more complex arrangements involving more than one
deliverable.
This standard is effective for annual accounting periods beginning on or after 1
January 2017 but earlier application is allowed.
Summary
IFRS 15:

establishes a new control-based revenue recognition model;

changes the basis for deciding whether revenue is recognised at a point in

time or over time;

provides new and more detailed guidance on specific topics; and

expands and improves disclosures about revenue.

1.2 Core principle and the five step model

IFRS 15 is based on a core principle that requires an entity to recognise revenue:

in a manner that depicts the transfer of goods or services to customers

at an amount that reflects the consideration the entity expects to be entitled
to in exchange for those goods or services.

Applying this core principle involves following a five step model as follows:

Step 1: Identify the contract(s) with the customer

Step 2: Identify the separate performance obligations

Step 3: Determine the transaction price

Step 4: Allocate the transaction price

Step 5: Recognise revenue when or as an entity satisfies performance

obligations

Definitions
Revenue is income arising in the course of an entitys ordinary activities..
A customer is a party that has contracted with an entity to obtain goods or
services that are an output of the entitys ordinary activities.

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IFRS 15: THE FIVE STEP MODEL

Section overview

Step 1: Identify the contract(s) with a customer

Step 2: Identify the separate performance obligations in the contract

Step 3: Determine the transaction price

Step 4: Allocate the transaction price to the performance obligations

Step 5: Recognise revenue when or as an entity satisfies performance

obligations

2.1 Step 1: Identify the contract(s) with a customer

The first step in IFRS 15 is to identify the contract. This may be written, oral, or
implied by an entitys customary business practices.
Definition
A contract is an agreement between two or more parties that creates enforceable
rights and obligations.
The general IFRS 15 model applies only when or if:

the parties have approved the contract;

the entity can identify each partys rights;

the entity can identify the payment terms for the goods and services to be
transferred; and

the contract has commercial substance (i.e. the risk, timing or amount of
the entitys future cash flows is expected to change as a result of the
contract); and

it is probable the entity will collect the consideration.

If a customer contract does not meet these criteria, revenue is recognised only
when either:

the entitys performance is complete and substantially all of the

consideration in the arrangement has been collected and is non-refundable;
or

the contract has been terminated and the consideration received is nonrefundable.

A contract does not exist if each party has an enforceable right to terminate a
wholly unperformed contract without compensating the other party.
Combination of contracts
An entity must combine two or more contracts entered into at or near the same
time with the same customer (or related parties of the customer) and treat them
as a single contract if one or more of the following conditions are present:

the contracts are negotiated as a package with a single commercial

objective;

the amount of consideration to be paid in one contract depends on the price

or performance of the other contract; or

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the goods or services promised in the contracts (or some goods or services
promised in the contracts) are a single performance obligation

Contract modifications
A contract modification is any change in the scope and/or price of a contract
approved by both parties for example changes in design, quantity, timing or
method of performance).
If a scope change is approved but the corresponding price change is not yet
determined, these requirements are applied when the entity has an expectation
that the price modification will be approved.
This requirement interacts with the guidance on determining the transaction
price.
A contract modification must be accounted for as a separate contract when:

the scope of the contract increases because of the addition of promised

goods or services that are distinct; and

the price of the contract increases by an amount of consideration that

reflects the entitys stand-alone selling prices of the additional promised
goods or services and any appropriate adjustments to that price to reflect
the circumstances of the particular contract.

2.2 Step 2: Identify the separate performance obligations in the contract

Performance obligations are normally specified in the contract but could also
include promises implied by an entitys customary business practices, published
policies or specific statements that create a valid customer expectation that
goods or services will be transferred under the contract.
Definition
A performance obligation is a promise in a contract with a customer to transfer to
the customer either:
a.

a good or service (or a bundle of goods or services) that is distinct; or

b.

a series of distinct goods or services that are substantially the same and
that have the same pattern of transfer to the customer.

At the inception of a contract the entity must assess the goods or services
promised in a contract with a customer and must identify as a performance
obligation each promise to transfer to the customer either:

a good or service (or a bundle of goods or services) that is distinct; or

a series of distinct goods or services that are substantially the same and
that have the same pattern of transfer to the customer (described by
reference to promises satisfied over time, and progress to completion
assessment)

A good or service is distinct if both of the following criteria are met:

the customer can benefit from the good or service either on its own or
together with other resources that are readily available to the customer; and

the entitys promise to transfer the good or service is separately identifiable

from other promises in the contract.

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If a good or service is regularly sold separately, this would indicate that

customers generally can benefit from the good/service on its own or in
conjunction with other available resources.
If a promised good or service is not distinct, an entity must combine that good or
service with other promised goods or services until it identifies a bundle of goods
or services that is distinct. In some cases, this would result in the entity
accounting for all the goods or services promised in a contract as a single
performance obligation
Example: Promised goods and services
Goods produced by an entity for sale
Resale of goods purchased by an entity
Resale of rights to goods or services purchased by an entity
Performing a contractually agreed-upon task for a customer
Standing ready to provide goods or services
Providing a service of arranging for another party to transfer goods or services to
the customer
Granting rights to goods or services to be provided in the future that a customer
can resell
Constructing, manufacturing or developing an asset on behalf of a customer
Granting licences
Granting options to purchase additional goods/services

An aside
When (or as) a performance obligation is satisfied, an entity will recognise as
revenue the amount of the transaction price (excluding estimates of variable
consideration that are constrained) allocated to that performance obligation (step
5))
There are two issues to address:

The amount of the transaction price, including any constraints (step 3))

The allocation of that price to POs (step 4))

2.3 Step 3: Determine the transaction price

Definition
The transaction price is the amount of consideration an entity expects to be
entitled to in exchange for the goods or services promised under a contract,
excluding any amounts collected on behalf of third parties (for example, sales
taxes).
An entity must consider the terms of the contract and its customary practices in
determining the transaction price
The transaction price assumes transfers to the customer as promised in
accordance with the existing contract and that the contract will not be cancelled,
renewed or modified.

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The transaction price is not adjusted for effects of the customers credit risk, but
is adjusted if the entity (e.g. based on its customary business practices) has
created a valid expectation that it will enforce its rights for only a portion of the
contract price.
An entity must consider the effects of all the following factors when determining
the transaction price:

variable consideration;

the constraint on variable consideration;

time value of money;

non-cash consideration;

consideration payable to the customer.

2.4 Step 4: Allocate the transaction price to the performance obligations

The entity allocates a contracts transaction price to each separate performance
obligation within that contract on a relative stand-alone selling price basis at
contract inception.
Definition
A stand-alone selling price is the price at which an entity would sell a promised
good or service separately to a customer.
IFRS 15 suggests, but does not require, the following three methods as suitable
for estimating the stand-alone selling price:

adjusted market assessment approach

expected cost plus margin approach

residual approach.

2.5 Step 5: Recognise revenue when or as an entity satisfies performance

obligations
Revenue is recognised when or as the promised goods or services are
transferred to a customer.

A transfer occurs when the customer obtains control of the good or service.

A customer obtains control of an asset (good or service) when it can direct

the use of and obtain substantially all the remaining benefits from it. Control
includes the ability to prevent other entities from directing the use of and
obtaining the benefits from an asset. Indicators of control include:
x

The entity has a present right to payment for the asset

The customer has legal title

The customer has physical possession (exceptions for bill and hold,
consignment sales and repos)

The customer has the significant risks and rewards of ownership of

the asset

The customer has accepted the asset

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The benefits of an asset are the potential cash flows that can be obtained
directly or indirectly from the asset in many ways.

When goods or services are transferred continuously, a revenue recognition

method that best depicts the entitys performance should be applied (updated as
circumstances change).
Acceptable methods include:

Output methods: units produced, units delivered, contract milestones or

surveys of work performed; or

Input methods: costs incurred, labour hours expended, machine hours

used.

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OTHER ASPECTS OF IFRS 15

Section overview

Contract costs

Presentation

3.1 Contract costs

Costs might be incurred in obtaining a contract and in fulfilling that contract.
Incremental costs of obtaining a contract
The incremental costs of obtaining a contract with a customer are recognised as
an asset if the entity expects to recover those costs.
The incremental costs of obtaining a contract are those costs that would not have
been incurred if the contract had not been obtained.
Costs to obtain a contract that would have been incurred regardless of whether
the contract was obtained are expensed as incurred (unless they can be
recovered from the customer regardless of whether the contract is obtained).
Example: Incremental costs of obtaining a contract
X Limited wins a competitive bid to provide consulting services to a new
customer.
X Limited incurred the following costs to obtain the contract:
Rs.
Commissions to sales employees for winning the contract

10,000

External legal fees for due diligence

15,000

Travel costs to deliver proposal

25,000

Total costs incurred

50,000

Analysis
The commission to sales employees is incremental to obtaining the contract and
should be capitalised as a contract asset.
The external legal fees and the travelling cost are not incremental to obtaining
the contract because they have been incurred regardless of whether X Plc
obtained the contract or not.
An entity may recognise the incremental costs of obtaining a contract as an
expense when incurred if the amortisation period of the asset that the entity
otherwise would have recognised is one year or less.
Costs to fulfil a contract
Costs incurred in fulfilling a contract might be within the scope of another
standard (for example, IAS 2: Inventories, IAS 16: Property, Plant and Equipment
or IAS 38: Intangible Assets). If this is not the case, the costs are recognised as
an asset only if they meet all of the following criteria:

the costs relate directly to a contract or to an anticipated contract that the

entity can specifically identify;

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the costs generate or enhance resources of the entity that will be used in
satisfying (or in continuing to satisfy) performance obligations in the future;
and

the costs are expected to be recovered.

Costs that relate directly to a contract might include:

direct labour and direct materials;

allocations of costs that relate directly to the contract or to contract

activities;

costs that are explicitly chargeable to the customer under the contract; and

other costs that are incurred only because an entity entered into the
contract (e.g. payments to subcontractors).

The following costs must be recognised as expenses when incurred:

general and administrative costs (unless those costs are explicitly

chargeable to the customer under the contract);

costs of wasted materials, labour or other resources to fulfil the contract

that were not reflected in the price of the contract;

costs that relate to satisfied performance obligations (or partially satisfied

performance obligations) in the contract (i.e. costs that relate to past
performance).

Amortisation and impairment

An asset for contract costs recognised in accordance with this standard must be
amortised on a systematic basis consistent with the transfer to the customer of
the goods or services to which the asset relates.
The amortisation must be updated to reflect a significant change in the entitys
expected timing of transfer to the customer of the goods or services to which the
asset relates.
An impairment loss must be recognised in profit or loss to the extent that the
carrying amount of an asset recognised exceeds:

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 costs that relate directly to providing those goods or services and that
have not been recognised as expenses.

When the impairment conditions no longer exist or have improved a reversal of

the impairment loss is recognised. This will reinstate the asset but the increased
carrying amount of the asset must not exceed the amount that would have been
determined (net of amortisation) if no impairment loss had been recognised
previously.

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Example: Amortisation of contract costs

X Limited wins a 5 year contract to provide a service to a customer.
The contract contains a single performance obligation satisfied over time.
X Limited recognises revenue on a time basis
Costs incurred by the end of year 1 and forecast future costs are as follows:
Rs.
Costs to date

10,000

Estimate of future costs

18,000

Total expected costs

28,000

Analysis
Costs must be recognised in the P&L on the same basis as that used to recognise
revenue.
X Limited recognises revenue on a time basis, therefore 1/5 of the total expected
cost should be recognised = Rs. 5,600 per annum.

Example: Amortisation of contract costs

X Limited wins a 5 year contract to provide a service to a customer.
The contract is renewable for subsequent one-year periods.
The average customer term is seven years.
The contract contains a single performance obligation satisfied over time.
X Limited recognises revenue on a time basis.
Costs incurred by the end of year 1 and forecast future costs are as follows:
Rs.
Costs to date

10,000

Estimate of future costs

18,000

Total expected costs

28,000

Analysis
Costs must be recognised in the P&L on the same basis as that used to recognise
revenue.
X Limited recognises revenue on a time basis. The asset relates to the services
transferred to the customer during the contract term of five years and X Limited
anticipates that the contract will be renewed for two subsequent one-year
periods.
Therefore 1/7 of the total expected cost should be recognised = Rs. 4,000 per
annum.

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Example: Amortisation of contract costs

X Limited wins a contract to build an asset for a customer. It is anticipated that
the asset will take 2 years to complete
The contract contains a single performance obligation. Progress to completion is
measured on an output basis.
At the end of year 1 the assets is 60% complete.
Costs incurred by the end of year 1 and forecast future costs are as follows:
Rs.
Costs to date

10,000

Estimate of future costs

18,000

Total expected costs

28,000

Analysis
Costs must be recognised in the P&L on the same basis as that used to recognise
revenue.
Therefore 60% of the total expected cost should be recognised (Rs. 16,800) at
the end of year 1.

3.2 Presentation
This section explains how contracts are presented in the statement of financial
position. In order to do this it explains the double entries that might result from
the recognition of revenue. The double entries depend on circumstance.
An unconditional right to consideration is presented as a receivable.
The accounting treatment to record the transfer of goods for cash or for an
unconditional promise to be paid consideration is straightforward.
Illustration: Possible double entries on recognition of revenue
Debit
X
X

Cash
Receivable
Revenue

Credit

Example: Double entry Unconditional right to consideration

1 January 20X8
X Limited enters into a contract to transfer Products A and B to Y Limited in
exchange for Rs. 1,000.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
The promises to transfer Products A and B are identified as separate performance
obligations. Rs.400 is allocated to Product A and Rs.600 to Product B.
X Limited recognises revenue and recognises its unconditional right to the
consideration when control of each product transfers to Y Limited.

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The following entries would be required to reflect the progress of the contract).
Contract progress
28 February: X Limited transfers Product A to Y Limited.
At 28 February

Dr (Rs.)

Receivables

Cr (Rs.)

400

Revenue

400

31 March:: X Limited transfers Product B to Y Limited

31 March
Receivables

600

Revenue

600

In other cases, a contract is presented as a contract asset or a contract liability

depending on the relationship between the entitys performance and the
customers payment.
Contract assets
A supplier might transfer goods or services to a customer before the customer
pays consideration or before payment is due. In this case the contract is
presented as a contract asset (excluding any amounts presented as a
receivable).
A contract asset is a suppliers right to consideration in exchange for goods or
services that it has transferred to a customer. A contract asset is reclassified as a
receivable when the suppliers right to consideration becomes unconditional.
Example:: Double entry Recognition of a contract asset
1 January 20X8
X Limited enters into a contract to transfer Products A and B to Y Limited in
exchange for Rs. 1,000.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
The promises to transfer Products A and B are identified as separate performance
obligations. Rs.400 is allocated to Product A and Rs.600 to Product B.
Revenue is recognised when control of each product transfers to Y Plc.
Payment for the delivery of Product A is conditional on the delivery of Product B.
(i.e. the consideration of Rs. 1,000 is due only after X Limited has transferred
both Products A and B to Y Limited). This means that X Limited does not have a
right to consideration that is unconditional (a receivable) until both Products A
and B are transferred to Y Limited.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:
28 February: X Limited transfers Product A to Y Limited
X Plc does not have an unconditional right to receive the Rs.400 so the amount is
recognised as a contract asset.

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At 28 February

Dr (R
Rs.))

Contract asset
Revenue

400

Cr (R
Rs.))
400

31 March: X Limited transfers Product B to Y Limited

X Limited now has an unconditional right to receive the full Rs. 1,000. The Rs.400
previously recognised as a contract asset is reclassified as a receivable and the
Rs.600 for the transfer of product B is also recognised as receivable.
31 March

Dr (R
Rs.))

Receivable

1,000

Cr (R
Rs.))

Contract asset

400

Revenue

600

Contract liabilities
A contract might require payment in advance or allow the supplier a right to an
amount of consideration that is unconditional (i.e. a receivable), before it
transfers a good or service to the customer.
In these cases, the supplier presents the contract as a contract liability when the
payment is made or the payment is due (whichever is earlier).
The contract liability is a suppliers obligation to transfer goods or services to a
customer for which it has received consideration (an amount of consideration is
due) from the customer.
Example:: Double entry Recognition of a contract liability
1 January 20X8
X Limited enters into a contract to transfer Products A and B to Y Limited in
exchange for Rs. 1,000.
X Limited can invoice this full amount on 31 January.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
The promises to transfer Products A and B are identified as separate performance
obligations. Rs.400 is allocated to Product A and Rs.600 to Product B.
Revenue is recognised when control of each product transfers to Y Limited.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:
At 31 January
Dr (R
Rs.)
Receivable
1,000
Contract liability
28 February: X Limited transfers Product A to Y Limited
At 28 February
Dr (Rs.)
Contract liability
400
Revenue
31 March:: X Limited transfers Product B to Y Limited
31 March
Dr (Rs.)
Contract liability
600
Revenue

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Cr (R
Rs.)
1,000
Cr (Rs.)
400
Cr (Rs.)
600

The Institute of Chartered Accountants of Pakistan

CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

IAS 16: Property, plant

and equipment
Contents
1 Initial measurement of property, plant and equipment
2 Depreciation
3 Revaluation of property, plant and equipment
4 Derecognition of property, plant and equipment
5 Disclosure requirements of IAS 16
6 Interpretations involving accounting for non-current
assets

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 17

IAS 16: Property, plant and equipment

B (a) 33

IFRIC 1: Changes in existing decommissioning, restoration and similar

liabilities

B (a) 48

IFRIC 20: Stripping costs in the production phase of a surface mine

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Chapter 6: IAS 16: Property, plant and equipment

INITIAL MEASUREMENT OF PROPERTY, PLANT AND EQUIPMENT

Section overview

Introduction
Bearer plants

Initial measurement

Elements of cost

Exchange of assets
Subsequent expenditure

1.1 Introduction
Rules on accounting for property, plant and equipment are contained in IAS 16:
Property, plant and equipment.
Scope
IAS 16 does not apply to property, plant and equipment classified as held for sale
in accordance with IFRS 5: Non-current assets held for sale and discontinued
operations.
Furthermore, IAS 16 does not apply to:

biological assets related to agricultural activity (other than bearer plants

which are covered by IAS 16) (see IAS 41: Agriculture);
the recognition and measurement of exploration and evaluation assets (see
IFRS 6: Exploration for and evaluation of mineral resources); nor
mineral rights and mineral reserves such as oil, natural gas and similar
non-regenerative resources.-

Definition
Definition: Property, plant and equipment
Property, plant and equipment are tangible items that:
are held for use in the production or supply of goods or services, for rental
(a)
to others, or for administrative purposes; and
(b)
are expected to be used during more than one period.
Items such as spare parts, stand-by equipment and servicing equipment are
recognised as property, plant and equipment when they meet the above
definition. If this is not the case they are recognised as inventory.
Initial recognition
The cost of an item of property, plant and equipment must be recognised as an
asset if, and only if:

it is probable that future economic benefits associated with the item will flow
to the entity; and

the cost of the item can be measured reliably.

Items of property, plant and equipment may be acquired for safety or

environmental reasons. At first sight it looks as if such items would not be
recognised as property, plant and equipment according to the recognition criteria
because they do not directly increase future economic benefits. However, they

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may be necessary in order that a company obtain the future economic benefits
from its other assets so they do qualify for recognition.
Illustration:
A chemical manufacturer may install new chemical handling processes to comply
with environmental requirements for the production and storage of dangerous
chemicals.
This would be recognised as an asset because without them the company cannot
make and sell chemicals.

1.2 Bearer plants

Definitions
A bearer plant is a living plant that:
a. is used in the production or supply of agricultural produce;
b. is expected to bear produce for more than one period; and
c. has a remote likelihood of being sold as agricultural produce, except for
incidental scrap sales.
All living plants used to be accounted for according to the guidance set out in IAS
41 Agriculture.
An amendment to IAS 16 and IAS 41 was issued in June 2014 to change this.
Bearer plants are used solely to grow produce. The only significant future
economic benefits from bearer plants arise from selling the agricultural produce
that they create. Therefore, bearer plants meet the definition of property, plant
and equipment in IAS 16 and their operation is similar to that of manufacturing.
Accordingly, the amendments require bearer plants to be accounted for as
property, plant and equipment and included within the scope of IAS 16, instead of
IAS 41.
Produce growing on bearer plants remains within the scope of IAS 41. For
example: grapevines, rubber trees and oil palms.

1.3 Initial measurement

Property, plant and equipment are initially recorded in the accounts of a business
at their cost.
Definition: Cost
Cost is the amount of cash or cash equivalents paid or the fair value of the other
consideration given to acquire an asset at the time of its acquisition or construction
or, where applicable, the amount attributed to that asset when initially recognised
in accordance with the specific requirements of other IFRSs. (For example assets
held under finance leases).
The cost of an item of property, plant and equipment is the cash price equivalent
at the recognition date. If payment is deferred beyond normal credit terms, the
difference between the cash price equivalent and the total payment is recognised
as interest over the period of credit unless it is capitalised in accordance with IAS
23: Borrowing costs (covered later).

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Example: Deferred consideration

A company buys a machine on 1 January 2015.
The terms of the purchase are that the company will pay Rs.5 million for the
machine on 31 December 2015 (1 year later).
An appropriate discount rate is 6%
1 January 2015 Initial recognition
Initial measurement of the
Rs.5m u
purchase price

1
= Rs.4,716,981
(1  0.06)
Debit

Property, plant and equipment

Credit

4,716,981

Liability

4,716,981

31 December 2015 Date of payment

Recognition of interest expense

Rs.4,716,981 @ 6%
Debit

Statement of comprehensive income

= 283,019
Credit

283,019

Liability

283,019

Balance on the liability

Rs.

Balance brought forward

4,716,981

Interest expense recognised in the period

283,019
5,000,000

Cash/bank

(5,000,000)


1.4 Elements of cost

The definition of cost for property, plant and equipment has close similarities
with the cost of inventories, although property, plant and equipment will often
include more items of other expense within cost.
The cost of an item of property, plant and machinery consists of:

its purchase price after any trade discount has been deducted, plus any
import taxes or non-refundable sales tax; plus

the directly attributable costs of bringing the asset to the location and
condition necessary for it to be capable of operating in the manner intended
by management. These directly attributable costs may include:
x

employee costs arising directly from the installation or construction of

the asset;

the cost of site preparation;

delivery costs (carriage inwards);

installation and assembly costs;

testing costs to assess whether the asset is functioning properly (net

of sale proceeds of items produced during the testing phase).

professional fees directly attributable to the purchase.

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When the entity has an obligation to dismantle and remove the asset at the
end of its life, its initial cost should also include an estimate of the costs of
dismantling and removing the asset and restoring the site where it is
located. This will be explained in more detail in chapter 13 which covers
IAS 37: Provisions, contingent liabilities and contingent assets.

The recognition of costs ceases when the asset is ready for use. This is when it
is in the location and condition necessary for it to be capable of operating in the
manner intended by management.
Cost of self-constructed assets
The cost of a self-constructed asset is determined using the same principles as
for an acquired asset.
A company might make similar assets for sale in the normal course of business.
The cost of an asset for the company to use itself would normally be the same as
the cost of an asset for sale as measured according to IAS 2: Inventories.
IAS23: Borrowing costs, deals with whether interest costs on borrowing to
finance the construction of a non-current asset should be included in the cost of
the asset. This is covered in the next chapter.
Bearer plants are accounted for in the same way as self-constructed assets
(where constructed is taken to mean cultivated).
Not part of cost
Only those costs necessary to bring an asset to a condition and location where it
is capable of operating in the manner intended by management are recognised.
IAS 16 provides the following list of costs that are not costs of an item of
property, plant and equipment:

costs of opening a new facility;

costs of introducing a new product or service (including costs of advertising

and promotional activities);

costs of conducting business in a new location or with a new class of

customer (including costs of staff training); and

administration and other general overhead costs.

1.5 Exchange of assets

When an item of property, plant or equipment is purchased for cash, the cash
paid is the cost of the asset. However, an item of property, plant and equipment
may be paid for using an asset other than cash (e.g. another item of property,
plant and equipment or inventories).
The cost of such items is measured at fair value unless:

the exchange transaction lacks commercial substance; or,

the fair value of neither the asset received nor the asset given up is reliably
measurable.

If the acquired item is not measured at fair value it is measured at the carrying
amount of the asset given up.

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Fair value
The fair value of the asset given up is used to measure the cost of the asset
received unless the fair value of the asset received is more clearly evident.
Fair value may be determinable with reference to comparable market
transactions.
If there are no comparable market transactions fair value is reliably measurable if:

the variability in the range of reasonable fair value estimates is not

significant for that asset; or

the probabilities of the various estimates within the range can be

reasonably assessed and used in estimating fair value.

Commercial substance
An exchange transaction has commercial substance if:

the configuration (risk, timing and amount) of the cash flows of the asset
received differs from the configuration of the cash flows of the asset
transferred; or

the entity-specific value of the portion of the entity's operations affected by

the transaction changes as a result of the exchange; and

either of the above differences are significant relative to the fair value of the
assets exchanged.

Definition
Entity-specific value is the present value of the cash flows an entity expects to
arise from the continuing use of an asset and from its disposal at the end of its
useful life or expects to incur when settling a liability.

Example: Acquisition of PP and E in exchange for a non-monetary asset

X Limited acquired a sugar processing line from Y Limited.
The sugar processing line had a fair value of Rs. 1,500,000.
Both parties agreed that the sugar processing line would be paid for with a plot of
land owned by X Limited but not currently being used. This plot of land had a fair
value had a carrying value of Rs. 1,000,000. The land was recently valued at Rs.
1,400,000.
Analysis
The exchange has commercial substance. Either of the following points would
lead to this conclusion:
a)

The configuration (risk, timing and amount) of the cash flows of a sugar
processing line differs from that of an unused plot of land.

b)

Currently the land is not generating a return. This means that the entityspecific value of the portion of the entity's operations affected by the
transaction will change as a result of the exchange.

X Limited must recognise the new asset at Rs. 1,400,000 (the fair value of the
asset given up to pay for the asset).
X Limited would recognise a profit on disposal of the land in the amount of Rs.
400,000 (1,400,000  1,00,000)

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The double entry made by X Limited is as follows:

Property, plant and equipment

Sugar processing line

Debit
Credit
Rs.
Rs.
1,400,000
1,000,000

Land
Statement of profit or loss

400.000

1.6 Subsequent expenditure

Expenditure relating to non-current assets, after their initial acquisition, should be
capitalised if it meets the criteria for recognising an asset.
In practice, this means that expenditure is capitalised if it:

improves the asset (for example, by enhancing its performance or

extending its useful life); or

is for a replacement part (provided that the part that it replaces is treated as
an item that has been disposed of).

Repairs and maintenance expenditure is revenue expenditure. It is recognised as

an expense as it is incurred, because no additional future economic benefits will
arise from the expenditure.
A basic rule is that improvements are capitalised but repairs are expensed. You
may have to correct situations when an amount spent has not been treated
correctly. This is covered in section 6 of this chapter.
Major inspections
A company might only be allowed to operate some assets if those assets are
subject to regular major inspections for faults.
The cost of such major inspections is recognised in the carrying amount of the
asset as a replacement if the recognition criteria are satisfied.
When a major inspection is carried out any remaining carrying amount of the cost
of the previous inspection is derecognised.
Example: Major overhaul
A shipping company is required to put its ships into dry dock every three years for
an overhaul, at a cost of Rs. 3,000,000. The ships have a useful life of 20 years. A
ship is purchased from a shipbuilder at a cost of Rs.200 million.
Initial recognition
Rs. 3,000,000 of the asset cost should be treated as a separate component and
depreciated over three years.
The rest of the cost of the ship (Rs.297 million) should be depreciated over 20
years.
End of year 3
An overhaul is required.
The cost of the overhaul is capitalised and added to the assets cost.
The cost (Rs. 3,000,000) and accumulated depreciation of the depreciated
component is removed from the accounts.

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DEPRECIATION
Section overview

Measurement after initial recognition

Depreciation

Depreciable amount and depreciation period

Reviews of the remaining useful life and expected residual value

Depreciation method

2.1 Measurement after initial recognition

IAS 16 allows a choice of accounting treatments after initial recognition.
All items of property, plant and equipment in a class can be accounted for using
one of two models:

Cost model - Property, plant and equipment is carried at cost less any
accumulated depreciation and any accumulated impairment losses.

Revaluation model - Property, plant and equipment is carried at a revalued

amount. This is the fair value at the date of the revaluation less any
subsequent accumulated depreciation and any accumulated impairment
losses.

The above choice must be applied consistently. A business cannot carry one
item of property, plant & equipment at cost and revalue a similar item. However, a
business can use different models for different classes of property, plant &
equipment. For example, companies might use the cost model for plant and
equipment but use the revaluation model for property.
Depreciation is an important component of both models. You should be familiar
with the measurement and recognition of depreciation from your previous
studies. This section provides a reminder of the key concepts.

2.2 Depreciation
Depreciation is an expense that matches the cost of a non-current asset to the
benefit earned from its ownership. It is calculated so that a business recognises
the full cost associated with a non-current asset over the entire period that the
asset is used.
Definitions
Depreciation is the systematic allocation of the depreciable amount of an asset
over its useful life.
Depreciable amount is the cost of an asset, or other amount substituted for cost,
less its residual value.
The residual value of an asset is the estimated amount that an entity would
currently obtain from disposal of the asset, after deducting the estimated costs of
disposal, if the asset were already of the age and in the condition expected at the
end of its useful life.

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Definitions (continued)
Useful life is:
(a)

the period over which an asset is expected to be available for use by an

entity; or

(b)

the number of production or similar units expected to be obtained from the

asset by an entity.

Carrying amount is the amount at which an asset is recognised after deducting any
accumulated depreciation and accumulated impairment losses. Net book value
(NBV) is a term that is often used instead of carrying amount.
Parts of an asset
Each part of an asset that has a cost that is significant in relation to the total cost
of the item must be depreciated separately. This means that the cost of an asset
might be split into several different assets and each depreciated separately.
Illustration: Cost
A company has purchased a new Gulf Stream jet for Rs. 5,500 million.
The company has identified the following cost components and useful lives in
respect of this jet.
Useful lives
Rs. million
Engines

2,000

3 years

Airframe

1,500

10 years

Fuselage

1,500

20 years

500

5 years

Fittings

5,500
Depreciation is charged as an expense in the statement of comprehensive
income each year over the life of the asset unless it relates to an asset being
used to construct another asset. In this case the depreciation is capitalised as
part of the cost of that other asset in accordance with the relevant standard (For
example: IAS 2: Inventories; IAS 16 Property, plant and equipment; IAS 38;
Intangible assets).

2.3 Depreciable amount and depreciation period

The depreciable amount of an asset must be allocated on a systematic basis
over its useful life.
Commencement of depreciation
Depreciation of an asset begins when that asset is available for use. This means
when the asset is in the location and condition necessary for it to be capable of
operating in the manner intended by management. This might be before the
asset is actually used.
Cessation of depreciation
Depreciation ends at the earlier of when an asset is classified as held for sale in
accordance with IFRS 5: Non-current assets held for sale and discontinued
operations and when it is derecognised.

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Depreciation does not cease when an asset becomes idle or is withdrawn or

retired from active use.
Residual value
In practice, the residual value of an asset is often insignificant and therefore
immaterial in the calculation of the depreciable amount.
However, in some cases, the residual value may be equal to or greater than the
asset's carrying amount. In this case the depreciation charge would be zero.
Land and buildings
Land and buildings are separable assets and are dealt with separately for
accounting purposes, even when they are acquired together.
Land normally has an unlimited life and is therefore not depreciated. However,
there are exceptions to this. If land has a physical attribute that is used over a
period then the land should be depreciated over this period.
Buildings normally have a limited life and are therefore depreciable assets.

2.4 Reviews of the remaining useful life and expected residual value
Review of useful life
IAS 16 requires useful lives and residual values to be reviewed at each year-end.
Any change is a change in accounting estimate. The carrying amount (cost minus
accumulated depreciation) of the asset at the date of change is written off over
the (revised) remaining useful life of the asset.
Residual value
The residual value of an item of property, plant and equipment must be reviewed
at least at each financial year end and if expectations differ from previous
estimates the depreciation rate for the current and future periods is adjusted.
A change in the assets residual value is accounted for prospectively as an
adjustment to future depreciation.

2.5 Depreciation method

The depreciation method used should reflect the way in which the economic
benefits of the asset are consumed by the business over time.
That method should be applied consistently from period to period unless there is
a change in the expected pattern of consumption of those future economic
benefits.
IAS 16 has been amended to clarify that a depreciation method based on
revenue generated by an activity that includes the use of an asset is not
appropriate. This is because revenue would usually reflect factors other than the
consumption of the economic benefits of an asset.
Review of depreciation method
The depreciation method applied to property, plant and equipment must be
reviewed periodically and, if there has been a significant change in the expected
pattern of economic benefits from those assets, the method is changed to reflect
the changed pattern.
Where there is a change in the depreciation method used, this is a change in
accounting estimate. A change of accounting estimate is applied from the time of
the change, and is not applied retrospectively. The carrying amount (cost minus
accumulated depreciation) of the asset at the date of the change is written off
over the remaining useful life of the asset.

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REVALUATION OF PROPERTY, PLANT AND EQUIPMENT

Section overview

Revaluation and the entitys accounting policy

Companies Ordinance 1984: Rules on revaluation

Accounting for revaluation

Changing the carrying amount of the asset

Depreciation of a re-valued asset

Realisation of the revaluation surplus

Revaluation model: the frequency of revaluations

3.1 Revaluation and the entitys accounting policy

An item of property, plant and equipment is recognised at cost when it is first
acquired.
IAS 16 allows a business to choose one of two measurement models as its
accounting policy for property, plant and equipment after acquisition. The same
model should be applied to all assets in the same class.
The two measurement models for property, plant and equipment after acquisition
are:

cost model (i.e. cost less accumulated depreciation); and

revaluation model (i.e. revalued amount less accumulated depreciation

since the most recent revaluation).

For example, a companys policy might be to value all its motor vehicles at cost,
but to apply the revaluation model to all its land and buildings.
Revaluation model Issues
The following accounting issues have to be addressed when using the
revaluation model:
Issue
1

What happens to the other side of the entry when the carrying amount of
an asset is changed as a result of a revaluation adjustment?
An asset value may increase or decrease.
What happens in each case?

How the carrying amount of the asset being revalued is changed?

The carrying amount is located in two accounts (cost and accumulated
depreciation) and it is the net amount that must be changed so how is this
done?

How often should the revaluation take place?

The Companies Ordinance 1984 contains rules on accounting for revaluation of

assets which conflict with those in IAS 16. The rules in the Companies Ordinance
take precedence when there is such a conflict. This impacts the answer to issue
1 above.

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3.2 Companies Ordinance 1984: Rules on revaluation

Section.235 of the Companies Ordinance 1984 sets out the following rules.
Where a company revalues its fixed assets any increase in the value of such
assets must be transferred to an account to be called Surplus on Revaluation of
Fixed Assets Account and shown in the balance-sheet of the company after
Capital and Reserves. This means that the revaluation surplus is recognised
outside equity. This has an impact on the revaluation double entry and this will be
explained later.
Unless a surplus is subsequently realised on disposal of a revalued asset it
cannot be used to reduce a loss or to add to the income, profit or surplus of the
company, or used directly or indirectly by way of dividend or bonus. However, it
can be used to set a deficit arising from the revaluation of any other fixed asset of
the company.
Depreciation of revalued assets is based on the revalued amount of those assets
and must be charged to the Profit and Loss Account. However, an amount equal
to incremental depreciation for the period must be transferred from Surplus on
Revaluation of Fixed Assets Account to accumulated profit through the
statement of changes in equity to record the realisation of surplus to the extent of
the incremental depreciation charge for the period.
Conflict with IAS 16
The requirement to recognise the revalution surplus outside equity causes a
conflict with IAS 16.
Revaluation gains under IFRS fall within the definition of income.
Definition: Income
Increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from equity participants.
Under IFRS any gain must be recognised through other comprehensive income
and accumulated as a revaluation surplus in equity.
However, under law in Pakistan the surplus is outside equity. Only inflows or
enhancements that increase equity are recognised in other comprehensive
income. Therefore, gains recognised under the law in Pakistan are recognised
directly in the revaluation surplus account.

3.3 Accounting for revaluation

When a non-current asset is revalued, its carrying amount in the statement of
financial position is adjusted from carrying amount to its fair value (normally
current market value) at the date of the revaluation.
How the carrying amount is changed will be addressed later. This section
concentrates on the other side of the entry.
Asset carried at cost revalued upwards
Companies Ordinance 1984: An increase in value is credited to directly to an
account outside equity called revalution surplus.
IAS 16: An increase in value is credited to other comprehensive income and
accumulated in equity under the heading of revaluation surplus.

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Example: Upward revaluation

Land was purchased for Rs. 100 on the first day of the 2015 accounting period.
The business revalues land as permitted by the IAS 16.
The land was revalued to Rs. 130 at the end of the first year of ownership.
Double entry: Companies Ordinance 1984

Debit
30

Land
Revaluation surplus

Credit
30

Double entry: IAS 16

Land
Other comprehensive income (an accumulated in a
revaluation surplus).

Debit
30

Credit

30

Extract from the statement of financial position as at 31/12/15

Property, plant and equipment

CO 1984

IFRS

130

130

Equity (revaluation surplus)

30

Revaluation surplus

30

Asset carried at cost revalued downwards

A decrease in value is debited as an expense to the statement of profit or loss.
Example: Downward revaluation
Land was purchased for Rs.100 on the first day of the 2015 accounting period.
The business revalues land as permitted by the IAS 16.
The land was revalued to Rs. 90 at the end of the first year of ownership.
Double entry: Companies Ordinance 1984 and IAS 16
Debit
10

Statement of profit or loss

Land

Credit
10

Asset carried at a revaluation deficit is revalued upwards

An asset might be carried at an amount lower than its original cost as a result of
being revalued downwards.
If the asset is later revalued upwards, the revaluation increase is recognised in
the statement of profit or loss to the extent of the previously recognised expense.
That part of any increase above the previously recognised expense is recognised
in the usual way, directly in the revaluation surplus account (Companies
Ordinance 1984) or in other comprehensive income (IAS 16).
Asset carried at a revaluation surplus revalued downwards
An asset might be carried at an amount higher than its original cost as a result of
being revalued upwards.

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Companies Ordinance 1984: If the asset is later revalued downwards, the

revaluation decrease is recognised directly in equity to the extent of the
previously recognised surplus. That part of any decrease above the previously
recognised surplus is recognised in the statement of profit or loss the usual way.
IAS 16: If the asset is later revalued downwards, the revaluation decrease is
recognised in other comprehensive income to the extent of the previously
recognised surplus. That part of any decrease above the previously recognised
surplus is recognised in the statement of profit or loss the usual way.
Example: Downward revaluation Accounted for under Companies Ordinance
1984
A business purchased a plot of land on the first day of the 2015 accounting period.
The business applies the IAS 16 revaluation model to the measurement of land
after initial recognition. The business has a policy of revaluing land annually.
The initial amount recognised and the year end values are shown below:
Rs.
Measurement on initial recognition
100
Valuation as at:
31 December 2015
31 December 2016
31 December 2017
31 December 2018
The double entries are as follows::
31 December 2015
Land (130 100)
Revaluation surplus

130
110
95
116
Debit
30

Credit
30

31 December 2016
Debit
Credit
Revaluation surplus
20
Land (110 130)
20
The fall in value reverses a previously recognised surplus. It is recognised in
revaluation surplus to the extent that it is covered by the surplus.
31 December 2017
Debit
Credit
Revaluation surplus
10
Statement of profit or loss
5
Land (95 110)
15
The fall in value in part reverses a previously recognised surplus. It is recognised
in Revaluation surplus to the extent that it is covered by the surplus. This
reduces the revaluation surplus to zero.
Any amount not covered by the surplus is recognised as an expense in the
statement of profit or loss.
31 December 2018
Debit
Credit
Land (116 95)
21
Statement of profit or loss
5
Revaluation surplus
16
A rise in value that reverses a previously recognised expense is recognised
in the statement of profit or loss to the extent that it reverses the expense.
Any amount above this is recognised in equity.

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Example (continued) Overview

Land

Revaluation
surplus

Statement of
profit or loss

At start
Double entry

100
30


30Cr

31/12/15
5

130

b/f

130

Adjustment

(20)

20Dr

31/12/16
6

110

b/f
Adjustment

110
(15)

10Dr

5Dr

31/12/17
7

95

b/f
Adjustment

95
21

16Cr

5Cr

31/12/18
8

116

Example: Downward revaluation Accounted for under IAS 16

A business purchased a plot of land on the first day of the 2015 accounting period.
The business applies the IAS 16 revaluation model to the measurement of land
after initial recognition. The business has a policy of revaluing land annually.
The initial amount recognised and the year end values are shown below:

Measurement on initial recognition

Rs.
100

Valuation as at:
31 December 2015
31 December 2016
31 December 2017

130
110
95

31 December 2018

116

The double entries are as follows::

31 December 2015
Land (130 100)

Debit
30

Other comprehensive income

30

31 December 2016
Other comprehensive income

Debit
20

Land (110 130)

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The fall in value reverses a previously recognised surplus. It is recognised in

OCI to the extent that it is covered by the surplus.
31 December 2017
Other comprehensive income

Debit
10

Statement of profit or loss

Credit

Land (95 110)

15

The fall in value in part reverses a previously recognised surplus. It is

recognised in OCI to the extent that it is covered by the surplus. This
reduces the revaluation surplus to zero.
Any amount not covered by the surplus is recognised as an expense in the
statement of profit or loss.
31 December 2018
Land (116 95)

Debit
21

Credit

Statement of profit or loss

Other comprehensive income

5
16

A rise in value that reverses a previously recognised expense is recognised

in the statement of profit or loss to the extent that it reverses the expense.
Any amount above this is recognised in other comprehensive income.

Example (continued) Overview

Land

Other
comprehensive
income

At start
Double entry

100
30


30Cr

31/12/15
5

130

b/f

130

Adjustment

(20)

20Dr

31/12/16
6

110

b/f
Adjustment

110
(15)

10Dr

5Dr

31/12/17
7

95

b/f
Adjustment

95
21

16Cr

5Cr

31/12/18
8

116

Statement of
profit or loss

All later examples will follow only Companies Ordinance 1984. This will also be
the case in the exam where the Companies Ordinance will also be followed.

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3.4 Changing the carrying amount of the asset

In the previous example land was revalued. Land is not depreciated so the
carrying amount of land is represented in a single account. This made it easy to
change:
The carrying amount of depreciable assets is the net of balances on two separate
accounts. The double entry to revalue the asset must take this into account.
IAS 16 allows a choice of two approaches which differ in the treatment of the
accumulated depreciation account.
When an item of property, plant and equipment is revalued, any accumulated
depreciation at the date of the revaluation is treated in one of the following ways:
Method 1
Restate accumulated depreciation proportionately with the change in the gross
carrying amount of the asset so that the carrying amount of the asset after
revaluation equals its revalued amount.
Method 2
Step 1: Transfer the accumulated depreciation to the asset account. The result of
this is that the balance on the asset account is now the carrying amount of the
asset and the accumulated depreciation account in respect of this asset is zero.
Step 2: Change the balance on the asset account to the revalued amount.
Example: Method 1
A building owned by a company is carried at Rs. 20 million (Cost of Rs. 25 million
less accumulated depreciation of Rs. 5 million. The companys policy is to apply
the revaluation model to all of its land and buildings.
A current valuation of this building is now Rs. 26 million.
Before

After

Cost

25

u 26/20

32.5

Accumulated depreciation

(5)

u 26/20

(6.5)

Carrying amount

20

u 26/20

26

Journals

Rs. m

Asset

7.5

Accumulated depreciation

1.5

Revaluation surplus

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Example: Method 2
A building owned by a company is carried at Rs. 20 million (Cost of Rs. 25 million
less accumulated depreciation of Rs. 5 million. The companys policy is to apply
the revaluation model to all of its land and buildings.
A current valuation of this building is now Rs. 26 million.

Step 1

Rs. m

Accumulated depreciation

Rs. m

Asset

Step 2
Asset (Rs. 26 Rs. 20m)

Revaluation surplus

Alternatively this could be done with a single

journal
Asset (Rs. 26 Rs. 25m)

Accumulated depreciation

Revaluation surplus

Before

After

Cost

25

(5)

26

Accumulated depreciation

(5)

Carrying amount

20


26

Example:
An office building was purchased four years ago for Rs.3 million.
The building has been depreciated by Rs. 100,000.
It is now re-valued to Rs.4 million. Show the book-keeping entries to record the
revaluation.

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Answer
Building account
Opening balance b/f
Revaluation account
Opening balance b/f

Rs.
3,000,000 Accumulated
depreciation
1,100,000 Closing balance c/f
4,100,000
4,000,000

Rs.
100,000
4,000,000
4,100,000

Accumulated depreciation of building account

Building account

Rs.
100,000 Opening balance b/f

Rs.
100,000

Revaluation surplus
Rs.
Revaluation account

Rs.
1,100,000

3.5 Depreciation of a revalued asset

After a non-current asset has been revalued, depreciation charges are based on
the new valuation.
Example:
An asset was purchased three years ago, at the beginning of Year 1, for Rs.
100,000.
Its expected useful life was six years and its expected residual value was Rs.
10,000.
It has now been re-valued to Rs. 120,000. Its remaining useful life is now
estimated to be three years and its estimated residual value is now Rs. 15,000.
The straight-line method of depreciation is used.
Required
(a)

What is the transfer to the revaluation surplus at the end of Year 3?

(b)
(c)

What is the annual depreciation charge in Year 4?

What is the carrying amount of the asset at the end of Year 4?

Answer
Original annual depreciation (for Years 1 3) = Rs.(100,000 10,000)/6 years = Rs.15,000.
Rs.
Cost
Less: Accumulated depreciation at the time
of revaluation (= 3 years x Rs.15,000)
Carrying amount at the time of the
revaluation
Revalued amount of the asset

(45,000)
55,000
120,000

Transfer to the revaluation surplus

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Revised annual depreciation = Rs.(120,000 15,000)/3 years = Rs.35,000.

The annual depreciation charge in Year 4 will therefore be Rs. 35,000.
Rs.
120,000
(35,000)

Revalued amount
Less: depreciation charge in Year 4
Carrying amount at the end of Year 4

85,000

3.6 Realisation of the revaluation surplus

All assets eventually disappear from the statement of financial position either by
becoming fully depreciated or because the company sells them.
If nothing were done this would mean that there was a revaluation surplus on the
face of the statement of financial position that related to an asset that was no
longer owned.

IAS 16 allows (but does not require) the transfer of a revaluation surplus to
retained earnings when the asset to which it relates is derecognised
(realised).

Section 235 Companies Ordinance 1984 requires this.

This might happen over several years as the asset is depreciated or at a point in
time when the asset is sold.
Revalued assets being depreciated
Revaluation of an asset causes an increase in the annual depreciation charge.
The difference is known as excess depreciation (or incremental depreciation):
Excess depreciation is the difference between:

the depreciation charge on the re-valued amount of the asset, and

the depreciation that would have been charged on historical cost.

Each year a business might make a transfer from the revaluation surplus to the
retained profits equal to the amount of the excess depreciation.
Illustration:
Debit
Revaluation surplus

Credit

Retained earnings

Revalued assets being sold

When a revalued asset is sold the business might transfer the balance on the
revaluation surplus in respect of the asset into retained earnings. The journal
entry would be the same as above.

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Example:
An asset was purchased two years ago at the beginning of Year 1 for Rs. 600,000.
It had an expected life of 10 years and nil residual value.
Annual depreciation is Rs. 60,000 (Rs. 600,000/10 years) in the first two years.
At the end of Year 2 the carrying value of the asset was Rs. 480,000.
After two years it is re-valued to Rs. 640,000.
Double entry: Revaluation
Debit
40

Asset (Rs.640,000 Rs.600,000)

Accumulated depreciation

Credit

120

Revaluation surplus

160

Each year the business is allowed to make a transfer between the revaluation
surplus and retained profits:
Double entry: Transfer
Debit
20

Revaluation surplus (160/8)

Retained profits

Credit
20

The above can also be calculated as follows:

Depreciation after revaluation
Depreciation if asset were not revalued

80
60

Incremental depreciation to be transferred from the

revaluation surplus account to retained earnings

20

3.7 Revaluation model: the frequency of revaluations

When the revaluation model is applied to the measurement of property, plant and
equipment, revaluations must be made with sufficient regularity to ensure that the
carrying amount does not differ materially from that which would be determined
using fair value at the end of the reporting period.
The frequency of revaluations should depend on the volatility in the value of the
assets concerned. When the value of assets is subject to significant changes
(high volatility), annual revaluations may be necessary.
However, such frequent revaluations are unnecessary for items subject to only
insignificant changes in fair value. In such cases it may be necessary to revalue
the item only every three or five years.

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DERECOGNITION OF PROPERTY, PLANT AND EQUIPMENT

Section overview

Gain or loss on disposal of a non-current asset

4.1 Gain or loss on disposal of a non-current asset

Property, plant and equipment are eventually disposed of:

by sale, or

if they have no sale value, through disposal as scrap.

Disposal can occur at any time, and need not be at the end of the assets
expected useful life.
There is a gain or loss on disposal of the asset, as follows:
Illustration: Gain or loss on disposal

Sale proceeds on disposal

Rs.
X

Less disposal costs

(X)

Net disposal value

Asset at cost

Less: Accumulated depreciation

(X)

Carrying amount at date of disposal

(X)

Gain /loss on disposal

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DISCLOSURE REQUIREMENTS OF IAS 16

Section overview

Disclosure requirements of IAS 16

Accounting policies

5.1 Disclosure requirements of IAS 16

IAS 16 requires the following disclosures in the notes to the financial statements,
for each major class of property, plant and equipment.

The measurement bases used (cost or revaluation model);

The depreciation methods used;

The useful lives or depreciation rates used;

Gross carrying amounts and the accumulated depreciation at the beginning

and at the end of the period;

A reconciliation between the opening and closing values for gross carrying
amounts and accumulated depreciation, showing:
x

Additions during the year;

Disposals during the year;

Depreciation charge for the year;

Assets classified as held for sale in accordance with IFRS 5;

Acquisitions of assets through business combinations;

Impairment losses;

The effect of revaluations.

The following is an example of how a simple table for tangible non-current assets
may be presented in a note to the financial statements.
Illustration:

Property

Plant and
equipment

Cost

Rs.m

Rs.m

At the start of the year

7,200

2,100

9,300

Additions

920

340

1,260

Disposals

(260)

(170)

(430)

At the end of the year

Total
Rs.m

7,860

2,270

10,130

At the start of the year

800

1,100

1,900

Depreciation expense

120

250

370

Accumulated depreciation

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Accumulated depreciation on
disposals

(55)

At the end of the year

865

1,220

2,085

At the start of the year

6,400

1,000

7,400

At the end of the year

6,995

1,050

8,045

(130)

(185)

Carrying amount

5.2 Accounting policies

IAS 1 requires the disclosure of accounting policies used that are relevant to an
understanding of the financial statements. Property, plant and equipment often
includes the largest numbers in the statement of financial position and results in
significant expense in the statement of comprehensive income.
One of the learning outcomes in this area is that you be able to formulate
accounting policies for property, plant and equipment.

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INTERPRETATIONS INVOLVING ACCOUNTING FOR NON-CURRENT

ASSETS
Section overview

IFRIC 1: Changes in existing decommissioning, restoration and similar liabilities

IFRIC 20: Stripping costs in the production phase of a surface mine

Core inventories

6.1 IFRIC 1: Changes in existing decommissioning, restoration and similar

liabilities
Scope
IFRIC 1 applies to changes in the measurement of an existing decommissioning
cost that is recognised both as:

part of the cost of an item of property plant and equipment in accordance

with IAS 16; and

a liability in accordance with IAS 37

The issue
Decommissioning costs are recognised as part of the initial cost of PPE if an
obligation has been recognised for these costs. This will be the case when the
costs satisfy the IAS 37 recognition criteria.
The provision is measured in accordance with IAS 37 rules. IAS 37 requires that
provisions are reviewed at each reporting date and adjusted to reflect the best
estimate of the expected outcome.
The carrying amount of a provision might need to change in order to reflect:

unwinding of the discount; and

change in estimates including:

x

timing of the cash flows;

size of the cash flows; or

discount rate.

IFRIC 1 gives guidance on the location of the other side of the entry when a
provision is adjusted.
Consensus: Unwinding of a discount
A movement on a provision due to the unwinding of a discount is a finance cost
and must be recognised in the statement of profit or loss. Capitalisation in
accordance with the rules in IAS 23 is not permitted.

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Consensus: Other causes of a movement

The accounting treatment for an increase or decrease in a provision due to other
causes depends how the related asset is measured.
Related asset carried at cost less accumulated depreciation
A change in the liability is added to/deducted from the carrying amount of the
related asset if it is measured using the cost model:

A decrease in the provision (Dr Provision) reduces the carrying amount of

the related asset (Cr Asset). Once the carrying amount of the related asset
is reduced to zero any further decrease is recognised as an expense in the
statement of profit or loss

An increase in the provision (Cr Provision) increases the carrying amount of

the related asset (Dr Asset). However, an increase in a provision might
indicate that the related asset might not be fully recoverable. If this is the
case the asset must be tested for impairment by estimating its recoverable
amount. Any impairment loss must be recognised in accordance with IAS
36.

Example: Accounting for movements on a provision related to an asset accounted

for using the cost model
1 January 2015
X Limited purchased and installed an asset on 1st January 2015 at a cost of
Rs.10m.
X Limited made the following estimates with respect to the asset and future
decommissioning costs to which it was committed at this date:
Useful life

40 Years

Decommission cost at end of useful life

Rs.2,000,000

Discount rate

5%

1 January 2015
Amount recognised for the provision


The double entry is as follows:

Debit
284,091

Asset
Provision

Credit
284,091

Thus the carrying amount of the asset on initial recognition is:

Cash cost
Initial estimate of decommission costs

Rs.
10,000,000
284,091

Initial estimate of decommission costs

10,284,091

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Example (continued): Accounting for movements on a provision related to an

asset accounted for using the cost model
31 December 2015
The asset must be depreciated over its estimated useful life.
In addition the company must recognise the unwinding of the discount
inherent in initial measurement of the provision.
Depreciation expense (10,284,091 40)

Debit
Rs.257,102

Provision

Credit
Rs.257,102

The company must recognise the unwinding of the discount inherent in

initial measurement of the provision.
Debit
Credit
Finance Cost (5% u 284,091)

Rs.14,205

Provision

Rs.14,205

The company must review the provision in accordance with IAS 37.
The provision was reviewed in accordance with IAS 37 and the following revised
estimates made:
Useful life (from this date)
41 years
Decommission cost at end of useful life

Rs.2,200,000

Discount rate

6%

Provision must be remeasured at:



The provision is remeasured as follows:

Rs.
284,091

Provision as at 1 January 2015

Unwinding of the discount

14,205

Provision as at 31 December 2015 before

adjustment to reflect change in estimates
Change due to change in estimates (balancing
figure)

(96,514)

Provision as at 31 December 2015

201,782

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Example (continued): Accounting for movements on a provision related to an

asset accounted for using the cost model
31 December 2015 (continued)
The double entry is as follows:
Debit
Provision

Credit

Rs.96,514

Asset

Rs.96,514

Thus the carrying amount of the asset on initial recognition is:

Rs.
Cash cost

2,000,000

Initial estimate of decommission costs

284,091
2,284,091

The double entries during 2015 can be summarised as follows:

Debit/(credit)
Asset
Rs.

Provision
Rs.

P&L
Rs.

1 January 2015
Cash
Decommissioning cost

10,000,000
284,091

(284,091)

10,284,091
31st December 2015
Depreciation
Unwinding of the discount
Change due to review of
provision

(257,102)
(14,205)
(96,514)

96,514

9,930,475

201,782

257,102
14,205

Related asset carried at fair value

The related asset might be accounted for at a revalued amount using the IAS 16
revaluation model.
In this case, any change in the estimate of dismantling cost does not affect the
carrying amount of the asset but is recognised in the revaluation surplus account.
However, any such adjustment cannot result in the balance on the revaluation
surplus account becoming negative. The maximum such adjustment reduces the
balance on the revaluation surplus account to zero with any further in profit or
loss.

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6.2 IFRIC 20: Stripping costs in the production phase of a surface mine
Background
A company involved in surface mining operations may find it necessary to
remove mine waste materials (overburden) to gain access to mineral ore
deposits. This waste removal activity is known as stripping.
The interpretation describes the period before production begins as the
development phase of the mine. Stripping costs incurred in the development
phase are usually capitalised as part of the depreciable cost of building,
developing and constructing the mine. Those capitalised costs are depreciated or
amortised on a systematic basis, usually by using the units of production method,
once production begins.
Once production begins, a mining company may continue to remove overburden
and to incur stripping costs. The material removed in the production phase will
not necessarily be all waste but will often be a combination of ore and waste.
Therefore, there might be two benefits accruing to the company from the
stripping activity:

usable ore that can be used to produce inventory; and

improved access to ore that will be mined in future periods.

IFRIC 20 applies to waste removal costs that are incurred in surface mining
activity during the production phase of the mine. It explains how to account for
these two benefits and how to measure them both initially and subsequently.
Issues
IFRIC 20 addresses the following issues:

recognition of production stripping costs as an asset;

initial measurement of the stripping activity asset; and

subsequent measurement of the stripping activity asset.

Consensus: Recognition of production stripping costs as an asset

A company must account for stripping costs as inventory to the extent that a
benefit from the stripping activity is realised in the form of inventory produced
A company must account for stripping costs as a non-current asset (a stripping
activity asset) to the extent that the benefit is improved access to ore as long as
the following criteria are met:

it is probable that the future economic benefit (improved access to the ore
body) associated with the stripping activity will flow to the company

the company can identify the component of the ore body for which access
has been improved; and

the costs relating to the stripping activity associated with that component
can be measured reliably.

The stripping activity asset must be accounted for as part of an existing asset
either as an addition to, or as an enhancement of, that asset. Therefore, the
nature of this existing asset will determine whether the stripping activity asset is
classified as tangible or intangible.

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Consensus: Initial measurement of the stripping activity asset

The stripping activity asset is initially measured at cost.
Cost is those costs directly incurred that improves access to the identified
component of ore, plus an allocation of directly attributable overhead costs.
If the costs of the stripping activity asset and the inventory produced are not
separately identifiable, the company must allocate the production stripping costs
between the inventory produced and the stripping activity asset by using an
allocation basis that is based on a relevant production measure for example,
volume of waste extracted compared with expected volume, for a given volume
of ore production.
Consensus: Subsequent measurement of the stripping activity asset
After initial recognition, the stripping activity asset is measured in the same way
as the existing asset of which it is a part. This could be either at cost or revalued
amount less depreciation or amortisation and less impairment losses.
The stripping activity asset must be depreciated on a systematic basis, over the
expected useful life of the identified component of the ore body that becomes
more accessible as a result of the stripping activity. The units of production
method must be applied unless another method is more appropriate.
The expected useful life of the identified component of the ore body that is used
to depreciate or amortise the stripping activity asset will differ from the expected
useful life that is used to depreciate or amortise the mine itself and the related
life-of-mine assets.
The exception to this are those limited circumstances when the stripping activity
provides improved access to the whole of the remaining ore body. For example,
this might occur towards the end of a mines useful life when the identified
component represents the final part of the ore body to be extracted.

6.3 Core inventories

The subject matter of this section was a question submitted to IFRSIC to see if
they would include it on their agenda with a view to issuing an interpretation on
the topic.
When IFRSIC receive such a submission they consider in detail, whether it
should become part of their agenda. When they decide not to include a topic that
has been submitted for consideration, they issue a paper to explain their
decision. They declined to include this topic.
The following discussion is a summary of their explanation.
The issue
Some production facilities require the presence of a minimum amount of
inventory in order to function. This means that a minimum amount of inventory
must be present at all times. This is described as core inventory. Examples
include oil or gas in a pipeline (line fill) or an amount of gas in cavern storage
facilities (cushion gas).
Core inventories are a minimum amount of material that:

is necessary to permit a production facility to start operating and to maintain

subsequent production;

cannot be physically separated from other inventories; and

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can be removed only when the production facility is finally

decommissioned.

The question is whether core inventory held in an entitys own facilities are
accounted for as inventories or as property, plant and equipment.
Analysis
Arguments supporting the rational for classification as inventory:

Core inventories meet the definition of inventories as assets:

x

held for sale in the ordinary course of business;

in the process of production for such sale; or

in the form of materials or supplies to be consumed in the production

process or in the rendering of services.

Core inventories are ordinarily interchangeable with other inventories, and

thus core inventories held at a particular reporting date will be either
consumed or sold in the next period.

Core inventories do not meet the definition of PP&E in IAS 16 because they
are not expected to be used during more than one period.

Arguments supporting the rational for classification as an element of property,

plant and equipment:

Core inventories are not held for sale or consumption; instead their
intended use is to ensure that a production facility is operating. Even
though core inventories are ordinarily interchangeable with other
inventories, the characteristics and intended use of a particular part of the
inventories remain the same at each individual reporting date. Thus these
core inventories need to be accounted for separately.

Core inventories are necessary to bring a PP&E asset to its required

operating condition.

IAS 16 (paragraph 16b) states that the cost of an item of property, plant
and equipment comprises any costs directly attributable to bringing the
asset to the location and condition necessary for it to be capable of
operating in the manner intended by management.

IAS 2 (paragraph 35) states that Some inventories may be allocated to

other asset accounts, for example, inventory used as a component of selfconstructed property, plant or equipment. Inventories allocated to another
asset in this way are recognised as an expense during the useful life of that
asset.

Conclusion
The classification of core inventories should be based on their primary intended
use rather than on their physical form.
Core inventories as described above are primarily held for making a production
facility operational. Thus, they would normally be classified as an element of the
cost of property, plant and equipment.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

Non-current assets:
sundry standards

Contents
1 IAS 23: Borrowing costs
2 IAS 20: Accounting for government grants and
disclosure of government assistance
3 IAS 40: Investment property

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 21

IAS 20: Accounting for government grants and disclosure of government

assistance

B (a) 23

IAS 23: Borrowing costs

B (a) 31

IAS 40: Investment property

B (a) 51

SIC 10: Government assistance no specific relation to operating activities

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IAS 23: BORROWING COSTS

Section overview

Introduction

Borrowing costs eligible for capitalisation

Period of capitalisation

Disclosures

1.1 Introduction
A company might incur significant interest costs if it has to raise a loan to finance
the purchase or construction of an asset. IAS 23: Borrowing costs defines
borrowing costs and sets guidance on the circumstances under which they are to
be capitalised as part of the cost of qualifying assets.
Definition: Borrowing costs
Borrowing costs are interest and other costs that an entity incurs in connection with
the borrowing of funds.

Definition: Qualifying asset

A qualifying asset is an asset that necessarily takes a substantial period of time to
get ready for its intended use or sale.
Any of the following may be qualifying assets depending on circumstances:

inventories;

items of property, plant and equipment;

intangible assets.

The following are not qualifying assets:

inventories that are manufactured, or otherwise produced, over a short

period of time, are not qualifying assets

assets that are ready for their intended use or sale when acquired.

Qualifying assets are usually self-constructed non-current assets.

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1.2 Borrowing costs eligible for capitalisation

Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset must be capitalised as part of the cost of that
asset. All other borrowing costs are recognised as an expense in the period in
which they are incurred.
Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset are those that would have been avoided if the
expenditure on the qualifying asset had not been made.
This includes the costs associated with specific loans taken to fund the
production or purchase of an asset and general borrowings. General borrowings
are included because if an asset were not being constructed it stands to reason
that there would have been a lower need for cash.
Funds specifically borrowed to obtain a qualifying asset
When a specific loan is taken in order to obtain a qualifying asset the borrowing
costs eligible for capitalisation are the actual borrowing costs incurred on that
borrowing during the period less any investment income on the temporary
investment of those borrowings.
Example: Specific borrowings
On 1 January 2016 Okara Engineering issued a bond to raise Rs. 25,000,000 to
fund a capital project which will take three years to complete.
Amounts not yet needed for the project are invested on a temporary basis.
During the year to 31 December 2016, Okara Engineering spent Rs. 9,000,000 on
the project.
The cost of servicing the bond was Rs. 1,250,000 during this period and the
company was able to earn Rs. 780,000 through the temporary reinvestment of the
amount borrowed.
The amounts recognised as capital work in progress in the period was:
Rs.
Costs incurred (labour, material, overhead etc.)

9,000,000

Interest capitalised:
Actual interest cost

1,250,000

Less: return on temporary investment

(780,000)
470,000

Additions to capital work in progress

9,470,000

General funds used for the purpose of obtaining a qualifying asset.

When general borrowings are used the amount of borrowing costs eligible for
capitalisation is obtained by applying a capitalisation rate to the expenditures on
that asset.

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The capitalisation rate is the weighted average of the borrowing costs applicable
to the borrowings that are outstanding during the period except for borrowings
made specifically for the purpose of obtaining a qualifying asset.
The amount of borrowing costs capitalised cannot exceed the amount of
borrowing costs it incurred during a period.
Example: General borrowings: Capitalisation rate
Sahiwal Construction has three sources of borrowing:
Average loan in the
year (Rs.)

Interest expense incurred

in the year (Rs.)

7 year loan

8,000,000

800,000

10 year loan

10,000,000

900,000

5,000,000

900,000

Bank overdraft

The 7 year loan has been specifically raised to fund the building of a
qualifying asset.
A suitable capitalisation rate for other projects is found as follows:
Average loan in the
year (Rs.)
10 year loan
Bank overdraft

Interest expense incurred

in the year (Rs.)

10,000,000

900,000

5,000,000

900,000

15,000,000

1,800,000

Capitalisation rate = 1,800,000/15,000,000 u 100 = 12%

Alternatively:
Rate on 10 year loan = 900,000/10,000,000 u 100 = 9%
Rate on bank overdraft = 900,000/5,000,000 u 100 = 18%
Weighted average:

9% u 10,000,000/15,000,000 + 18% u 5,000,000/15,000,000

6% + 6% = 12%

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The capitalisation rate is applied from the time expenditure on the asset is
incurred.
Example: General borrowings: Capitalisation rate
Continuing the example above, Sahiwal Construction has incurred the following
expenditure on a project funded from general borrowings for year ended 31
December 2016.
Date incurred:

Amount (R
Rs.)

31st March

1,000,000

31st July

1,200,000

30th October

800,000

The amount capitalised in respect of capital work in progress during

2016 is as follows:
Rs.
31st March  Expenditure

1,000,000

Interest (1,000,000 u 12% u 9/12)

90,000

31st July  Expenditure

1,200,000

Interest (1,200,000 u 12% u 5/12)

60,000

30th October  Expenditure

800,000

Interest (800,000 u 12% u 2/12)

16,000
3,166,000

1.3 Period of capitalisation

Commencement of capitalisation
Capitalisation of borrowing costs should start only when:

expenditures for the asset are being incurred; and

borrowing costs are being incurred, and

activities necessary to prepare the asset have started.

Suspension of capitalisation
Capitalisation of borrowing costs should be suspended if development of the
asset is suspended for an extended period of time.
Cessation of capitalisation
Capitalisation of borrowing costs should cease when the asset is substantially
complete. The costs that have already been capitalised remain as a part of the
assets cost, but no additional borrowing costs may be capitalised.

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Example: Commencement and suspension of capitalisation

Company A borrowed Rs. 9,000 @ 15% per annum to fund a project on 1st Jan
2015.
The following expenditures were made on the project during the year ending 31
December 2016
Date: 1st March 2016: Rs. 2,500
Date: 1st Oct 2016: Rs. 4,200
Work on the project was suspended during the month of August and resumed in
September.

The IAS 23 rules apply as follows:

The total interest cost of the borrowing is:
Rs. 9,000 u 15% u 10/12 = 1,125

The project commenced on 1st March resulting in a period of 10 months up to

the year end.
However, interest cannot be capitalised during the period of suspension.
Therefore, interest is capitalised only for 9 months.
The borrowing is specific to the project so interest on whole amount (principal) is
capitalised in the amount of:
9,000 u 15% u 9/12 = 1,012.5
The double entry to reflect the above is as follows:
Debit
Asset in the course of construction

1,012.5

Statement of profit or loss (finance costs)

Cash/interest liability

Credit

112.5
1,125

1.4 Disclosures
IAS 23 requires disclosure of the following:

the amount of borrowing costs capitalised during the period; and

the capitalisation rate used to determine the amount of borrowing costs

eligible for capitalisation.

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IAS 20: ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE

OF GOVERNMENT ASSISTANCE
Section overview

Introduction and definitions

Accounting treatment of government grants

Repayment of government grants

Government assistance

Disclosure requirements

SIC 10 Government assistance no specific relation to operating activities

2.1 Introduction and definitions

In many countries the government provides financial assistance to industry. The
most common form of such assistance is a grant of cash from local or national
government.
Definitions
Government assistance is action by government designed to provide an economic
benefit specific to an entity or range of entities qualifying under certain criteria.
Government assistance does not include benefits provided only indirectly through
action affecting general trading conditions, such as the provision of infrastructure
in development areas or the imposition of trading constraints on competitors.
Government grants are assistance by government in the form of transfers of
resources to an entity in return for past or future compliance with certain
conditions relating to the operating activities of the entity. They exclude those
forms of government assistance which cannot reasonably have a value placed
upon them and transactions with government which cannot be distinguished
from the normal trading transactions of the entity.
IAS 20 Accounting for Government Grants and Disclosure of Government
Assistance identifies two types of government grants:

grants related to assets, or

grants related to income.

Definitions
Grants related to assets are government grants whose primary condition is that
an entity qualifying for them should purchase, construct or otherwise acquire
long-term assets. Subsidiary conditions may also be attached restricting the type
or location of the assets or the periods during which they are to be acquired or
held.
Grants related to income are government grants other than those related to
assets.

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Government grants are sometimes called by other names such as subsidies,

subventions, or premiums.
Forgivable loans
Definition: Forgivable loans
Forgivable loans are loans which the lender undertakes to waive repayment of
under certain prescribed conditions.
A forgivable loan from government is treated as a government grant when there
is reasonable assurance that the entity will meet the terms for forgiveness of the
loan.
Loans at below market rates of interest
The benefit of a government loan at a below-market rate of interest is treated as
a government grant.
The benefit of the below-market rate of interest is measured as the difference
between the initial carrying value of the loan determined in accordance with IAS
39 (IFRS 9) and the proceeds received.
The benefit is accounted for in accordance with IAS 20.

2.2 Accounting treatment of government grants

IAS 20 states that grants should not be recognised until there is reasonable
assurance that:

the entity will comply with any conditions attaching to the grant, and

the grant will be received.

Once these recognition criteria are met, the grants should be recognised in profit
or loss over the periods necessary to match them with their related costs.
Neither type of grant should be credited directly to shareholders interests in the
statement of financial position. They must be reported on a systematic basis
through the statement of profit or loss (profit or loss).
Grants related to income
For grants related to income, IAS 20 states that an income approach should be
used, and the grant should be taken to income over the periods necessary to
match the grant with the costs that the grant is intended to compensate.
IAS 20 allows two methods of doing this:

Method 1. Include the grant for the period as other income for inclusion in
profit or loss for the period

Method 2. Deduct the grant for the period from the related expense.

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Example: Grant related to income

A company receives a cash grant of Rs. 30,000 on 31 December Year 0.
The grant is towards the cost of training young apprentices, and the training
programme is expected to last for 18 months from 1 January Year 1.
Actual costs of the training were Rs. 50,000 in Year 1 and Rs. 25,000 in Year 2.
The grant would be accounted for as follows:
At 31 December Year 0 the grant would be recognised as a liability and
presented in the statement of financial position split between current and noncurrent amounts. Rs. 20,000 (12 months/18 months u Rs. 30,000) is current and
would be recognised in profit for Year 1.The balance is non-current.
At the end of year 1 there would be a current balance of Rs. 10,000 (being the
non-current balance at the end of Year 0 reclassified as current) in the statement
of financial position. This would be recognised in profit in Year 2.
Extracts from the financial statements are as follows:
Statement of financial position (extracts)

Current liabilities
Deferred income
Non--current liabilities
Deferred income

31
December
Year 0

31
December
Year 1

31
December
Year 2

20,000

10,000

10,000

31
December
Year 1

31
December
Year 2

(50,000)
20,000

(25,000)
10,000

Statement of profit or loss (extracts)

Method 1
Training costs
Government grant received
Method 2
Training costs (50,000 20,000)
Training costs (25,000 10,000)

30,000
15,000

Grants related to assets

For grants related to assets, IAS 20 allows two methods of doing this:

Method 1. Deduct the grant from the cost of the related asset. The asset is
included in the statement of financial position at cost minus the grant.
Depreciate the net amount over the useful life of the asset.

Method 2. Treat the grant as deferred income and recognise it as income

on a systematic basis over the useful life of the asset.

Both methods achieve the same effective result.

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Example: Grant related to an asset

A company receives a government grant of Rs. 400,000 towards the cost of an
asset with a cost of Rs. 1,000,000.
The asset has an estimated useful life of 10 years and no residual value.
The amounts could be reflected in the financial statements prepared at the end
of Year 1 in accordance with IAS 20 in the following ways:
Method 1:
Statement of financial position (extract)
Rs.

Property, plant and equipment

Cost (1,000,000 400,000)
Accumulated depreciation

600,000
(60,000)

Carrying amount

540,000

Included in statement of profit or loss (extract)

Depreciation charge (Rs. 600,000/10 years)

Rs.
60,000

Method 2:
Statement of financial position (extract)
Rs.

Property, plant and equipment

Cost

1,000,000

Accumulated depreciation

(100,000)

Carrying amount

900,000

Current liabilities
Deferred income

40,000

Non--current liabilities
320,000

Deferred income

At the end of year 1 there would be Rs. 360,000 of the grant left to
recognise in profit in the future at Rs. 40,000 per annum. Rs. 40,000
would be recognised in the next year and is therefore current. The balance
is non-current
Included in statement of profit or loss (extract)
Expense: Depreciation charge (Rs. 1,000,000/10 years)
Income: Government grant (Rs. 400,000/10 years)

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Practice question

On January Year 1 Entity O purchased a non-current asset with a cost of Rs.

500,000 and received a grant of Rs. 100,000 in relation to that asset.
The asset is being depreciated on a straight-line basis over five years.
Required
Show how the asset and the grant would be reflected in the financial
statements at the end of the first year under both methods of accounting
for the grant allowed by IAS 20.
Grants as compensation for expenses or losses
A government grant may be awarded for the purpose of giving immediate
financial support to an entity rather than as an incentive to undertake specific
expenditures.
The circumstances under which the grant is made may warrant immediate
recognition of the grant in profit or loss in the period in which the entity qualifies
to receive it with disclosure to ensure that its effect is clearly understood.
A government grant may become receivable by an entity as compensation for
expenses or losses incurred in a previous period. Such a grant is recognised in
profit or loss of the period in which it becomes receivable, with disclosure to
ensure that its effect is clearly understood.

2.3 Repayment of government grants

A government gran might become repayable by the entity (e.g. when the entity
fails to meet the underlying conditions for the grant).
When a government grant becomes repayable it is accounted for as a change in
accounting estimate (IAS 8: Accounting policies, changes in accounting
estimates and errors).
Repayment of a grant related to income
Repayment of a grant related to income is applied in the first instance against
any unamortised deferred credit recognised in respect of the grant. If the
repayment exceeds any such deferred credit any excess is recognised
immediately in profit or loss.

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Example: Repayment of grant related to income

On 1 January Year 1 X Limited received a cash grant of Rs. 500,000 towards the
cost of employing an environmental impact analyst on a new project for a 5 year
period.
The grant is repayable in full if the project is not completed.
The analyst was employed and the project commenced from the 1 January Year
1.
On 1 January Year 3 the project was abandoned and the grant became repayable
in full.
The grant and its subsequent repayment is accounted for as follows:
Year 1
Debit
Cash

Credit

500,000

Deferred income

500,000

Statement of profit or loss

(reduction of employment cost)

100,000

Deferred income

100,000

Year 2
Statement of profit or loss
(reduction of employment cost)
Deferred income

100,000
100,000

The balance on the deferred income account at the end of Year 2 is Rs.
300,000 (Rs. 500,000 Rs. (2 u Rs. 100,000).
The double entry to reflect the repayment is as follows
Debit
Deferred income
Statement of profit or loss

Credit

300,000
200,000

Cash

500,000

Repayment of a grant related to an asset

Accounting for a repayment of a grant related to an asset depends on how the
grant was accounted for originally.
If the grant was accounted for as reduction of the carrying amount of the related
asset, its repayment is recognised by increasing the carrying amount of the
asset.
If the grant was accounted for as deferred income, its repayment is recognised
by reducing the deferred income balance by the amount repayable.

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The cumulative additional depreciation that would have been recognised in profit
or loss to date in the absence of the grant must be recognised immediately in
profit or loss.
Also note that the circumstances giving rise to repayment of the grant might
indicate the possible impairment of the new carrying amount of the asset.

2.4 Government assistance

The definition of government grants (see earlier) excludes:

certain forms of government assistance which cannot reasonably have a

value placed upon them (e.g. free advice and the provision of guarantees);
and

transactions with government which cannot be distinguished from the

normal trading transactions of the entity (e.g. a government procurement
policy that is responsible for a portion of the entitys sales).

There is no specified accounting treatment for either of these. However, the

significance of the benefit may require disclosure of the nature, extent and
duration of the assistance in order to prevent the financial statements being
misleading.

2.5 Disclosure requirements

IAS 20 requires the following disclosures in the notes to the financial statements:

the accounting policy adopted for government grants, including the method
of presentation in the financial statements

the nature and extent of government grants recognised in the financial

statements and an indication of other forms of government assistance from
which the entity has directly benefitted.

unfulfilled conditions and other contingencies attaching to government

assistance (if this assistance has been recognised in the financial
statements).

Government assistance may be significant so that disclosure of the nature, extent

and duration of the assistance is necessary in order that the financial statements
may not be misleading.

2.6 SIC 10 Government assistance no specific relation to operating activities

A company might receive a grant or other assistance that is not linked to
operating activities.
Issue
The issue is whether such government assistance is "a government grant" within
the scope of IAS 20 and should therefore be accounted for in accordance with
this Standard.
Consensus
Such assistance meets the definition of government grants in IAS 20. Such
grants should therefore not be credited directly to shareholders' interests.
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IAS 40: INVESTMENT PROPERTY

Section overview

Definitions

Accounting treatment of investment property

Why investment properties are treated differently from other properties

Transfers and disposals of investment property

Disclosure requirements

3.1 Definitions
IAS 40: Investment Property, defines and sets out the rules on accounting for
investment properties.
Definition: Investment property
An investment property is property (land or a building, part of a building or both)
held to earn rentals or for capital appreciation or both.
Investment property differs from other property, which is:

used in the production or supply of goods, or for administrative purposes

(which is covered by IAS 16; Property, plant and equipment); or

held for sale in the ordinary course of business (which is covered by IAS 2:
Inventories).

The property could be held by:

the owner; or

the lessee under a finance lease or an operating lease.

Examples of investment property

The following are examples of investment property:

land held for long-term capital appreciation rather than for short-term sale in
the ordinary course of business.

land held for a currently undetermined future use. (If an entity has not
determined that it will use the land as owner-occupied property or for shortterm sale in the ordinary course of business,

a building owned by the entity (or held by the entity under a finance lease)
and leased out under one or more operating leases.

a building that is vacant but is held to be leased out under one or more
operating leases.

property that is being constructed or developed for future use as investment

property.

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Not investment property

The following are examples of items that are not investment property:

property intended for sale in the ordinary course of business;

property being constructed or developed on behalf of third parties;

owner-occupied property including (among other things) property held for

future use as owner-occupied property, property held for future
development and subsequent use as owner-occupied property, property
occupied by employees (whether or not the employees pay rent at market
rates) and owner-occupied property awaiting disposal;

property being leased to another entity under a finance lease.

Scope limitation
IAS 40 does not apply to:

biological assets related to agricultural activity (IAS 41: Agriculture and IAS
16: Property, plant and equipment); and

mineral rights and mineral reserves such as oil, natural gas and similar
non-regenerative resources.

Property held under an operating lease

A property interest that is held by a lessee under an operating lease may be
classified and accounted for as investment property if, and only if, the property
would otherwise meet the definition of an investment property and the lessee
accounts for it using the IAS 40 fair value model.
This classification alternative is available on a property-by-property basis.
However, once this classification alternative is selected for one such property
interest held under an operating lease, all property classified as investment
property must be accounted for using the fair value model.
This means that a company might lease two properties under operating leases
and account for each differently.
Example: Property held under an operating lease
A Limited rents a property from B Limited under an operating lease.
A Limited sublets this property and it satisfies the IAS 40 definition of investment
properties from As view.
A Limited has a choice of accounting treatment:
1.

A Limited could apply IAS 17 accounting for it as a lessee from B Limited

and a lessor to other parties.

2.

A Limited could account for its interest in the property as an investment

property as alternative to the IAS 17 treatment as a lessee from B
Limited. It would still use IAS 17 as a lessor to the third parties.

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Example: Property held under an operating lease

A Limited rents two properties from B Limited under operating leases.
A Limited sublets these properties and they satisfy the IAS 40 definition of
investment properties from As view.
A Limited has a choice of accounting treatment for its interests in these
properties:
1.

A Limited could use IAS 17 operating lessee accounting for both

properties.

2.

A Limited could use IAS 40 investment property accounting for both

properties.

3.

A Limited could use IAS 17 operating lessee accounting for one property
and IAS 40 investment property accounting for the other.

If it applies IAS 40 it must apply the IAS 40 fair value model to the property and
to all other investment properties that it might hold.
In summary, not all operating leases that would qualify to be investment
properties have to be treated in the same way, but once an operating lease is
treated as an investment property, the fair value model must be used for all
investment properties.
Property leased within a group
In some cases, an entity owns property that is leased to, and occupied by, its
parent or another subsidiary.

The property could qualify as investment property from the perspective of

the entity that owns it (if it meets the IAS 40 definition). In that case the
lessor must account for the property as investment property in its individual
financial statements.

The property does not qualify as investment property in the consolidated

financial statements, because the property is owner-occupied from the
perspective of the group.

Partly occupied buildings

An entity might use part of a property for the production or supply of goods or
services or for administrative purposes and hold another part of the same
property to earn rentals or for capital appreciation. In other words, part of a
property might be owner occupied and part held as an investment.
The two parts are accounted for separately if they could be sold separately (or
leased out separately under a finance lease).
If this is not the case the property is investment property only if an insignificant
portion is owner occupied.

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3.2 Accounting treatment of investment property

The recognition criteria for investment property are the same as for property,
plant and equipment under IAS 16. An investment property should be recognised
as an asset only when:

it is probable that future economic benefits associated with the property will
flow to the entity; and

the cost of the property can be measured reliably.

Measurement at recognition
Investment property should be measured initially at cost plus any directly
attributable expenditure (e.g. legal fees, property transfer taxes and other
transaction costs) incurred to acquire the property.
A property held under an operating lease may be classified as an investment
property. The initial cost of such a property is found by capitalising the operating
lease as if it were a finance lease according to IAS 17 Leases.
The cost of an investment property is not increased by:

start-up costs (unless 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 investment property achieves the

planned level of occupancy; or

abnormal waste incurred in constructing or developing the property.

Measurement after recognition

After initial recognition an entity may choose as its accounting policy:

the fair value model; or

the cost model.

The chosen policy must be applied to all the investment property of the entity.
Once a policy has been chosen it cannot be changed unless the change will
result in a more appropriate presentation. IAS 40 states that a change from the
fair value model to the cost model is unlikely to result in a more appropriate
presentation.

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Fair value model for investment property

Definition: Fair value
Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.
Under the fair value model the entity should:

revalue all its investment property to fair value (open market value) at the
end of each financial year; and

recognise any resulting gain or loss in profit or loss for the period.

The property would not be depreciated.

This is different to the revaluation model of IAS 16, where gains are reported as
other comprehensive income and accumulated as a revaluation surplus.
If it is not possible to arrive at a reliable fair value figure then the cost model
should be adopted for that property. This is an exception to the rule that all
investment property must be valued under either one model or the other.
If an entitys policy is to measure investment properties at fair value but it
measures an investment property at cost because its fair value cannot be
measured reliably then that property must continue to be measured at cost even
if its fair value can be determined subsequently. In this particular case IAS 40
prohibits the move from cost to fair value.
Cost model for investment property
The cost model follows the provisions of IAS 16. The property is measured at
cost less accumulated depreciation (related to the non-land element) and less
impairment loss if any.
Example: Accounting for investment property
On 1 January Year 1 Entity P purchased a building for its investment potential.
The building cost Rs. 1 million with transaction costs of Rs. 10,000.
The depreciable amount of the building component of the property at this date
was Rs. 300,000.
The property has a useful life of 50 years.
At the end of Year 1 the propertys fair value had risen to Rs. 1.3 million.
The amounts which would be included in the financial statements of Entity P at
31 December Year 1, under the cost model are as follows:
Cost model
The property will be included in the statement of financial position as follows:
Rs.
Cost (1,000,000 + 10,000)
1,010,000
Accumulated depreciation (300,000 50 years)
(6,000)
Carrying amount
1,004,000

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The statement of profit or loss will include depreciation of Rs. 6,000.

The amounts which would be included in the financial statements of Entity P at
31 December Year 1, under the fair value model are as follows:
Fair value model
The property will be included in the statement of financial position at its fair value
of Rs. 1,300,000.
The statement of profit or loss will include a gain of Rs. 290,000 (Rs. 1,300,000
Rs. 1,010,000) in respect of the fair value adjustment.

3.3 Why investment properties are treated differently from other properties
Most properties are held to be used directly or indirectly in the entitys business.
For example, a factory houses plant and equipment which is used to produce
goods for sale. The property is being consumed and it is appropriate to
depreciate it over its useful life.
An investment property is held primarily because it is expected to increase in
value. It generates economic benefits for the entity because it will eventually be
sold at a profit. An investment property also differs from other properties because
it generates revenue and cash flows largely independently of other assets held
by an entity.
The most relevant information about an investment property is its fair value (the
amount for which it could be sold). Depreciation is largely irrelevant. Therefore it
is appropriate to re-measure an investment property to fair value each year and
to recognise gains and losses in profit or loss for the period.

3.4 Transfers and disposals of investment property

If a property is transferred into or out of this category it must be reclassified as an
investment property or as no longer being an investment property. A transfer of
investment property can only be made where there is a change of use as
illustrated below.
Circumstance
Commenceme
nt of owneroccupation
End of owneroccupation

Transfer from/to
Transfer from
investment property to
owner-occupied property
Transfer from owneroccupied property to
investment property

Commenceme
nt of
development
with a view to
sale
Commenceme
nt of an
operating lease
to another
party

Transfer from
investment property to
inventories

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Deemed transfer value

Fair value at the date of change of
use becomes the deemed cost for
future accounting purposes
Where investment properties are
measured at fair value, revalue in
accordance with IAS 16 prior to
the transfer
Fair value at the date of change of
use becomes the deemed cost for
future accounting purposes

Fair value at the date of the

transfer, and any difference
compared to previous carrying
amount is recognised in profit or
loss
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Gain or loss on disposal

Gains or losses on disposals of investment properties are included in profit or
loss in the period in which the disposal occurs.
Example: Disposal of investment property
The investment property in the previous example was sold early in Year 2 for Rs.
1,550,000,
Selling costs were Rs. 50,000.

The amount that would be included in the statement of profit or loss for Year 2 in
respect of this disposal under the cost model is as follows:
Cost model
Sale value

Rs.
1,550,000

Selling costs

(50,000)

Net disposal proceeds

Minus: Carrying amount

1,500,000
(1,004,000)

Gain on disposal

496,000

The amount that would be included in the statement of profit or loss for Year 2 in
respect of this disposal under the fair value model is as follows:
(F
Fair value model
Sale value
Selling costs

Rs.
1,550,000
(50,000)

Net disposal proceeds

Minus: Carrying amount

1,500,000
(1,300,000)

Gain on disposal

200,000

3.5 Disclosure requirements

The following disclosures are required by IAS 40 in the notes to the accounts.
Disclosure requirements applicable to both the fair value model and the cost model

whether the fair value model or the cost model is used

the methods and assumptions applied in arriving at fair values

the extent to which the fair value of investment property was based on a
valuation by a qualified, independent valuer with relevant, recent
experience

amounts recognised in income or expense in the statement of profit or loss

for:
x

rental income from investment property

operating expenses in relation to investment property

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details of any restrictions on the ability to realise investment property or any

restrictions on the remittance of income or disposal proceeds

the existence of any contractual obligation to purchase, construct or

develop investment property or for repairs, maintenance or enhancements.

Disclosure requirements applicable to the fair value model only

There must be a reconciliation, in a note to the financial statements, between
opening and closing values for investment property, showing:

additions during the year

assets classified as held for sale in accordance with IFRS 5

net gains or losses from fair value adjustments

acquisitions through business combinations

This reconciliation should show separately any amounts in respect of investment

properties included at cost because their fair values cannot be estimated reliably.
For investment properties included at cost because fair values cannot be
estimated reliably, the following should also be disclosed:

a description of the property

an explanation as to why fair values cannot be determined reliably

if possible, the range within which the propertys fair value is likely to lie.

Disclosure requirements applicable to the cost model only

the depreciation methods used

the useful lives or depreciation rates used

gross carrying amounts and accumulated depreciation at the beginning and

at the end of the period

A reconciliation between opening and closing values showing:

x

additions

depreciation

assets classified as held for sale in accordance with IFRS 5

acquisitions through business combinations

impairment losses

transfers.

When the cost model is used, the fair value of investment property should also be
disclosed. If the fair value cannot be estimated reliably, the same additional
disclosures should be made as under the fair value model.

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

The amounts could be reflected in the financial statements prepared at the end of Year
1 in accordance with IAS 20 in the following ways:
Method 1:
Statement of financial position
Property, plant and equipment
Cost (500,000 100,000)
Accumulated depreciation

Rs.
400,000
(80,000)

Carrying amount

320,000

Included in statement of profit or loss

Rs.
80,000

Depreciation charge (Rs. 400,000/5 years)

Method 2:
Statement of financial position
Rs.
Property, plant and equipment
Cost

500,000

Accumulated depreciation

(100,000)

Carrying amount

400,000

Current liabilities
Deferred income

20,000

Non--current liabilities
60,000

Deferred income

At the end of year 1 there would be Rs. 80,000 of the grant left to recognise
in profit in the future at Rs. 20,000 per annum. Rs. 20,000 would be
recognised in the next year and is therefore current. The balance is noncurrent.
Rs.
Included in statement of profit or loss
Expense: Depreciation charge (Rs. 500,000/5 years)

Income: Government grant (Rs. 100,000/5 years)

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

IAS 38: Intangible assets

Contents
1 IAS 38: Intangible assets Introduction
2 Internally-generated intangible assets
3 Intangible assets acquired in a business combination
4 Measurement after initial recognition
5 Disclosure requirements

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 29

IAS 38: Intangible assets

B (a) 57

SIC 32: Intangible Assets web site costs

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IAS 38: INTANGIBLE ASSETS - INTRODUCTION

Section overview

Introduction
Scope of IAS 38

Definition of an intangible asset

Recognition criteria for intangible assets

Separate acquisition
Exchange transactions

Granted by government

Subsequent expenditure on intangible assets

1.1 Introduction
IAS 38: Intangible assets sets out rules on the recognition, measurement and
disclosure of intangible assets.
IAS 38 establishes similar rules for intangible assets to those set out elsewhere
(mainly in IAS 16) for tangible assets. It was developed from the viewpoint that
an asset is an asset so there should be no real difference in how tangible and
intangible assets are accounted for. However, there is an acknowledgement that
it can be more difficult to identify the existence of an intangible asset so IAS 38
gives broader guidance on how to do this when an intangible asset is acquired
through a variety of means.
IAS 38:

requires intangible assets to be recognised in the financial statements if,

and only if, specified criteria are met and explains how these are applied
however an intangible asset is acquired.
x

A key issue with expenditure on intangible items is whether it should

be treated as an expense and included in full in profit or loss for the
period in which incurred, or whether it should be capitalised and
treated as a long-term asset.

IAS 38 sets out criteria to determine which of these treatments is

appropriate in given circumstances.

explains how to measure the carrying amount of intangibles assets when

they are first recognised and how to measure them at subsequent reporting
dates;
x

Most types of long-term intangible asset are amortised over their

expected useful life. (Amortisation of intangible assets is the
equivalent of depreciation of tangible non-current assets.)

sets out disclosure requirements for intangible assets in the financial

statements.

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1.2 Scope of IAS 38

IAS 38 applies to all intangible assets, except those that are within the scope of
another standard. For example, IAS 38 does not apply to the following:

intangible assets held by an entity for sale in the ordinary course of

business (IAS 2: Inventories);

deferred tax assets (IAS 12: Income taxes);

leases that are within the scope of IAS 17: Leases;

assets arising from employee benefits (IAS 19: Employee Benefits);

financial assets (as defined in IAS 32: Financial assets: presentation);

financial assets recognised and measured in accordance with IFRS 10:

Consolidated financial statements, IAS 27: Separate financial statements
and IAS 28: Investments in associates and joint ventures;

goodwill acquired in a business combination (IFRS 3: Business

combinations);

deferred acquisition costs, and intangible assets, arising from an insurers

contractual rights under insurance contracts within the scope of IFRS 4:
Insurance contracts (but note that the IAS 38 disclosure requirements do
apply to those intangible assets);

non-current intangible assets classified as held for sale (or included in a

disposal group that is classified as held for sale) (IFRS 5: Non-current
assets held for sale and discontinued operations); and

assets arising from contracts with customers that are recognised in

accordance with IFRS 15: Revenue from contracts with customers.

In addition the following are also excluded specifically from the scope of IAS 38:

the recognition and measurement of exploration and evaluation assets (see

IFRS 6: Exploration for and evaluation of mineral resources); and

expenditure on the development and extraction of minerals, oil, natural gas

and similar non-regenerative resources.

1.3 Definition of an intangible asset

Definitions
An asset: A resource controlled by the company as a result of past events and from
which future economic benefits are expected to flow.
Intangible asset: An identifiable, non-monetary asset without physical substance
An intangible asset is a type of asset. Therefore expenditure on an intangible
item must satisfy both definitions before it can be considered to be an asset.
Commentary on the definitions
Control
Control means that a company has the power to obtain the future economic
benefits flowing from the underlying resource and also can restrict the access of
others to those benefits.

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Control would usually arise where there are legal rights, for example legal rights
over the use of patents or copyrights. Ownership of legal rights would indicate
control over them. However, legal enforceability is not a necessary condition for
control.
For tangible assets such as property, plant and equipment the asset physically
exists and the company controls it. However, in the case of an intangible asset,
control may be harder to achieve or prove.
Some companies have tried to capitalise intangibles such as the costs of staff
training or customer lists on the basis that they provide access to future
economic benefits. However, these would not be assets as they are not
controlled.

Staff training: Staff training creates skills that could be seen as an asset for
the employer. However, staff could leave their employment at any time,
taking with them the skills they have acquired through training.

Customer lists: Similarly, control is not achieved by the acquisition of a

customer list, since most customers have no obligation to make future
purchases. They could take their business elsewhere.

Future economic benefits

These may include revenues and/or cost savings.
Evidence of the probability that economic benefits will flow to the company may
come from:

market research;

feasibility studies; and,

a business plan showing the technical, financial and other resources

needed and how the company will obtain them.

Need to be identifiable
An intangible asset must also be identifiable. Intangibles, by their very nature,
do not physically exist. It is therefore important that this identifiability test is
satisfied.
IAS 38 states that to be identifiable an intangible asset:

must be separable; or

must arise from contractual or other legal rights.

To be separable, the intangible must be capable of being separated or divided

from the company, and sold, transferred, licensed, rented or exchanged.
Many typical intangibles such as patent rights, copyrights and purchased brands
would meet this test, (although they might fail other recognition criteria for an
intangible asset).
Without physical substance
Non-physical form increases the difficulty of identifying the asset.
Certain intangible assets may be contained in or upon an article which has
physical substance (e.g. floppy disc). Whether such assets are treated as
tangible or intangible requires judgement. This judgement is based on which
element is the most significant.

Computer software for a computer controlled machine tool that cannot

operate without that specific software is an integral part of the related

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hardware and it is treated as property, plant and equipment. The same

applies to the operating system of a computer.

Computer software, other than the operating system, is an intangible asset.

The same applies to licences, patents or motion picture films acquired or
internally generated by the reporting company.

Identifiable assets that result from research and development activities (such as
a prototype) are intangible assets because any physical (tangible) element of
those assets is secondary to the knowledge (intangible element) that is the
primary outcome of those activities.

1.4 Recognition criteria for intangible assets

Introduction
If an intangible item satisfies the definitions it is not necessarily recognised in the
financial statements. In order to be recognised it must satisfy the recognition
criteria for intangible assets.
If an item meets the definitions of being an asset, and being intangible, certain
recognition criteria must be applied to decide whether the item should be
recognised as an intangible asset.
Recognition
An intangible asset is recognised when it:

complies with the definition of an intangible asset; and,

meets the recognition criteria set out in the standard.

Recognition criteria
An intangible asset must be recognised if (and only if):

it is probable that future economic benefits specifically attributable to the

asset will flow to the company; and,

the cost of the asset can be measured reliably.

The probability of future economic benefits must be assessed using reasonable

and supportable assumptions that represent managements best estimate of the
set of economic conditions that will exist over the useful life of the asset.
These recognition criteria are broadly the same as those specified in IAS 16 for
tangible non-current assets.
Measurement
An intangible asset must be measured at cost when first recognised.
Means of acquiring intangible assets
A company might obtain control over an intangible resource in a number of ways.
Intangible assets might be:

purchased separately;

acquired in exchange for another asset;

given to a company by way of a government grant.

internally generated; or

acquired in a business combination;

IAS 38 provides extra guidance on how the recognition criteria are to be applied
and/or how the asset is to be measured in each circumstance.

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1.5 Separate acquisition

Recognition guidance
The probability recognition criterion is always satisfied for separately acquired
intangible assets.
The price paid to acquire separately an intangible asset normally reflects
expectations about the probability that the future economic benefits embodied in
the asset will flow to the company. The effect of the probability is reflected in the
cost of the asset.
Also the cost of a separately acquired intangible asset can usually be measured
reliably especially when the purchase consideration is in the form of cash or other
monetary assets.
Cost guidance
Cost is determined according to the same principles applied in accounting for
other assets.
The cost of a separately acquired intangible asset comprises:

its purchase price, including any import duties and non-refundable

purchase taxes, after deducting any trade discounts and rebates; and

any directly attributable expenditure on preparing the asset for its intended
use. For example:
x

costs of employee benefits (as defined in IAS 19, Employee Benefits)

arising directly from bringing the asset to its working condition;

professional fees for legal services; and

costs of testing whether the asset is functioning properly.

The recognition of costs ceases when the intangible asset is in the condition
necessary for it to be capable of operating in the manner intended by
management.
Deferred payments are included at the cash price equivalent and the difference
between this amount and the payments made are treated as interest.

1.6 Exchange transactions

An intangible asset may be acquired in exchange or part exchange for another
intangible asset or another asset.
The cost of such items is measured at fair value unless:

the exchange transaction lacks commercial substance; or,

the fair value of neither the asset received nor the asset given up is reliably
measurable.

If the acquired item is not measured at fair value it is measured at the carrying
amount of the asset given up.
Note, that these rules are the same as those described for tangible assets in an
earlier chapter.

1.7 Granted by government

A government might transfer or allocate an intangible asset to an entity.
Examples of such assets include airport landing rights, licences to operate radio

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or television stations, import licences or quotas or rights to access other restricted

resources.
An intangible asset may be acquired free of charge, or for nominal consideration,
by way of a government grant.
IAS 20: Accounting for Government Grants and Disclosure of Government
Assistance, allows the intangible asset and the grant to be recorded at fair value
initially or at a nominal amount plus any expenditure that is directly attributable to
preparing the asset for its intended use.

1.8 Subsequent expenditure on intangible assets

Subsequent expenditure is only capitalised if it can be measured and attributed to
an asset and enhances the value of the asset. This would rarely be the case:

The nature of intangible assets is such that, in many cases, there are no
additions to such an asset or replacements of part of it.

Most subsequent expenditure is likely to maintain the expected future

economic benefits embodied in an existing intangible asset rather than
meet the definition of an intangible asset and the recognition criteria.

Also it is often difficult to attribute subsequent expenditure directly to a

particular intangible asset rather than to the business as a whole.

Maintenance expenditure is expensed.

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INTERNALLY GENERATED INTANGIBLE ASSETS

Section overview

Internally-generated intangible items

Research and development

Accounting treatment of development costs

SIC 32: Intangible assets Web site costs

2.1 Internally-generated intangible items

An internally-generated intangible asset is an asset created by a company
through its own efforts. (An internally-generated asset differs from an acquired
asset that has been purchased from an external seller.) For example, a
publishing company may build up legal copyrights by publishing books.
It can sometimes be difficult for a company to assess whether an internallygenerated asset qualifies for recognition as an asset in the financial statements
because:

it is not identifiable: or

its cost cannot be determined reliably.

Recognition prohibited
IAS 38 prohibits the recognition of the following internally-generated intangible
items:

goodwill;

brands;

mastheads (Note: a masthead is a recognisable title, usually in a distinctive

typographical form, appearing at the top of an item. An example is a
newspaper masthead on the front page of a daily newspaper);

publishing titles; and

customer lists.

Recognition of these items as intangible assets when they are generated

internally is prohibited because the internal costs of producing these items cannot
be distinguished separately from the costs of developing and operating the
business as a whole.
Note that any of these items would be recognised if they were purchased
separately.
Other internally generated intangibles
IAS 38 provides further guidance on how to assess whether other internally
generated intangibles assets meet the criteria for recognition.

2.2 Research and development

The term research and development is commonly used to describe work on the
innovation, design, development and testing of new products, processes and
systems.

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Assessment of whether an internally generated intangible asset meets the criteria

for recognition requires a company to classify the generation of the asset into:

a research phase; and

a development phase.

If the research phase cannot be distinguished from the development phase the
expenditure on the project is all treated as that incurred on the research phase.
Research phase
Definition: Research
Research is original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
Examples of research activities include:

Activities aimed at obtaining new knowledge.

The search for and evaluation of applications of knowledge obtained from

research.

The search for alternative materials, products or processes.

The formulation and testing of possible alternatives for new materials,

products or processes.

Research costs cannot be an intangible asset. Expenditure on research should

be recognised as an expense as it is incurred and included in profit or loss for the
period.
Development phase
Definition: Development
Development is the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial production
or use.
Examples of development activities include:

The design, construction and testing of pre-production prototypes and

models.

The design of tolls involving new technology.

The construction and operation of a pilot plant that is not large enough for
economic commercial production.

The design, construction and testing of new materials, products or

processes.

2.3 Accounting treatment of development costs

Development costs are capitalised when they meet certain further criteria. (These
comprise more detailed guidance on whether it is probable that future economic
benefits from the asset will flow to the entity and whether the cost can be
measured reliably).
Development costs must be recognised as an intangible asset, but only if all the
following conditions can be demonstrated.

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It is technically feasible to complete the development project.

The company intends to complete the development of the asset and then
use or sell it.

The asset that is being developed is capable of being used or sold.

Future economic benefits can be generated. This might be proved by the

existence of a market for the assets output or the usefulness of the asset
within the company itself.

Resources are available to complete the development project.

The development expenditure can be measured reliably (for example, via

costing records).

If any one of these conditions is not met, the development expenditure must be
treated in the same way as research costs and recognised in full as an expense
when it is incurred.
Only expenditure incurred after all the conditions have been met can be
capitalised.
Once such expenditure has been written off as an expense, it cannot
subsequently be reinstated as an intangible asset.
Example: Accounting treatment of development costs
Company Q has undertaken the development of a new product. Total costs to date
have been Rs. 800,000. All of the conditions for recognising the development costs
as an intangible asset have now been met.
However, Rs. 200,000 of the Rs. 800,000 was spent before it became clear that
the project was technically feasible, could be resourced and the developed product
would be saleable and profitable.
Development costs.
The Rs. 200,000 incurred before all of the conditions for recognising the
development costs as an intangible asset were met must be written off as an
expense.
The remaining Rs. 600,000 should be capitalised and recognised as an intangible
asset (development costs).
Initial measurement
The cost of an internally generated intangible asset is the sum of expenditure
incurred from the date when the intangible asset first meets the recognition
criteria for such assets.
Expenditure recognised as an expense in previous annual financial statements or
interim financial reports may not be capitalised.
The cost of an internally generated intangible asset comprises all expenditure
that can be directly attributed, and is necessary to creating, producing, and
preparing the asset for it to be capable of operating in the manner intended by
management.
Where applicable cost includes:

expenditure on materials and services used or consumed;

the salaries, wages and other employment related costs of personnel

directly engaged in generating the asset; and

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any expenditure that is directly attributable to generating the asset.

In addition, IAS 23 specifies criteria for the recognition of interest as an element

of the cost of an internally generated intangible asset. The IAS 23 guidance was
covered in the previous chapter.
Costs that are not components of cost of an internally generated intangible asset
include:

selling and administration overhead costs;

initial operating losses incurred;

costs that have previously been expensed, (e.g., during a research phase)
must not be reinstated; and,

training expenditure.

2.4 SIC 32: Intangible assets Web site costs

Issue
An entity may incur expenditure on the development and operation of its own
web site for internal or external access.
The issues are:

whether the web site is an internally generated intangible asset that is

subject to the requirements of IAS 38; and

the appropriate accounting treatment of such expenditure.

SIC 32 does not apply to expenditure on

purchasing, developing, and operating hardware (e.g. web servers, staging

servers, production servers and internet connections). IAS 16 applies.

an internet service provider hosting the entitys web site. (This expenditure
is recognised as an expense as and when the services are received).

the development or operation of a web site for sale to another entity.

SIC 32 must be applied by the:

lessor of web site when it is leased under an operating lease, and

lessee of the web site when it is leased under a finance lease.

The operating stage begins once development of a web site has been completed.
During this stage, an entity maintains and enhances the applications,
infrastructure, graphical design and content of the web site.
Consensus
An entitys own web site is an internally generated intangible asset that is subject
to the requirements of IAS 38. It should be recognised as an intangible asset if it
satisfies the IAS 38 recognition criteria.
If a web site is developed solely (or primarily) for promoting and advertising its
own products and services then an entity will not be able to demonstrate how it
will generate probable future economic benefits. All expenditure on developing
such a web site should be recognised as an expense when incurred.
The nature of each activity for which expenditure is incurred (e.g. training
employees and maintaining the web site) and the web sites stage of
development or post development should be evaluated to determine the
appropriate accounting treatment
The best estimate of a web sites useful life should be short.

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SIC 32 identifies several stages in the development of a website and provides

guidance on the accounting treatment that is appropriate for each stage.
Stage

Activities

Accounting treatment

Planning
(This stage is
similar in nature
to the research
phase)

Feasibility studies

Expense when incurred

Defining hardware and software

specifications
Evaluating alternative products
and suppliers
Selecting preferences

Application
and
infrastructure
development*
(This stage is
similar in nature
to the
development
phase)

Obtaining a domain name

Developing operating software
(e.g. operating system and
server software)
Developing code for the
application
Installing developed applications
on the web server
Stress testing

Expense when incurred,

unless the expenditure
meets the IAS 38
recognition criteria.

Graphical
design
development*

Designing the appearance of

web pages

See above

Content
development*

Creating, purchasing, preparing

and uploading information on the
web site before the completion of
the web sites development.

See above

Operating

Updating graphics and revising

content
Adding new functions, features
and content
Registering the web site with
search engines
Backing up data
Reviewing security access
Analysing usage of the web site

Expense when incurred,

unless it meets the IAS
38 criteria for the
capitalisation of
subsequent expenditure
(this will only occur in
rare circumstances).

Other

Selling, administrative and other

general overhead expenditure
unless it can be directly
attributed to preparing the web
site for use
Inefficiencies and initial
operating losses incurred
Training employees to operate
the web site

Expense when incurred

* These will be capitalised only when the purpose of building a website is solely
promotion of the business (marketing purpose).

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INTANGIBLE ASSETS ACQUIRED IN A BUSINESS COMBINATION

Section overview

Recognition guidance

Cost guidance

In-process research and development

This section relates to intangible assets acquired when a company (the acquirer)
buys a controlling interest in another company (the acquiree). The section largely
relates to the recognition of intangibles in the consolidated financial statements of
the parent.

3.1 Recognition guidance

Any intangible asset identified in a business combination will be recognised as
both recognition criteria are deemed to be met.
The probability recognition criterion always considered to be satisfied for
intangible assets acquired in business combinations. This is because the fair
value of an intangible asset reflects expectations about the probability that the
expected future economic benefits embodied in the asset will flow to the
company. In other words, the entity expects there to be an inflow of economic
benefits.
The reliable measurement criterion is always considered to be satisfied for
intangible assets acquired in business combinations. If an asset acquired in a
business combination is separable or arises from contractual or other legal rights,
sufficient information exists to measure reliably the fair value of the asset.
Commentary
This means that an intangible asset that was not recognised in the financial
statements of the new subsidiary might be recognised in the consolidated
financial statements.
Illustration: Recognition
Company X buys 100% of Company Y.
Company Y owns a famous brand that it launched several years ago.
Analysis
The brand is not recognised in Company Ys financial statements (IAS 38 prohibits
the recognition of internally generated brands).
From the Company X group viewpoint the brand is a purchased asset. Part of the
consideration paid by Company X to buy Company Y was to buy the brand and it
should be recognised in the consolidated financial statements. (This will reduce the
amount of goodwill that would otherwise have been recognised).
Examples of intangible assets
The following are all items that would meet the definition of an intangible asset if
acquired in a business combination.

Market related intangibles

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Trademarks, trade names, service marks, collective marks and

certification marks;

Internet domain names;

Newspaper mastheads; and

Non-competition agreements

Customer related intangibles

x

Customer lists;

Order or production backlog;

Customer contracts and the related customer relationships; and

Artistic related intangibles

x

Plays, operas and ballets;

Books, magazines, newspapers and other literary works;

Musical works (compositions, song lyrics and advertising jingles);

Pictures and photographs; and

Video and audio visual material:

Music videos; and

Television programmes

Contract based intangibles

x

Licensing and royalty agreements;

Construction permits;

Franchise agreements

Operating and broadcasting rights;

Use rights such as drilling, water, air, mineral, timber-cutting and

route authorities;

Technology based intangibles

x

Patented and unpatented technology;

Computer software and databases; and

Trade secrets (secret formulas, processes, recipes)

3.2 Cost guidance

If an intangible asset is acquired in a business combination, its cost is the fair
value at the acquisition date.
If cost cannot be measured reliably then the asset will be subsumed within
goodwill.

3.3 In-process research and development

Another similar example involves in-process research and development
The acquiree might have a research and development project in process.
Furthermore, it might not recognise an asset for the project because the
recognition criteria for internally generated intangible assets have not been met.

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However, the acquirer would recognise the in-process research and development
as an asset in the consolidated financial statements as long as it:

meets the definition of an asset; and

is identifiable, i.e. is separable or arises from contractual or other legal

rights.

Illustration: In-process research and development

Company X buys 100% of Company Y.
Company Y has spent Rs. 600,000 on a research and development project. This
amount has all been expensed as the IAS 38 criteria for capitalising costs incurred
in the development phase of a project have not been met. Company Y has
knowhow as the result of the project.
Company X estimates the fair value of Company Ys knowhow which has arisen as
a result of this project to be Rs. 500,000.
Analysis
The in-process research and development is not recognised in Company Ys
financial statements because the recognition criteria have not been met.
From the Company X group viewpoint the in-process research and development is
a purchased asset. Part of the consideration paid by Company X to buy Company Y
was to buy the knowhow resulting from the project and it should be recognised in
the consolidated financial statements at its fair value of Rs. 500,000.
Subsequent expenditure on an acquired in-process research and development
project
Subsequent expenditure incurred on an in-process research or development
project acquired separately or in a business combination and recognised as an
intangible asset is accounted for in the usual way by applying the IAS 38
recognition criteria.
This means that further expenditure on such a project would not be capitalised
unless the criteria for the recognition of internally generated intangible assets
were met.
Illustration: Subsequent expenditure on acquired in-process R and D
Continuing the previous example.
Company X owns 100% of Company Y and has recognised an intangible asset of
Rs. 500,000 as a result of the acquisition of the company.
Company Y has spent a further Rs. 150,000 on the research and development
project since the date of acquisition. This amount has all been expensed as the IAS
38 criteria for capitalising costs incurred in the development phase of a project
have not been met.
Analysis
The Rs. 150,000 expenditure is not recognised in Company Ys financial
statements (IAS 38 prohibits the recognition of internally generated brands).
From the Company X group viewpoint, further work on the in-process research and
development project is research and the expenditure of Rs. 150,000 must be
expensed.

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MEASUREMENT AFTER INITIAL RECOGNITION

Section overview

Choice of policy
Revaluation model

Amortisation of intangible assets

Disposals of intangible assets

4.1 Choice of policy

Intangible assets are recognised at cost when first acquired.
IAS 38 allows a business to choose one of two measurement models as its
accounting policy for intangible assets after acquisition. The same model should
be applied to all assets in the same class.
The two measurement models for intangible assets after acquisition are:

cost model (i.e. cost less accumulated amortisation and accumulated

impairment losses); and

revaluation model (i.e. revalued amount less accumulated amortisation and

accumulated impairment losses since the most recent revaluation).

Class of assets
The same model should be applied to all assets in the same class. A class of
intangible assets is a grouping of assets of a similar nature and use in an entitys
operations. Examples of separate classes may include:

brand names;

mastheads and publishing titles;

computer software;

licences and franchises;

copyrights, patents and other industrial property rights, service and

operating rights;

recipes, formulae, models, designs and prototypes; and

intangible assets under development.

Cost model
An intangible asset is carried at its cost less any accumulated amortisation and
any accumulated impairment losses after initial recognition.

4.2 Revaluation model

Intangible assets can be revalued according to the same rules as those applied
to the revaluation of property, plant and equipment. These were explained in
detail in the previous chapter so will be covered in less detail here.
An intangible asset is carried at a revalued amount which is its fair value at the
date of the revaluation less any subsequent accumulated amortisation and any
accumulated impairment losses.
This is only allowed if the fair value can be determined by reference to an active
market in that type of intangible asset.

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Definition: Active market

An active market is a market in which all the following conditions exist:
(a)

the items traded in the market are homogeneous;

(b)

willing buyers and sellers can normally be found at any time; and

(c)

prices are available to the public.

Active markets for intangible assets are rare. Very few companies revalue
intangible assets in practice.
The requirement that intangible assets can only be revalued with reference to an
active market is a key difference between the IAS 16 revaluation rules for
property, plant and equipment and the IAS 38 revaluation rules for intangible
assets.
An active market for an intangible asset might disappear. If the fair value of a
revalued intangible asset can no longer be measured by reference to an active
market the carrying amount of the asset going forward is its revalued amount at
the date of the last revaluation less any subsequent accumulated amortisation
and impairment losses.
Frequency of revaluations
Revaluations must be made with sufficient regularity so that the carrying amount
does not differ materially from its fair value at the reporting date.
The frequency of revaluations should depend on the volatility in the value of the
assets concerned. When the value of assets is subject to significant changes
(high volatility), annual revaluations may be necessary.
However, such frequent revaluations are unnecessary for items subject to only
insignificant changes in fair value. In such cases it may be necessary to revalue
the item only every three or five years.
Changing the carrying amount of the asset
When an intangible asset is revalued, any accumulated amortisation at the date
of the revaluation is treated in one of the following ways:
Method 1: Restate accumulated amortisation proportionately with the change in
the gross carrying amount of the asset so that the carrying amount of the asset
after revaluation equals its revalued amount.
Method 2:

Step 1: Transfer the accumulated amortisation to the asset account. The

result of this is that the balance on the asset account is now the carrying
amount of the asset and the accumulated amortisation account in respect
of this asset is zero.

Step 2: Change the balance on the asset account to the revalued amount.

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Accounting for the revaluation

The revaluation is carried out according to the same principles applied in
accounting for other assets.
IAS 38
Upwards
revaluations

Recognised in other comprehensive income and accumulated in

equity under the heading of revaluation surplus.

However:

An increase is recognised in profit or loss to the extent that it

reverses a revaluation decrease of the same asset previously
recognised in profit or loss.

Downward
revaluations

Recognised in profit or loss.

However:

A decrease is recognised in other comprehensive income to the

extent of any credit balance in the revaluation surplus in respect
of that asset thus reducing the amount accumulated in equity
under the heading of revaluation surplus.

Realisation of the revaluation surplus

Most intangible assets eventually disappear from the statement of financial
position either by becoming fully amortised or because the company sells them.
If nothing were done this would mean that there was a revaluation surplus on the
face of the statement of financial position that related to an asset that was no
longer owned.
IAS 38 allows (but does not require) the transfer of a revaluation surplus to
retained earnings when the asset to which it relates is derecognised (realised).
This might happen over several years as the asset is depreciated or at a point in
time when the asset is sold.
Revaluation of an asset causes an increase in the annual amortisation charge.
The difference is known as excess amortisation (or incremental amortisation):
Excess amortisation is the difference between:

the amortisation charge on the re-valued amount of the asset, and

the amortisation that would have been charged on historical cost.

Each year a business might make a transfer from the revaluation surplus to the
retained profits equal to the amount of the excess amortisation.

4.3 Amortisation of intangible assets

A company must assess whether the useful life of an intangible asset is:

finite: or

indefinite.

If the useful life of an intangible asset is assessed as being finite the company
must assess its useful life.
An intangible asset is assessed as having an indefinite useful life when (based
on an analysis of all of the relevant factors) there is no foreseeable limit to the
period over which the asset is expected to generate net cash inflows.

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Intangibles with a finite useful life

The depreciable amount of an intangible asset with a finite useful life is allocated
on a systematic basis over its useful life.
Amortisation begins when the asset is available for use, i.e. when it is in the
location and condition necessary for it to be capable of operating in the manner
intended by management.
Amortisation ends at the earlier of the date that the asset is classified as held for
sale in accordance with IFRS 5 and the date that the asset is derecognised.
The amortisation method used must reflect the pattern in which the asset's future
economic benefits are expected to be consumed by the entity. If that pattern
cannot be determined reliably, the straight-line method must be used.
There is a rebuttable presumption that an amortisation method based on revenue
generated by an activity that includes the use of an intangible asset is
inappropriate.
The residual value of an intangible asset must be assumed to be zero unless:

there is a commitment by a third party to purchase the asset at the end of

its useful life; or

there is an active market for the asset and:

x

residual value can be determined by reference to that market; and

it is probable that such a market will exist at the end of the asset's
useful life.

The amortisation period and the amortisation method must be reviewed at least
at each financial year-end.

Where there is a change in the useful life, the carrying amount (cost minus
accumulated amortisation) of the asset at the date of change is written off
over the (revised) remaining useful life of the asset.

Where there is a change in the amortisation method used, this is a change

in accounting estimate. A change of accounting estimate is applied from the
time of the change, and is not applied retrospectively. The carrying amount
(cost minus accumulated amortisation) of the asset at the date of the
change is written off over the remaining useful life of the asset.

Intangibles with an indefinite useful life

Where the useful life is assessed as indefinite:

the intangible asset should not be amortised; but

impairment reviews should be carried out annually (or even more frequently
if there are any indications of impairment).

The useful life of an intangible asset that is not being amortised must be
reviewed each period to determine whether events and circumstances continue
to support an indefinite useful life assessment for that asset.
If they do not, the change in the useful life assessment from indefinite to finite is
accounted for as a change in an accounting estimate in accordance with IAS 8.
This means that the carrying amount at the date of the change is amortised over
the estimated useful life from that date.

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4.4 Disposals of intangible assets

The rules for de-recognition of intangible assets (accounting for their disposal)
are the same as for property, plant and equipment under IAS 16. There is a gain
or loss on disposal equal to the difference between the net disposal proceeds
and the carrying value of the asset at the time of disposal.

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DISCLOSURE REQUIREMENTS
Section overview

Disclosure requirements

Accounting policies

5.1 Disclosure requirements

In the financial statements, disclosures should be made separately for each class
of intangible asset. (Within each class, disclosures must also be made by
internally-generated intangibles and other intangibles, where both are
recognised.)
Most of the disclosure requirements are the same as for tangible non-current
assets in IAS 16. The only additional disclosure requirements are set out below.

Whether the useful lives of the assets are finite or indefinite.

If the useful lives are finite, the useful lives or amortisation rates used.

If the useful lives are indefinite, the carrying amount of the asset and the
reasons supporting the assessment that the asset has an indefinite useful
life.

For any intangible asset that is individually material to the financial

statements, the following disclosure is required:

a description

its carrying amount

the remaining amortisation period.

The total amount of research and development expenditure written off (as
an expense) during the period must also be disclosed.

5.2 Accounting policies

IAS 1 requires the disclosure of accounting policies used that are relevant to an
understanding of the financial statements. Property, plant and equipment is often
includes the largest numbers in the statement of financial position and the results
in significant expense in the statement of comprehensive income.
There are several areas that are important to explain to users of financial
statements.
Amortisation policy
The depreciable amount of an intangible asset must be written off over its useful
life.
Formulating a policy in this area involves estimating the useful lives of different
categories of intangible assets.
Under the guidance in IAS 38 the estimated residual values of an asset would
usually be zero and the straight line method would usually be used.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

IAS 36: Impairment of assets

Contents
1 Impairment of assets
2 Cash generating units
3 Other issues

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 27

IAS 36: Impairment of assets

B (a) 39

IFRIC 10: Interim financial reporting and impairment

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IMPAIRMENT OF ASSETS
Section overview

Objective and scope of IAS 36

Identifying impairment or possible impairment

Measuring recoverable amount

Accounting for impairment

Summary of the approach

1.1 Objective and scope of IAS 36

An asset is said to be impaired when its recoverable amount is less than its
carrying amount in the statement of financial position.
From time to time an asset may have a carrying value that is greater than its fair
value but this is not necessarily impairment as the situation might change in the
future. Impairment means that the asset has suffered a permanent loss in value.
The objective of IAS 36 Impairment of assets is to ensure that assets are
carried (valued) in the financial statements at no more than their recoverable
amount.
Scope of IAS 36
IAS 36 applies to accounting for impairment of all assets except the following:

inventories (IAS 2: Inventories);

assets arising from contracts with customers that are recognised in

accordance with IFRS 15: Revenue from contracts with customers.

deferred tax assets (IAS 12: Income taxes);

assets arising from employee benefits (IAS 19: Employee Benefits);

financial assets (IAS 39: Financial assets: recognition and measurement;

IFRS 9: Financial instruments);

Financial assets recognised and measured in accordance with IFRS 10:

Consolidated financial statements, IAS 27: Separate financial statements
and IAS 28: Investments in associates and joint ventures;

investment property that is measured at fair value (IAS 40: Investment

property);

biological assets related to agricultural activity within the scope of IAS 41:
Agriculture that are measured at fair value less costs to sell;

deferred acquisition costs, and intangible assets, arising from an insurers

contractual rights under insurance contracts within the scope of IFRS 4:
Insurance contracts (but note that the IAS 38 disclosure requirements do
apply to those intangible assets); and

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non-current assets classified as held for sale (or included in a disposal

group that is classified as held for sale) (IFRS 5: Non-current assets held
for sale and discontinued operations).

IAS 36 does apply to financial assets classified as:

subsidiaries (IFRS 10: Consolidated financial statements);

associates (IAS 28: Investments in associates and joint ventures); and

joint ventures (IFRS 11: Joint arrangements).

Recoverable amount of assets

Definitions
The recoverable amount of an asset is defined as the higher of its fair value
minus costs of disposal, and its value in use.
Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.
Value in use is the present value of future cash flows from using an asset,
including its eventual disposal.
Impairment loss is the amount by which the carrying amount of an asset (or a
cash-generating unit) exceeds its recoverable amount.
Cash-generating units will be explained later.
Stages in accounting for an impairment loss
There are various stages in accounting for an impairment loss:
Stage 1: Establish whether there is an indication of impairment.
Stage 2: If so, assess the recoverable amount.
Stage 3: Write down the affected asset (by the amount of the impairment) to its
recoverable amount.
Each of these stages will be considered in turn.

1.2 Identifying impairment or possible impairment

An entity must carry out an impairment review when there is evidence or an
indication that impairment may have occurred. At the end of each reporting
period, an entity should assess whether there is any indication that impairment
might have occurred. If such an indication exists, the entity must estimate the
recoverable amount of the asset, in order to establish whether impairment has
occurred and if so, the amount of the impairment.
Indicators of impairment
The following are given by IAS 36 as possible indicators of impairment. These
may be indicators outside the entity itself (external indicators), such as market
factors and changes in the market. Alternatively, they may be internal indicators
relating to the actual condition of the asset or the conditions of the entitys
business operations.
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When assessing whether there is an indication of impairment, IAS 36 requires

that, at a minimum, the following sources are considered:
External sources

Internal sources

An unexpected decline in the assets

market value.

Evidence that the asset is damaged or

no longer of use to the entity.

Significant changes in technology,

markets, economic factors or laws
and regulations that have an adverse
effect on the company.

There are plans to discontinue or

restructure the operation for which the
asset is currently used.

An increase in interest rates, affecting

the value in use of the asset.

There is a reduction in the assets

expected remaining useful life.

The companys net assets have a

higher carrying value than the
companys market capitalisation
(which suggests that the assets are
over-valued in the statement of
financial position).

There is evidence that the entitys

expected performance is worse than
expected.

If there is an indication that an asset (or cash-generating unit) is impaired then it

is tested for impairment. This involves the calculating the recoverable amount of
the item in question and comparing this to its carrying amount.
Additional requirements for testing for impairment
The following assets must be reviewed for impairment at least annually, even
when there is no evidence of impairment:

an intangible asset with an indefinite useful life; and

goodwill acquired in a business combination.

1.3 Measuring recoverable amount

It has been explained that recoverable amount is the higher of an assets:

fair value less costs of disposal; and

its value in use.

If either of these amounts is higher than the carrying value of the asset, there has
been no impairment.
IAS 36 sets out the requirements for measuring fair value less costs of disposal
and value in use.
Measuring fair value less costs of disposal
Fair value is normally market value. If no active market exists, it may be possible
to estimate the amount that the entity could obtain from the disposal.
Direct selling costs normally include legal costs, taxes and costs necessary to
bring the asset into a condition to be sold. However, redundancy and similar

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costs (for example, where a business is reorganised following the disposal of an

asset) are not direct selling costs.
Calculating value in use
Value in use is a value that represents the present value of the expected future
cash flows from use of the asset, discounted at a suitable discount rate or cost of
capital.
Estimates of future cash flows should be based on reasonable and supportable
assumptions that represent managements best estimate of the economic
conditions that will exist over the remaining useful life of the asset.
Estimates of future cash flows must include:

cash inflows from the continuing use of the asset;

cash outflows that will be necessarily incurred to generate the cash inflows
from continuing use of the asset; and

net disposal proceeds at the end of the assets useful life.

Estimates of future cash flows must not include:

cash inflows or outflows from financing activities; or

income tax receipts or payments.

Also note that future cash flows are estimated for the asset in its current
condition. Therefore, any estimate of future cash flows should not include
estimated future cash flows that are expected to arise from:

a future restructuring to which an entity is not yet committed; or

improving or enhancing the assets performance.

The discount rate must be a pre-tax rate that reflects current market assessments
of:

the time value of money; and

the risks specific to the asset for which the future cash flow estimates have
not been adjusted.

However, both the expected future cash flows and the discount rate might be
adjusted to allow for uncertainty about the future such as the business risk
associated with the asset and expectations of possible variations in the amount
or timing of expected future cash benefits from using the asset.

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Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying
amount of Rs. 300,000.
The machine is used to manufacture the companys best-selling product range,
but the entry of a new competitor to the market has severely affected sales.
As a result, the company believes that the future sales of the product over the
next three years will be only Rs. 150,000, Rs. 100,000 and Rs. 50,000. The asset
will then be sold for Rs. 25,000.
An offer has been received to buy the machine immediately for Rs. 240,000, but
the company would have to pay shipping costs of Rs. 5,000.The risk-free market
rate of interest is 10%.
Market changes indicate that the asset may be impaired and so the recoverable
amount for the asset must be calculated.
Fair value less costs of disposal

Rs.

Fair value

240,000

Costs of disposal

(5,000)
235,000

Year

Cash flow (Rs. 000)

Discount factor

150,000

1/1.1

Present
value
136,364

100,000

1/1.12

82,645

50,000 + 25,000

1/1.13

56,349
275,358

The recoverable amount is the higher of Rs. 235,000 and Rs. 275,358,
i.e. Rs. 275,358.
The asset must be valued at the lower of carrying value and recoverable
amount.
The asset has a carrying value of Rs. 300,000, which is higher than the
recoverable amount from using the asset.
It must therefore be written down to the recoverable amount, and an
impairment of Rs. 24,642 (Rs. 300,000 Rs. 275,358) must be
recognised.

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1.4 Accounting for impairment

The impairment loss is normally recognised immediately in profit or loss.
Example: Measurement of recoverable amount
A company has a machine in its statement of financial position at a carrying
amount of Rs. 300,000.
The machine has been tested for impairment and found to have recoverable
amount of Rs. 275,358 meaning that the company must recognise an
impairment loss of Rs. 24,642.
This is accounted for as follows:
Debit
Statement of profit or loss

Credit

24,642

Accumulated impairment loss

24,642

(Property, plant and equipment would

be presented net of the balance on
this account on the face of the
statement of financial position).

Practice question

On 1 January Year 1 Entity Q purchased for Rs. 240,000 a machine with an

estimated useful life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
On 1 January Year 4 an impairment review showed the machines
recoverable amount to be Rs. 100,000 and its remaining useful life to be
10 years.
Calculate:
a)

The carrying amount of the machine on 31 December Year 3

(immediately before the impairment).

b)

The impairment loss recognised in the year to 31 December Year 4.

c)

The depreciation charge in the year to 31 December Year 4.cc)

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However, an impairment loss recognised in respect of an asset carried at a

previously recognised revaluation surplus is recognised in other comprehensive
income to the extent that it is covered by that surplus. Thus it is treated in the
same way as a downward revaluation, reducing the revaluation reserve balance
relating to that asset in the statement of changes in equity.
Impairment not covered by a previously recognised surplus on the same asset is
recognised in profit or loss.
Example: Measurement of recoverable amount
A company has a machine in its statement of financial position at a carrying
amount of Rs. 300,000 including a previously recognised surplus of Rs. 20,000.
The machine has been tested for impairment and found to have recoverable
amount of Rs. 275,358 meaning that the company must recognise an
impairment loss of Rs. 24,642.
This is accounted for as follows:
Debit
Statement of profit or loss

Credit

4,642

Other comprehensive income

Property, plant and equipment

20,000
24,642

Following the recognition of the impairment, the future depreciation of the asset
must be based on the revised carrying amount, minus the residual value, over
the remaining useful life.
Practice question

On 1 January Year 1 Entity Q purchased for Rs. 240,000 a machine with an

estimated useful life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
The asset had been re-valued on 1 January Year 3 to Rs. 250,000, but with
no change in useful life at that date.
On 1 January Year 4 an impairment review showed the machines
recoverable amount to be Rs. 100,000 and its remaining useful life to be
10 years.
Calculate:
a)

The carrying amount of the machine on 31 December Year 2 and

hence the revaluation surplus arising on 1 January Year 3.

b)

The carrying amount of the machine on 31 December Year 3

(immediately before the impairment).

c)

The impairment loss recognised in the year to 31 December Year 4.

d)

The depreciation charge in the year to 31 December Year 4.

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1.5 Summary of the approach

Impairment of an asset should be identified and accounted for as follows:
(1)

At the end of each reporting period, the entity should assess whether there
are any indications that an asset may be impaired.

(2)

If there are such indications, the entity should estimate the assets
recoverable amount.

(3)

When the recoverable amount is less than the carrying value of the asset,
the entity should reduce the assets carrying value to its recoverable
amount. The amount by which the value of the asset is written down is an
impairment loss.

(4)

This impairment loss is recognised as a loss for the period.

(5)

However, if the impairment loss relates to an asset that has previously

been re-valued upwards, it is first offset against any remaining revaluation
surplus for that asset. When this happens it is reported as other
comprehensive income for the period (a negative value) and not charged
against profit.

(6)

Depreciation charges for the impaired asset in future periods should be

adjusted to allocate the assets revised carrying amount, minus any
residual value, over its remaining useful life (revised if necessary).

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CASH GENERATING UNITS

Section overview

Cash-generating units

Allocating an impairment loss to the assets of a cash-generating unit

2.1 Cash-generating units

It is not always possible to calculate the recoverable amount of individual assets.
Value in use often has to be calculated for groups of assets because assets may
not generate cash flows in isolation from each other. An asset that is potentially
impaired may be part of a larger group of assets which form a cash-generating
unit.
IAS 36 defines a cash-generating unit (CGU) as the smallest identifiable group of
assets that generates cash inflows that are largely independent of the cash
inflows from other assets or groups of assets.
Goodwill
The existence of cash-generating units may be particularly relevant to goodwill
acquired in a business combination. Purchased goodwill must be reviewed for
impairment annually, and the value of goodwill cannot be estimated in isolation.
Often, goodwill relates to a whole business.
It may be possible to allocate purchased goodwill across several cash-generating
units. If allocation is not possible, the impairment review is carried out in two
stages:
1

Carry out an impairment review on each of the cash-generating units

(excluding the goodwill) and recognise any impairment losses that have
arisen.

Then carry out an impairment review for the entity as a whole, including the
goodwill.

This is explained in more detail in Chapter 18: Business combinations and

consolidation (Section 6.2).

2.2 Allocating an impairment loss to the assets of a cash-generating unit

When an impairment loss arises on a cash-generating unit, the impairment loss is
allocated across the assets of the cash-generating unit in the following order:

first, to the goodwill allocated to the cash-generating unit; then

to the other assets in the cash-generating unit, on a pro-rata basis (i.e. in

proportion to the carrying amount of the assets of the cash-generating unit).

However, the carrying amount of an asset cannot be reduced below the highest
of:

its fair value less costs of disposal (if determinable);

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its value in use (if determinable); and

zero.

Example: Allocation of impairment loss in cash-generating unit

A cash-generating unit is made up of the following assets.
Rs. m
Property, plant and equipment
Goodwill
Other assets

90
10
60
160

The recoverable amount of the cash-generating unit has been assessed as Rs.
140 million.
The impairment loss would be allocated across the assets of the cash-generating
unit as follows:
There is a total impairment loss of Rs. 20 million (= Rs. 160m Rs. 140m). Of
this, Rs. 10 million is allocated to goodwill, to write down the goodwill to Rs. 0.
The remaining Rs. 10 million is then allocated to the other assets pro-rata.
Therefore:
Rs. 6 million (= Rs. 10m 90/150) of the impairment loss is allocated to
property, plant and equipment, and
Rs. 4 million (= Rs. 10m 60/150) of the loss is allocated to the other assets
in the unit.
The allocation has the following result:

Property, plant and equipment

Goodwill
Other assets

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Before
loss
Rs. m

Impairment
loss
Rs. m

After
loss
Rs. m

90
10
60

(6)
(10)
(4)

84

56

160

(20)

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OTHER ISSUES
Section overview

Reversal of an impairment loss

IFRIC 10: Interim financial reporting and impairment

IAS 36 disclosure requirements for the impairment of assets

3.1 Reversal of an impairment loss

A company must make an assessment at the end of each reporting period as to
whether a previously recognised impairment should be increased or may no
longer exist. If the loss no longer exists it is reversed subject to the following
guidance.
Any reversal:

must be justifiable, by reference to an improvement in the indicators of

impairment; and

should not lead to a carrying amount in excess of what the carrying amount
of the asset would have been without the recognition of the original
impairment loss.

In allocating a reversal of an impairment loss the carrying amount of an asset

must not be increased above the lower of:

its recoverable amount (if determinable); and

the carrying amount that would have been determined (net of amortisation
or depreciation) had no impairment loss been recognised for the asset in
prior periods.

A reversal should be:

recognised immediately in profit or loss; unless

the original impairment was charged to the revaluation reserve, in which

case the reversal should be credited to the revaluation reserve (and
reported in the same way as a revaluation in other comprehensive income
for the period).

Depreciation charges for future periods should be adjusted to allocate the assets
revised carrying amount, minus any residual value, over its remaining useful life.
An impairment loss that has arisen on purchased goodwill cannot be reversed.
This is because any reversal of an impairment loss to goodwill is likely to be
caused by an increase in internally-generated goodwill rather than a reversal of
the impairment of purchased goodwill. Internally-generated goodwill must not be
reported as an asset.

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Example: Reversal of impairment loss

1st January Year 1
An asset was purchased at a cost of Rs. 100,000 and is being written off over
10 years on a straight line basis. Annual depreciation is Rs. 10,000 per annum.
31st December Year 2
The asset has a carting amount of Rs. 80,000 (Rs. 100,000 (2 years u Rs.
10,000).
There are indications that the asset is impaired and its recoverable amount is
estimated at Rs. 64,000. The resultant impairment loss of Rs. 16,000 is
recognised.
The carrying amount of the asset after the recognition of the impairment loss
(Rs. 64,000) is written off over the remaining useful life of 8 years resulting in
an annual depreciation charge of Rs. 8,000.
31st December Year 4
The carrying amount of the asset is Rs. 48,000 (Rs. 64,000 (2 years u Rs.
8,000).
There are indications that the impairment loss might have decreased and the
company estimates the recoverable amount of the asset to be Rs. 70,000.
This implies a reversal of Rs. 22,000 (Rs. 70,000 Rs. 48,000).
However, the carrying amount of the asset cannot be increased to above what
it would have been had no impairment loss been recognised in the first place.
This is an amount of Rs. 60,000 (Rs. 100,000 (4 years u Rs. 10,000).
Therefore a reversal of Rs. 12,000 is recognised.
The carrying amount of the asset after the recognition of the reversal of the
impairment loss (Rs. 60,000) is written off over the remaining useful life of 6
years resulting in an annual depreciation charge of Rs. 10,000.
Reversal of impairment of a cash-generating unit
A reversal of an impairment loss for a cash-generating unit must be allocated to
the assets of the unit (except for goodwill) on a pro rata basis.
These increases in carrying amounts must be treated as reversals of impairment
losses for individual assets.

3.2 IFRIC 10: Interim financial reporting and impairment

Background
IAS 34 requires application of the same accounting policies in interim financial
statements as are applied in annual financial statements and states that the
frequency of an entitys reporting (annual, half-yearly, or quarterly) shall not affect
the measurement of its annual results.

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It also requires that measurement for interim reporting purposes must be made
on a year-to-date basis.
IAS 36 prohibits reversal of impairment loss for goodwill
IAS 39 prohibits reversal of impairment loss recognised in P&L for available for
sale (AFS) equity instruments and for financial assets carried at cost.
This leads to an apparent conflict
An impairment loss on goodwill recognised in the interim financial statements
might not have been recognised at the next year end (due to change in
circumstances).

IAS 34 would seem to require reversal; but

IAS 36 prohibits reversal.

The issue
Should an impairment loss on goodwill (and certain investments) recognised in
an interim period, be reversed if a loss would not have been recognised (or a
smaller loss would have been recognised) if the assessment had been made only
at a later reporting date?
Consensus
The impairment principle overrides the interim measurement rule.
An impairment loss recognised in a previous interim period in respect of goodwill
(or certain investments) must not be reversed when circumstances change by a
later reporting date.
Exxample: IFRIC 10: In
nterim financial reporting and impairment
Entity X is a listed company that is required to produce quarterly financial
statements in accordance with IAS 34.
End of Q1
There were indications of impairment of one of Entity Xs cash-generating units
(CGU).
The carrying amount of the CGU was Rs. 120,000 including goodwill of Rs.
30,000).
The recoverable amount of the CGU was estimated to be Rs. 100,000.
Therefore, an Impairment of Rs. 20,000 was booked in the Q1 financial
statements. This was allocated to goodwill included within the CGU.
End of Q4 (year-end)
At the year-end the recoverable amount is unchanged at Rs. 100,000.
The carrying amount of the CGU that would have been determined if no
impairment had been booked in Q1 was Rs. 90,000 (accounting for depreciation
charge for the three quarters).
Therefore, if interim financial statements had not been prepared at Q1 and the
impairment test was carried out for the purpose of preparing the annual financial
statements there would be no impairment loss.
Application of the IAS 34 (year-to-date) approach would suggest reversal of the
loss previously recognised. However since that impairment was allocated to
goodwill, the impairment loss cannot be reversed.

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3.3 IAS 36 disclosure requirements for the impairment of assets

For all impairments, the following disclosures should be made for each class of
assets:

The amount of impairment losses recognised in profit or loss for the period
and the line item in which those items are included.

Similar information about reversals of impairment losses recognised in

profit or loss for the period.

The amount of impairment losses on revalued assets that have been

recognised (or reversed) in other comprehensive income for the period
(and in the revaluation reserve).

If the recognition or reversal of an individual impairment loss is material to

the financial statements, there should be additional disclosure of:

the events that led to the recognition or reversal of the impairment

loss

the amount of the impairment loss recognised or reversed

the nature of the asset

whether the recoverable amount is fair value less costs of disposal or

value in use, and how the figure for the recoverable amount was
calculated.

There are additional disclosures in aggregate for impairment losses

(reversals) that are not individually material, and extensive disclosures for
CGUs that include goodwill or intangible assets with an indefinite useful life,
including estimated sensitivities for changes in assumptions used to derive
a value in use or fair value less costs of disposal (headroom disclosures)

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

On 31 December Year 3 the machine was stated at the following amount:

a)

b)

c)

Carrying amount of the machine on 31 December Year 3

Cost
Accumulated depreciation (3 (240,000 20 years))

Rs
240,000
(36,000)

Carrying amount
204,000
Impairment loss at the beginning of Year 4 of Rs. 104,000 (Rs. 204,000 Rs.
100,000). This is charged to profit or loss.
Depreciation charge in Year 4 of Rs. 10,000 (= Rs. 100,000 10). The
depreciation charge is based on the recoverable amount of the asset.

Solution
a)

Carrying amount on
Cost
Accumulated depreciation at 1 January Year 3
(2 years (240,000 20))

Rs.
240,000

Carrying amount
Valuation at 1 January Year 3

216,000
250,000

(24,000)

Revaluation surplus
b)

34,000

When the asset is revalued on 1 January Year 3, depreciation is charged on the

revalued amount over its remaining expected useful life.
On 31 December Year 3 the machine was therefore stated at:
Valuation at 1 January (re-valued amount)
Accumulated depreciation in Year 3 (= Rs. 250,000 18))

Rs.
250,000
(13,889)

Carrying amount
236,111
Note: The depreciation charge of Rs. 13,889 is made up of Rs. 12,000 (being
that part of the charge that relates to the original historical cost) and Rs.
1,889 being the incremental depreciation.
Rs. 1,889 would be transferred from the revaluation surplus into retained
earnings.
c)

On 1 January Year 4 the impairment review shows an impairment loss of Rs.

136,111 (Rs. 236,111 Rs. 100,000).
An impairment loss of Rs. 32,111 (Rs. 34,000  Rs. 1,889) will be taken to
other comprehensive income (reducing the revaluation surplus for the asset to
zero).
The remaining impairment loss of Rs. 104,000 (Rs. 136,111  Rs. 34,000) is
recognised in the statement of profit or loss for Year 4.

d)

Year 4 depreciation charge is Rs. 10,000 (Rs. 100,000 10 years).

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

10

IFRS 5: Non-current assets held for

sale and discontinued operations

Contents
1 Sale of non-current assets
2 Introduction to IFRS 5
3 Classification of non-current assets (or disposal
groups) as held for sale
4 Measurement of non-current assets (or disposal
groups) classified as held for sale
5 Presentation and disclosure
6 Discontinued operations

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with international

pronouncements and under the Companies Ordinance, 1984.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A9

IFRS 5: Non-current assets held for sale and discontinued operations

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SALE OF NON-CURRENT ASSETS

Section overview

General rules on derecognition

Assets that are held for sale

1.1 General rules on derecognition

When an asset is derecognised, its carrying amount is removed from the
statement of financial position. IAS 16 states that the carrying amount of an item
of property, plant and equipment should be derecognised in the following
circumstances:

on disposal of the asset; or

when no future economic benefits are expected to arise from its use or from
its disposal.

If a non-current asset is disposed of, the gain or loss on the disposal should be
included in profit or loss in the period in which the disposal occurs. The gain or
loss should not be included in sales revenue.
The gain or loss on the disposal is calculated as:
Illustration: Gain or loss on disposal
Rs.

Rs.

Sale proceeds on disposal

Less disposal costs

(X)

Net disposal value

Asset at cost/revalued amount

Less: Accumulated depreciation

(X)

Carrying amount at date of disposal

(X)

Gain /loss on disposal

1.2 Assets that are held for sale

Sometimes, a company might hold an asset at the year-end that it has the
intention of selling.
IFRS 5 Non-current assets held for sale and discontinued operations
contain rules which impact the measurement and presentation of such assets.
In summary:
Non-current assets (and groups of non-current assets) that meet certain strict
criteria are classified as being held for sale.

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Non-current assets that are held for sale are:

subject to an impairment test;

presented on a separate category on the face of the statement of financial

position; and

are no longer depreciated.

Any loss recognised on a non-current asset carried at cost as a result of the

impairment test at the date of its classification as held for sale is recognised in
the statement of profit or loss.
Any loss recognised on a non-current asset carried at a revalued amount as a
result of the impairment test at the date of its classification as held for sale is
recognised in other comprehensive income (to the extent that it is covered by the
previously recognised surplus on the same asset) with the balance being
recognised in the statement of profit or loss.
The above rules will be explained in more detail in the following sections.

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INTRODUCTION TO IFRS 5
Section overview

Objective of IFRS 5

Scope of IFRS 5

2.1 Objective of IFRS 5

IFRS 5 sets out requirements that specify the accounting treatment for assets
held for sale, and the presentation and disclosure of discontinued operations.
IFRS 5 requires assets that meet the criteria to be classified as held for sale are:

measured at the lower of carrying amount and fair value less costs to sell;

not depreciated; and

presented separately on the face of the statement of financial position.

Additionally the results of discontinued operations must be presented separately

in the statement of profit or loss.
IFRS 5 identifies three classes of item that might be described as held for sale.
These classes are of an increasing level of sophistication:

non-current assets;

disposal groups; and

discontinued operations.

Disposal group
Definition
Disposal group a group of assets to be disposed of in a single transaction, and
any liabilities directly associated with those assets that will be transferred in the
transaction.
A disposal group may be a group of cash-generating units, a single cashgenerating unit, or part of a cash-generating unit.
Some disposal groups might fall into the definition of a discontinued operation.

2.2 Scope of IFRS 5

Classification and presentation
The classification and presentation requirements of IFRS 5 apply to all
recognised non-current assets and to all disposal groups.

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Measurement
The measurement requirements of IFRS 5 apply to all recognised non-current
assets and disposal groups except for:

deferred tax assets (IAS 12 Income Taxes).

assets arising from employee benefits (IAS 19 Employee Benefits).

financial assets within the scope of IAS 39 Financial Instruments:

Recognition and Measurement.

non-current assets that are accounted for in accordance with the fair value
model in IAS 40 Investment Property.

non-current assets that are measured at fair value less estimated point-ofsale costs in accordance with IAS 41 Agriculture.

contractual rights under insurance contracts as defined in IFRS 4 Insurance

Contracts.

Comment on the scope of IFRS 5

The scope of IFRS 5 is a little complicated.
A non-current asset that is scoped out of IFRS 5 for measurement purposes may
fall within the classification and presentation rules.
Such a non-current asset might be part of a disposal group. In this case the
measurement rules of IFRS 5 apply to the disposal group as a whole but not to
the scoped out assets within the group which are measured individually
according to the rules set out in their own standards.
Abandonment of non-current assets
Non-current assets (or disposal groups) to be abandoned include non-current
assets (or disposal groups) that are to be:

used to the end of their economic life; or

closed rather than sold.

A non-current asset (or disposal group) that is to be abandoned must not be

classified as held for sale in accordance with IFRS 5.
Reclassification of non-current assets
Assets classified as non-current in accordance with IAS 1: Presentation of
financial statements cannot be reclassified as current assets until they meet the
criteria to be classified as held for sale.
This also applies to assets that would normally be regarded as non-current that
are acquired exclusively with a view to resale. Such assets cannot be classified
as current unless they meet the criteria to be classified as held for sale in
accordance with IFRS 5.

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CLASSIFICATION OF NON-CURRENT ASSETS (OR DISPOSAL GROUPS)

AS HELD FOR SALE
Section overview

Rule

Criteria

Sale expected in over 1 year

3.1 Rule
A non-current asset (or disposal group) must be classified as held for sale when
its carrying amount will be recovered principally through a sale transaction rather
than through continuing use.

3.2 Criteria
The following conditions must apply at the reporting date for an asset (or disposal
group) to be classified as held for sale:

it must be available for immediate sale in its present condition subject only
to terms that are usual and customary for sales of such assets (or disposal
groups);

the sale must be highly probable, i.e.:

the appropriate level of management must be committed to a plan to

sell the asset (or disposal group);

an active programme to locate a buyer and complete the plan must

have been initiated; and

the asset (or disposal group) must be actively marketed for sale at a
price that is reasonable in relation to its current fair value;

the sale must be expected to be completed within one year from the date of
classification (except in limited circumstances) and actions required to
complete the plan should indicate that it is unlikely that significant changes
to the plan will be made or that the plan will be withdrawn.

If the criteria are met for a non-current asset (or disposal group) after the
reporting date but before the authorisation of the financial statements for issue,
that asset must not be classified as held for sale as at the reporting date.
However the entity is required to make certain disclosures in respect of the noncurrent asset (or disposal group).

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Example: Classification of asset as held for sale

Entity R had the following asset at 31 March Year 4.
A property that it offered for sale for Rs. 5 million during June Year 3.
The market for this type of property has deteriorated and at 31 March Year 4 a
buyer had not yet been found.
Management does not wish to reduce the price because it hopes that the market
will improve.
Shortly after the year end (after 31 March Year 4) the entity received an offer of
Rs. 4 million and the property was eventually sold for Rs. 3.5 million during May
Year 4, before the financial statements were authorised for issue.
Analysis as at 31 March Year 4
The property cannot be classified as held for sale.
A non-current asset qualifies as held for sale if it is available for immediate sale
in its present condition and actively marketed for sale at a price that is
reasonable in relation to its current fair value.
The property had not been sold at the year-end although it had been on the
market for some time. It appears that the reason for this was that management
were asking too high a price; therefore the price is not reasonable in relation to
its current fair value.

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Example: Classification of asset as held for sale

Entity R had the following asset at 31 March Year 4.
Plant with a carrying value of Rs. 2.5 million.
At 31 March Year 4 the entity had ceased to use the plant but was still
maintaining it in working condition so that it could still be used if needed.
Entity R sold the plant on 14 May Year 4.
Analysis as at 31 March Year 4

The plant cannot be classified as held for sale.

At the year-end management had not made a firm commitment to sell the plant.
Even though the plant was sold just after the year-end, IFRS 5 prohibits the
classification of non-current assets as held for sale if the criteria are met after
the end of the reporting period and before the financial statements are signed.

3.3 Sale expected in over 1 year

Sometimes circumstances might extend the period to complete the sale beyond a
year. This does not preclude an asset (or disposal group) from being classified as
held for sale as long as:

the delay is caused by events or circumstances beyond the entitys control;

and

there is sufficient evidence that the entity remains committed to its plan to
sell the asset (or disposal group).

IFRS 5 sets out detailed guidance on when this is deemed to be the case.
Costs to sell that are to be paid after one year should be discounted with the
unwinding of the discount recognised subsequently as finance cost in the
statement of profit or loss.

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MEASUREMENT OF NON-CURRENT ASSETS (OR DISPOSAL GROUPS)

CLASSIFIED AS HELD FOR SALE
Section overview

Measurement of non-current assets and disposal groups held for sale

Allocation of an impairment loss on a disposal group

Subsequent remeasurement

Changes to a plan of sale

4.1 Measurement of non-current assets and disposal groups held for sale
Assets held for sale and disposal groups should be measured at the lower of:

their carrying amount (i.e. current values in the statement of financial

position, as established in accordance with accounting standards and
principles), and

fair value less costs to sell.

If the value of the held for sale asset is adjusted from carrying amount to fair
value less costs to sell, any impairment should be recognised as a loss in the
statement of profit or loss for the period unless the asset to which it relates is
carried at a previously recognised revaluation surplus. In this case the loss is
taken to other comprehensive income to the extent that it is covered by the
previously recognised surplus on that asset. Any amount not covered is
recognised in the statement of profit or loss.
A non-current asset must not be depreciated (or amortised) while it is classified
as held for sale or while it is part of a disposal group that is held for sale.
Example: Impact of classification as held for sale
An asset is reclassified as held for sale, when its carrying amount is Rs. 20
million.
Its fair value less estimated costs to sell is Rs. 17 million.
The asset should be revalued at Rs. 17 million and a loss of Rs. 3 million should
be reported in the period.
If the carrying amount is less than the fair value less costs to sell there is no
impairment. In this case there is no adjustment to the carrying amount of the
asset. (A gain is not recognised on reclassification as held for sale).

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Example: Impact of classification as held for sale

An asset is reclassified as held for sale, when its carrying amount is Rs. 20
million.
Its fair value less estimated costs to sell is Rs. 24 million.
The asset held for sale should not be remeasured and should continue to be
carried at Rs. 20 million.
A gain on disposal will be included in profit for the period when the disposal
actually occurs.
Example: Accounting on reclassification and subsequent disposal
A machine was purchased on 1 January Year 1 for Rs. 80,000. It had a useful life
of 8 years and no residual value.
On 31 December Year 4 the machine was classified as held for sale. On this date
the machines fair value was estimated at Rs. 50,000 and the costs to sell were
estimated at Rs. 1,000
The machine was sold for Rs. 48,000 on 30 June Year 5.
This would be accounted for as follows:
Year 4
The asset held for sales is carried at the lower of:
Carrying amount:

Rs.

Cost

80,000

Depreciation up to the point of reclassification

80,000 u 4 years/8years

(40,000)
40,000

Fair value less costs to sell (Rs. 50,000  Rs. 1,000)

49,000

The machine therefore remains at its carrying value of Rs. 40,000.

The machine would be reclassified to the held for sale category.
The necessary double entry is as follows:
Debit
Non-current asset held for sale

40,000

Cost (plant)

80,000

Accumulated depreciation

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Year 5
The asset is sold to give the following profit on disposal:
Rs.
Proceeds

48,000

Carrying amount

(40,000)

Gain

8,000

The necessary double entry is as follows:

Debit
Cash

48,000

Non-current asset held for sale

40,000

Statement of profit or loss (gain on disposal)

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Example: Accounting on reclassification and subsequent disposal

A machine was purchased on 1 January Year 1 for Rs. 80,000. It had a useful life
of 8 years and no residual value.
On 31 December Year 4 the machine was classified as held for sale. On this date
the machines fair value was estimated at Rs. 41,000 and the costs to sell were
estimated at Rs. 2,000
The machine was sold for Rs. 37,500 on 30 June Year 5.
This would be accounted for as follows:
Year 4
The asset held for sales is carried at the lower of:
Carrying amount:

Rs.

Cost

80,000

Depreciation up to the point of reclassification

80,000 u 4 years/8years

(40,000)
40,000

Fair value less costs to sell (Rs. 41,000  Rs. 2,000)

39,000

The machine is therefore written down to Rs. 39,000.

The statement of profit or loss for Year 4 will include an impairment loss
of Rs. 1,000 (Rs. 40,000 Rs. 39,000).
The necessary double entry is as follows:
Debit
Non-current asset held for sale
Impairment loss

Credit

39,000
1,000

Cost (plant)

80,000

Accumulated depreciation

40,000

Year 5
The asset is sold to give the following loss on disposal:
Rs.
Proceeds

37,500

Carrying amount

(39,000)

Loss

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The necessary double entry is as follows:

Debit
Cash

Credit

37,500

Non-current asset held for sale

39,000

Statement of profit or loss (loss on disposal)

1,500

4.2 Allocation of an impairment loss on a disposal group

IFRS 5 requires that if an impairment loss is recognised for a disposal group, the
loss should be allocated to reduce the carrying amounts of those non-current
assets in the disposal group (that are within the scope of the IFRS 5
measurement rules) in the following order:

goodwill; then

other non-current assets pro-rated on the basis of their carrying values.

Example: Allocation of impairment loss in a disposal group

An entity has decided to dispose of a group of its assets.
The carrying amount of the assets immediately before the classification as held
to sale were as follows:
Rs.
Goodwill

20,000

Property, plant and equipment (carried at revalued

amounts)

52,000

Property, plant and equipment (carried at cost)

80,000

Inventory

21,000

Financial assets

17,000

Total

190,000

The entity estimates that the fair value less costs to sell of the disposal group is
Rs. 160,000.
This means that the entity must recognise an impairment loss of Rs. 30,000 (Rs.
190,000 - Rs. 160,000).
Allocation of the impairment loss:
The first Rs. 20,000 of the impairment loss reduces the goodwill to zero.
The remaining Rs. 10,000 of the impairment loss should be allocated to the noncurrent assets in the disposal group pro rata to their carrying value.

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Carrying
amount before
allocation

Impairment
loss

Carrying
amount after
allocation

Rs.

Rs.

Rs.

Goodwill

20,000

20,000

Property, plant and

equipment (carried at
revalued amounts)

52,000

3,399

48,601

Property, plant and

equipment (carried at
cost)

80,000

5,228

74,772

Inventory

21,000

1,373

19,627

Financial assets

17,000

17,000

190,000

30,000

160,000

Total

This impairment loss of Rs. 30,000 will be included in the reported profit or loss
from discontinued operations.

4.3 Subsequent remeasurement

Subsequent remeasurement of the non-current asset (or disposal group) might
lead to:

a further impairment loss - which must be recognised; or

a gain - which is recognised but only to the extent that it is covered by a

previously recognised impairment loss.

4.4 Changes to a plan of sale

If an asset (or disposal group) has been classified as held for sale, but the criteria
are no longer met, it must be removed from this classification.
Such an asset is measured at the lower of:

the amount at which it would have been carried if it had never been
classified as held for sale (i.e.: its carrying amount before it was classified
as held for sale as adjusted for any depreciation, amortisation or
revaluations that would have been recognised if it had not been so
classified); and

its recoverable amount at the date of the subsequent decision not to sell.*

Any necessary adjustment to the carrying amount is recognised in income from

continuing operations, in the same statement of profit or loss caption used to
present a gain or loss on assets held for sale.

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PRESENTATION AND DISCLOSURE

Section overview

Assets (or disposal groups) held for sale

5.1 Assets (or disposal groups) held for sale

Statement of financial position presentation
Non-current assets classified as held for sale are presented separately from
other assets in the statement of financial position.
The assets and liabilities of a disposal group classified as held for sale are
presented separately from other assets and liabilities in the statement of financial
position. These assets and liabilities must not be offset and presented as a single
amount.
The major classes of assets and liabilities classified as held for sale must be
separately disclosed either on the face of the statement of financial position or in
the notes.
This disclosure is not required for disposal groups that are newly acquired
subsidiaries that are classified as held for sale on acquisition.
Comparatives are not restated to reflect the classification in the statement of
financial position for the latest period presented.
Gains or losses
Any gain or loss on the remeasurement of a non-current asset (or disposal
group) classified as held for sale that does not meet the definition of a
discontinued operation is included in profit or loss from continuing operations.
The gain or loss recognised on measuring or remeasuring a non-current asset (or
disposal group) classified as held for sale is disclosed. If it is not presented
separately on the face of the statement of profit or loss, the caption that includes
that gain or loss must also be disclosed.
Other disclosures
The following information must be disclosed in the notes in the period in which a
non-current asset (or disposal group) has been either classified as held for sale
or sold:

a description of the non-current asset (or disposal group);

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;

if applicable, the segment in which the non-current asset (or disposal

group) is presented in accordance with IFRS 8 Operating segments.

Changes to a plan of sale

When this occurs the following must be disclosed:

a description of the facts and circumstances leading to the decision; and

the effect of the decision on the results of operations for the period and any
prior periods presented.

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DISCONTINUED OPERATIONS
Section overview

Discontinued operation

Definition of discontinued operations

Presentation and disclosure of discontinued operations

Other disclosures

6.1 Discontinued operation

IFRS 5 Non-current assets held for sale and discontinued operations sets
out requirements for disclosure of financial information relating to discontinued
operations.
The reason for requiring disclosure of information about discontinued operations
is as follows:

Closing down some operations will affect the future financial prospects of
the entity.

It is therefore appropriate that users of the financial statements should be

provided with relevant information about the discontinuation. This will help
them to make a more reliable prediction of the future performance of the
entity.

This information can be produced by providing information about discontinued

operations separately from information about continuing operations.

6.2 Definition of discontinued operations

A discontinued operation is a disposal group that satisfies extra criteria. (IFRS 5
does not say as much but this is a helpful way to think of it).
Definition: Discontinued operation
Discontinued operation - A component of an entity that either has been disposed
of or is classified as held for sale and:
1.

represents a separate major line of business or geographical area of

operations,

2.

is part of a single co-ordinated plan to dispose of a separate major line of

business or geographical area of operations or

3.

is a subsidiary acquired exclusively with a view to resale.

A component of an entity comprises operations and cash flows that can be

clearly distinguished, operationally and for financial reporting purposes, from the
rest of the entity.
If an entity disposes of an individual non-current asset, or plans to dispose of an
individual asset in the immediate future, this is not classified as a discontinued

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operation unless the asset meets the definition of a component of an entity. The
asset disposal should simply be accounted for in the normal way, with the gain
or loss on disposal included in the operating profit for the year.
An operation cannot be classified as discontinued in the statement of financial
position if the criteria for classifying it as discontinued are met after the end of the
reporting period.
For example, suppose that an entity with a financial year ending 30 June shuts
down a major line of business in July and puts another major line of business up
for sale. It cannot classify these as discontinued operations in the financial
statements of the year just ended in June, even though the financial statements
for this year have not yet been approved and issued.
A disposal group might be, for example, a major business division of a company.
For example a company that operates in both shipbuilding and travel and tourism
might decide to put its shipbuilding division up for sale. If the circumstances meet
the definition of held for sale in IFRS 5, the shipbuilding division would be a
disposal group held for sale.

6.3 Presentation and disclosure of discontinued operations

Presentation in the statement of profit or loss
The following must be disclosed for discontinued operations:

a single amount on the face of the statement of profit or loss comprising the
total of:
x

the post-tax profit or loss of discontinued operations; and

the post-tax gain or loss recognised on the measurement to fair value

less costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation.

an analysis of this single amount:

x

the revenue, expenses and pre-tax profit or loss of discontinued

operations;

the related income tax expense;

the gain or loss recognised on the measurement to fair value less

costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation; and

the related income tax expense.

the net cash flows attributable to the operating, investing and financing
activities of discontinued operations.

The analysis may be presented in the notes or on the face of the statement
of profit or loss. (If presented on the face of the statement of profit or loss it
must be presented in a section identified as relating to discontinued
operations).

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The analysis is not required for disposal groups that are newly acquired
subsidiaries that are classified as held for sale on acquisition.
These disclosures are not required for disposal groups that are newly acquired
subsidiaries that are classified as held for sale on acquisition.
Comparatives
Comparatives must be restated for these disclosures so that the disclosures
relate to all operations that have been discontinued by the reporting date for the
latest period presented.
Example: Presentation of discontinued operations in the statement of financial
position
Information relating to discontinued operations might be presented as follows.
Statement of profit or loss
X Limited: Statement of profit or loss for the year ended 31 December
20X9
20X9
20X8
Rs. 000
Rs. 000
Continuing operations
Revenue
9,000
8,500
Cost of sales
(5,100)
(4,700)
Gross profit
Other income
Distribution costs
Administrative expenses
Other expenses
Finance costs

3,900
50
(1,200)
(1,400)
(150)
(300)

3,800
100
(1,000)
(1,200)
(200)
(300)

900
(300)

1,200
(400)

Profit for the period from continuing operations

Discontinued operations
Profit for the period from discontinued operations

600

800

250

180

Profit for the period

850

980

Profit before tax

Income tax expense

Note
The single figure of Rs. 250,000 for after-tax profit or loss from discontinued
operations should be analysed in a note to the accounts. Alternatively, the
analysis could be given on the face of the statement of profit or loss.
Presentation in the statement of financial position
Non-current assets classified as held for sale must be disclosed separately from
other assets in the statement of financial position.
Similarly, assets and liabilities that are part of a disposal group held for sale
must be disclosed separately from other assets and liabilities in the statement of
financial position.
This also applies to the assets and liabilities of a discontinued operation.
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Example: Presentation of discontinued operations in the statement of financial

position
An entity has two disposal groups held for sale:
Disposal group
Group 1
Group 2
Rs. 000
600
(50)

Property, plant and equipment

Liabilities

Rs. 000
300
(20)

Total
Rs. 000
900
(70)

Information relating to discontinued operations might be presented as follows.

Statement of financial position
Rs. 000
Assets
Non-current assets
Current assets
Non--current assets classified as held for sale (see above)

2,000
720
900

Total assets

3,620

Equity and liabilities

Share capital
Reserves

1,000
1,950

Total equity

2,950

Non--current liabilities
Current liabilities
Liabilities directly associated with non--current assets
classified as held for sale (see above)

400
200

Total liabilities

670

Total equity and liabilities

70

3,620

Note: In this summarised statement of financial position, the non-current assets

classified as held for sale are the sum of the non-current assets of disposal
groups 1 and 2 (Rs. 600,000 + Rs. 300,000).
Similarly the liabilities directly associated with non-current assets classified as
held for sale are the sum of the liabilities for disposal groups 1 and 2.
In the statement of financial position, the comparative figures for the previous
year are not restated. The amount for discontinued operations in the previous
year does not include discontinued items for the current year. The presentation in
the statement of financial position therefore differs from the presentation in the
statement of profit or loss.

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6.4 Other disclosures

Adjustments to carrying amounts of discontinued operations
Sometimes there is a need to adjust amounts previously presented in
discontinued operations that are directly related to the disposal of a discontinued
operation in a prior period.
For example, circumstances in which these adjustments may arise include the
resolution of uncertainties relating to:

the disposal (e.g. purchase price adjustments; or

obligations retained by the seller (e.g. environmental and product warranty

obligations).

Such adjustments are classified separately in discontinued operations and the

nature and amount of the adjustments are disclosed.
Note on discontinued operations and the statement of cash flows
IFRS 5 states that in the statement of cash flows, there should be separate
disclosure of the net cash flows in the period attributable to operating activities,
investing activities and financing activities of the discontinued operations.
These disclosures may be presented either on the face of the statement of cash
flows or in the notes to the financial statements.
Additional disclosures
Additional disclosures about discontinued operations must be included in the
notes to the financial statements. These include:

a description of the non-current asset or disposal group;

a description of the facts and circumstances of the sale; and

in the case of operations and non-current assets held for sale, a

description of the facts and circumstances leading to the expected disposal
and the expected manner and timing of the disposal.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

11

IFRS 16: Leases

Contents
1

Introduction and definitions

Lease classification

Accounting for lease by Lessee

Accounting for a finance lease: Lessor accounting

Accounting for an operating lease

Sale and leaseback transactions

Impact on presentation

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the

international pronouncements and under the Companies
Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm

decisions on the accounting treatment and reporting of the
same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 18

IFRS 16: Leases

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INTRODUCTION AND DEFINITIONS

Section overview

Introduction

Leases

Types of lessor

Inception and commencement

Defined periods
Residual values

Lease payments

Interest rate implicit in the lease

Initial direct costs

Lessee's incremental borrowing rate of interest

1.1 Introduction
The previous accounting model for leases as per IAS 17 required lessees and
lessors to classify their leases as either finance leases or operating leases and
account for those two types of leases differently. That model was criticised for
failing to meet the needs of users of financial statements because it did not
always provide a faithful representation of leasing transactions. In particular, it did
not require lessees to recognise assets and liabilities arising from operating
leases.
IFRS 16 introduces a single lessee accounting model and requires a lessee to
recognise assets and liabilities for all leases with a term of more than 12 months,
unless the underlying asset is of low value. A lessee is required to recognise a
right-of-use asset representing its right to use the underlying leased asset and a
lease liability representing its obligation to make lease payments.

1.2 Leases
IFRS 16 prescribes the accounting treatment of leased assets in the financial
statements of lessees and lessors.
Definition: Lease
A contract, or part of a contract, that conveys the right to use an asset (the
underlying asset) for a period of time in exchange for consideration.
A lease is a way of obtaining a use of an asset, such as a machine, without
purchasing it outright. The company that owns the asset (the lessor) allows
another party (the lessee) to use the asset for a specified period of time in return
for a series of rental payments.
Types of lease
IFRS 16 identifies two types of lease.
Definitions
A lease that transfers substantially all the risks and rewards incidental to
ownership of an underlying asset is known as finance lease.

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A lease that does not transfer substantially all the risks and rewards incidental to
ownership of an underlying asset is known as operating lease.
The identification of a lease as a finance lease or an operating lease is crucial as
it determines how a lease is accounted for by the lessor.
This is explained in more detail in later sections.

1.3 Types of lessors

Companies might be lessors as a result of a variety of business models.
Finance companies (often banks and their subsidiaries)
Finance companies provide finance for the purchase of assets. In addition they
might finance the use of assets through leases.
Finance companies are often associated with finance leases but they also fund
large operating leases. Many airlines have use of aircraft through operating
leases through finance companies.
Hire companies
These companies own a stock of capital assets which they will lease out for
varying periods.
They include:
tool hire companies;
plant hire companies; and
car hire companies
Hire companies are usually involved in operating leases.
Manufacturer/dealer lessors
Some companies make or buy assets to sell. They may offer to lease the asset
out as an alternative to outright sale.
Many motor vehicle manufacturers and dealers do this. Such leases would
usually be finance leases (but not necessarily).
Property companies
Many companies own properties which they lease out to others. These
companies might apply IAS 40: Investment Properties to these assets.

1.4 Inception and commencement

Definitions: Inception date of the lease
The earlier of the date of a lease agreement and the date of commitment by the
parties to the principal terms and conditions of the lease.
The type of lease in a contract (finance or operating) is identified at the date of
inception. This is where the parties to the lease contract commit to the terms of
the contract.
Definition: Commencement date of the lease
The date on which a lessor makes an underlying asset available for use by a
lessee.

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The accounting treatment required is applied to a lease at the date of

commencement. This is the date that a lessee starts to use the asset or, at least,
is entitled to start to use the asset.
A lease agreement may allow for an adjustment to the terms of the lease contract
during the period between the inception of the lease and the commencement of
the lease term. Such adjustments might be to take account of unexpected
changes in costs (for example the lessors costs of making the asset that is the
subject of the lease).
In such cases, the effect of any such changes is deemed to have taken place at
the inception of the lease.

1.5 Defined periods

IFRS 16 refers to different periods when describing its rules.
Definition: Lease term
The non-cancellable period for which a lessee has the right to use an underlying
asset, together with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably
certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably
certain not to exercise that option.
A lease may be split into a primary period followed by an option to extend the
lease for a further period (a secondary period).
In some cases, the lessee might be able to exercise such an option with a small
rental or even for no rental at all. If such an option exists and it is reasonably
certain that the lessee will exercise the option, the second period is part of the
lease term.
Definitions: Economic and useful life
Economic life is either:
(a) the period over which an asset is expected to be economically usable by one
or more users; or
(b) the number of production or similar units expected to be obtained from the
asset by one or more users.
Useful life is the period over which an asset is expected to be available for use by
an entity; or the number of production or similar units expected to be obtained
from an asset by an entity.
Economic life relates to the life of the asset whereas useful life relates to the
period that a party will obtain benefits from that asset.

1.6 Residual values

When a company that owns an asset leases it to another party they have two
interests in that asset:
It gives them a right to receive a series of rentals over the lease
term; and
They own the asset at the end of the lease.

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The value of the asset at the end of the lease is called its residual value. This
figure might be guaranteed by the lessee. This means that if the asset is not
worth the amount guaranteed, the lessee must pay the lessor the shortfall.
On the other hand, the residual value might not be guaranteed.
Definition: Unguaranteed residual value and residual value guarantee
Unguaranteed residual value is that portion of the residual value of the underlying
asset, the realisation of which by the lessor is not assured or is guaranteed solely
by a party related to the lessor.
Residual value guarantee is a guarantee made to a lessor by a party unrelated to
the lessor that the value (or part of the value) of an underlying asset at the end of
a lease will be at least a specified amount.

1.7 Lease payments

In essence, the term lease payments refers to the payments that a lessee
expects to make over a lease term or to the receipts that a lessor expects over
the economic life of the asset.
In a straight forward example the lease payments that a lessee expects to make
and a lessor expects to receive are same. However, this is not always the case.
The definition of lease payments takes that into account.
Definition: Lease payments
Payments made by a lessee to a lessor relating to the right to use an underlying
asset during the lease term, comprising the following:
(a)

fixed payments (including in-substance fixed payments), less any lease

incentives;

(b)

variable lease payments that depend on an index or a rate;

(c)

the exercise price of a purchase option if the lessee is reasonably certain to

exercise that option; and

(d)

payments of penalties for terminating the lease, if the lease term reflects
the lessee exercising an option to terminate the lease.

1.8 Interest rate implicit in the lease

Definition: Interest rate implicit in the lease
The interest rate implicit in the lease is the interest rate that causes the present
value of (a) the lease payments and (b) the unguaranteed residual value to be
equal to the sum of (i) the fair value of the underlying asset and (ii) any initial
direct costs of the lessor.
The interest rate implicit in the lease is the IRR of the cash flows from the lessors
viewpoint. It is the rate that equates the future cash inflows for the lessor to the
amount that the lessor invested in the asset.

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Example:: Interest rate implicit in the lease

A finance company has purchased an asset for Rs. 50,000 and will lease it out in
a series of leases as follows:
The first lease is to Company A for a period of 5 years at an annual rental of Rs.
10,000.
After the end of the lease to Company A the asset will be leased to Company B for
1 year at a rental of Rs. 10,000. Company B is a party related to Company A.
After the end of the lease to Company B the asset will be leased to Company C for
1 year at a rental of Rs. 10,000. Company C is not related to Companies A and B.
At the end of this lease the asset is expected to have an unguaranteed residual
value of Rs. 2,573.
The interest rate implicit in the lease is 10%.
Proof
Time
Narrative
Lessors cash
Discount
Present
flows
factor (10%)
value
0
Fair value of the asset
(50,000)
1
(50,000)
1 to 7
7

Lessors MLPs
Unguaranteed
residual value

10,000

4.868

48,680

2,573

0.513

1,320
50,000
nil

The interest rate implicit in the lease (its IRR) was given in the above example. In
an exam question you might have to calculate it in the usual way.

1.9 Initial direct costs

The definition of interest rate implicit in the lease makes reference to incremental
initial direct costs.
Definition: Initial direct costs
Initial direct costs are incremental costs for obtaining a lease that would not have
been incurred if the lease had not been obtained, except for such costs incurred by
a manufacturer or dealer lessor in connection with a finance lease.
The accounting treatment for initial direct costs will be explained later.

1.10 Lessee's incremental borrowing rate of interest

The interest rate implicit in the lease might be important in deciding whether a
lease is a finance lease or an operating lease.
It is calculated from the lessors viewpoint. Sometimes, the lessee might not be
able to ascertain the interest rate implicit in the lease. In that case, it would use
the lessees incremental borrowing cost instead.
Definition: Lessee's incremental borrowing rate of interest
The lessee's incremental borrowing rate of interest is the rate of interest that a
lessee would have to pay to borrow over a similar term, and with a similar
security, the funds necessary to obtain an asset of a similar value to the right-ofuse asset in a similar economic environment.
Further definitions important to finance lessor accounting will be provided in that
section.

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LEASE CLASSIFICATION
Section overview

Finance leases and operating leases

Identifying a finance lease

Commentary on finance lease indicators

2.1 Finance leases and operating leases

IFRS 16 describes two types of lease (with each type being accounted for in a
different way):
finance leases and
operating leases
A lessor shall classify each of its leases as either an operating lease or a finance
lease.
A lease is classified as a finance lease if it transfers substantially all the risks and
rewards incidental to ownership. A lease is classified as an operating lease if it
does not transfer substantially all the risks and rewards incidental to ownership.
Risks may be represented by the possibility of losses from:
idle capacity;
technological obsolescence;
variations in return caused by changes in economic conditions.
Rewards may be represented by the expectation of;
profitable use of the asset over its economic life;
gains from increases in value or profits on disposal.
Substance over form
Whether a lease is a finance lease or an operating lease depends on the
substance of the transaction rather than the form of the contract.
The legal form of a finance lease is that the lessor is the legal owner of the
underlying asset.
The economic substance of a finance lease is that the lessee has all the benefits
and costs associated with ownership of the asset. The finance lessee is in the
same position as it would have been if it had borrowed money to buy the asset
itself. That is why such leases are called finance leases; they provide finance for
the use of an asset.
Example Substantive substitution right
ABC Ltd enters into a 5 year contract with a freight carrier (XYZ Ltd.) to transport a
specified quantity of goods. XYZ Ltd. uses rail cars of a particular specification,
and has a large pool of similar rail cars that can be used to fulfil the requirements
of the contract. The rail cars and engines are stored at XYZ Ltd. premises when
they are not being used to transport goods. Costs associated with substituting the
rail cars are minimal for XYZ Ltd.

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In this case, because the rail cars are stored at XYZ Ltd. premises, it has a large
pool of similar rail cars and substitution costs are minimal, the benefits to XYZ
Ltd. of substituting the rail cars would exceed the costs of substituting the cars.
Therefore, XYZ Ltd. substitution rights are substantive and the arrangement does
not contain a lease.

2.2 Identifying a finance lease

At inception of a contract, an entity shall assess whether the contract is, or
contains, a lease. A contract is, or contains, a lease if the contract conveys the
right to control the use of an identified asset for a period of time in exchange for
consideration.
Examples of situations that individually or in combination would normally lead to a
lease being classified as a finance lease are:
(a) the lease transfers ownership of the underlying asset to the lessee by the
end of the lease term;
(b) the lessee has the option to purchase the underlying asset at a price that is
expected to be sufficiently lower than the fair value at the date the option
becomes exercisable for it to be reasonably certain, at the inception date,
that the option will be exercised;
(c) the lease term is for the major part of the economic life of the underlying
asset even if title is not transferred;
(d) at the inception date, the present value of the lease payments amounts to at
least substantially all of the fair value of the underlying asset; and
(e) the underlying asset is of such a specialised nature that only the lessee can
use it without major modifications.
Indicators of situations that individually or in combination could also lead to a
lease being classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessors losses associated with the
cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to
the lessee (for example, in the form of a rent rebate equaling most of the
sales proceeds at the end of the lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a
rent that is substantially lower than market rent.
In all these situations, it can normally be concluded that substantially all the risks
and rewards incidental to ownership are transferred to the lessee.
These indicators are not always conclusive. Classification should always be
based on the substance of the agreement taking account of all information.
Leases are classified at the inception of the lease. Sometimes, a lessee and
lessor agree to change the provisions of a lease and the changes might be of a
sort that would have changed the lease classification if the new terms had been in

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effect at the inception of the lease. In these cases, the revised agreement is
regarded as a new agreement over its term.
However, changes in estimates (for example, changes in estimates of the
economic life or of the residual value of the leased property), or changes in
circumstances (for example, default by the lessee), do not give rise to a new
classification of a lease for accounting purposes.
The following flowchart may assist entities in making the assessment of whether a
contract is, or contains, a lease.

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2.3 Commentary on finance lease indicators

It is not always obvious why the above circumstances indicate that a lease is a
finance lease. This section provides an explanation on some of these.
To understand these, it is useful to think of the terms from the lessors viewpoint.
Purchase option
If a lease includes a term whereby the lessee can buy the underlying asset at a
bargain price at the end of the lease that lease is a finance lease.
If the lessor includes this term in the lease, the lessor would expect the lessee to
take advantage of it. Therefore, the lessor knows that it needs to make sure to
recover the cost of the asset together with any related interest during the lease
term. The rentals and final sale price are set at a level which allows it to do this.
If the lease transfers ownership of the underlying asset to the lessee by the end
of the lease term or if the cost of the right-of-use asset reflects that the lessee will
exercise a purchase option, the lessee shall depreciate the right-of-use asset
from the commencement date to the end of the useful life of the underlying asset.
Therefore, the lessee will pay the full cash price of the asset together with related
finance expense over the lease term.
The lessee would only do this if it had access to the risks and benefits of
ownership
In substance, this is just like borrowing the cash and buying the asset
Therefore, the lease is a finance lease.
If there is a change in the assessment of an option to purchase the underlying
asset, a lessee shall determine the revised lease payments to reflect the change
in amounts payable under the purchase option.
Lease is for a major part of the expected economic life of the asset
If the lessor includes this term in the lease, the lessor knows that when the asset
is given back to it at the end of the lease, the asset will only have a small value.
Therefore, the lessor knows that it needs to make sure to recover the cost of the
asset together with any related interest during the lease term. The rentals are set
at a level which allows it to do this.
Therefore, the lessee will pay the full cash price of the asset together with related
finance expense over the lease term.
The lessee would only do this if it had access to the risks and benefits of
ownership
In substance, this is just like borrowing the cash and buying the asset
Therefore, the lease is a finance lease.
Specialised nature of the asset
If the lessor includes this term in the lease, the lessor knows that when the lease
comes to an end, it will be unable to lease the asset on to another party.
Therefore, the lessor knows that it needs to make sure to recover the cost of the
asset together with any related interest during the lease term. The rentals are set
at a level which allows it to do this.

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Therefore, the lessee will pay the full cash price of the asset together with related
finance expense over the lease term.
The lessee would only do this if it had access to the risks and benefits of
ownership.
In substance, this is just like borrowing the cash and buying the asset.
Therefore, the lease is a finance lease.
PV of future lease payments amounts to substantially all of the fair value of the
underlying asset
A lease is a finance lease if at the inception of the lease, the present value of all
the future lease payments amounts to substantially all of the fair value of the
underlying asset, or more. (The discount rate to be used in calculating the
present value of the lease payments is the interest rate implicit in the lease).
In this case, the lessee is paying the full cash price of the asset together with
related finance expense over the lease term.
Example: PV of future lease payments
A finance company has purchased an asset to lease out to a manufacturing
company.
The asset cost for Rs. 500,000 and has an economic life of 10 years.
The lease is for 9 years at an annual rental (in arrears) of Rs. 87,000 per annum.
The interest rate implicit in the lease is 10%.
Analysis: Lessors view
Time

Narrative

Cash flows

Discount
factor (10%)

1 to 9

Lessors LPs

87,000

5.759

Present
value
501,033

This is more than the fair value of the asset. This lease is a finance lease
(also note that the lease is for the major part of the expected economic
life of the asset which is another finance lease indicator).
Time

Narrative

Cash flows

Discount
factor (10%)

Present
value

1 to 9

Lessees LPs

87,000

5.759

501,033

This is more than the fair value of the asset. This lease is a finance lease
(also note that the lease is for the major part of the expected economic
life of the asset which is another finance lease indicator).
In the above example the lessee and the lessor have the same view of the lease.
This is not necessarily the case.

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Example: PV of future lease payments

A finance company has purchased an asset for Rs. 50,000 and will lease it out in a
series of leases as follows:
The first lease is to Company A for a period of 4 years at an annual rental of Rs.
10,000.
After the end of the lease to Company A the asset will be leased to Company B for
3 years at a rental of Rs. 10,000. Company B is not related to Company A.
At the end of this lease the asset is expected to have an unguaranteed residual
value of Rs. 2,573.
The Interest rate implicit in the lease is 10%.
Analysis: Lessors view
Time

Narrative

Cash flows

Discount
factor (10%)

1 to 7

Lessors MLPs

10,000

4.868

Present
value
48,680

This is 97.4% (48,680/50,000 u 100) of the fair value of the asset.

Most would agree that this was substantially all of the fair value of the
asset (though IFRS 16 does not give a numerical benchmark).
This lease is a finance lease.
Time

Narrative

Cash flows

Discount
factor (10%)

Present
value

1 to 4

Lessors MLPs

10,000

3.170

31,700

This is 63.4% (31,700/50,000 u 100) of the fair value of the asset.

Most would agree that this is not substantially all of the fair value of the
asset (though IFRS 16 does not give a numerical benchmark).
This lease is an operating lease.

Practice question

Jhang Construction has leased a cement lorry.

The cash price of the lorry would be Rs. 3,000,000.
The lease is for 6 years at an annual rental (in arrears) of Rs. 600,000. The
asset is believed to have an economic life of 7 years.
The interest rate implicit in the lease is 7%.
Jhang Construction is responsible for maintaining and insuring the asset.
Required
State with reasons the kind of lease Jhang has entered into.

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ACCOUNTING FOR LEASE BY LESSEE

Section overview

Substance over form

Lease accounting: Initial recognition

Lease accounting: Subsequent measurement of the asset

Lease accounting: Subsequent measurement of the liability

Calculating and allocating finance charges (interest)

Current and non-current elements of the finance lease liability

Lease payments made in advance

Disclosure

3.1 Substance over form

An earlier section explained that whether a lease is a finance lease or an
operating lease depends on the substance of the contract rather than its form.
The economic substance of a finance lease is that the lessee in effect has all the
benefits and costs associated with ownership of the asset. In substance it is as if
the lessee borrowed money to buy the asset.
Similarly, the lessor no longer has the benefits and costs associated with
ownership. The lessor should not account for the asset in its books. In substance,
the lessor has lent money to another party to enable them to buy the asset. The
lessor accounts for a receivable in its books being the right to receive a future
flow of rentals.

3.2 Lease accounting: Initial recognition

A lease is capitalised at the commencement of the lease term. This involves the
recognition of the asset that is subject to the lease and a liability for the future
lease payments.
At the commencement date, a lessee should recognise a right-of-use asset and a
lease liability. It is the date on which a lessor makes an underlying asset available
for use by a lessee.
At the commencement date, a lessee should measure the right-of-use asset at
cost.
The cost of the right-of-use asset should comprise:
(a)

the amount of the initial measurement of the lease liability;

(b)

any lease payments made at or before the commencement date, less any
lease incentives received;

(c)

any initial direct costs incurred by the lessee;

(d)

an estimate of costs to be incurred by the lessee in dismantling and

removing the underlying asset, restoring the site on which it is located or
restoring the underlying asset to the condition required by the terms and
conditions of the lease, unless those costs are incurred to produce
inventories.

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At the commencement date, a lessee shall measure the lease liability at the
present value of the lease payments that are not paid at that date. The lease
payments shall be discounted using the interest rate implicit in the lease, if that
rate can be readily determined. If that rate cannot be readily determined, the
lessee shall use the lessees incremental borrowing rate.
Lease liability + Initial direct costs + Prepaid lease payments + Estimated costs to
dismantle, remove or restore, measured - Lease incentives received = Right-ofuse asset
Illustration: Double entry on initial recognition of a lease
(Assumes that the leased asset is an item of property, plant and equipment)
Debit
Credit
Property, plant and equipment (at cost)

Liabilities: lease obligations

Initial direct costs are often incurred in connection with specific leasing activities,
such as negotiating and securing leasing arrangements.
Any initial direct costs of the lessee are added to the amount recognised as an
asset.
Typical initial direct costs of a lessee includes;

Commissions

Legal fees*

Costs of negotiating lease terms and conditions*

Costs of arranging collateral

Payments made to existing tenants to obtain the lease

* If they are contingent on origination of the lease
Illustration:
Debit
Property, plant and equipment (at cost)

Credit

Cash/bank

Example:
Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Jhang Construction incurred initial direct costs of Rs. 2,000 when arranging
the lease.
Double entry:
Debit
Credit
Property, plant and machinery (at cost)

80,000
80,000

Liabilities: lease obligations

Property, plant and machinery (at cost)

2,000

Cash/bank

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Recognition exemptions
A lessee may elect not to apply the requirements to recognise and measurment
the right-of-use the leased asset and liability to:
(a) short-term leases; and
(b) leases for which the underlying asset is of low value
Short-term lease
A lease that, at the commencement date, has a lease term of 12 months or less.
A lease that contains a purchase option is not a short-term lease.
Example - Applying the short term lease exemption
Lessee ABC enters into a 8-year lease of a machine to be used in manufacturing
parts for a plane that it expects to remain popular with consumers until it
completes development and testing of an improved model. The cost to install the
machine in DEF manufacturing facility is not significant. ABC and DEF each have
the right to terminate the lease without a penalty on each anniversary of the lease
commencement date.
The lease term consists of a one-year non-cancellable period because both ABC
and DEF have a substantive termination right
ABC and DEF have a substantive termination right
both can terminate the lease without penalty
and the cost to install the machine in DEF manufacturing facility is not
significant.
As a result, the lease qualifies for the short-term lease exemption.
Example Applying the leases of low value exemption
Lessee A is in the pharmaceutical manufacturing and distribution industry and has
the following leases:
leases of real estate: both office building and warehouse;
leases of office furniture;
leases of company cars, both for sales personnel and for senior management
and of varying quality, specification and value;
leases of trucks and vans used for delivery; and
leases of IT equipment such as laptops.
A determines that the leases of office furniture and laptops qualify for the
recognition exemption on the basis that the underlying assets, when they are new,
are individually of low value. B elects to apply the exemption to these leases.
As a result, it applies the recognition and measurement requirements in IFRS 16 to
its leases of real estate, company cars, trucks and vans.

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3.3 Lease accounting: Subsequent measurement of the asset

After the commencement date, a lessee should measure the right-of-use asset
applying a cost model, unless it applies either of the measurement models
described below
Cost model
To apply a cost model, a lessee should measure the right-of-use asset at cost:
(a) less any accumulated depreciation and any accumulated impairment losses;
and
(b) adjusted for any re-measurement of the lease liability.
A lessee should apply the depreciation requirements in IAS 16 Property, Plant
and Equipment in depreciating the right-of-use asset
If the lease transfers ownership of the underlying asset to the lessee by the end
of the lease term or if the cost of the right-of-use asset reflects that the lessee will
exercise a purchase option, the lessee should depreciate the right-of-use asset
from the commencement date to the end of the useful life of the underlying asset.
Otherwise, the lessee should depreciate the right-of-use asset from the
commencement date to the earlier of the end of the useful life of the right-of-use
asset or the end of the lease term.
Other measurement models
If a lessee applies the fair value model in IAS 40 Investment Property to its
investment property, the lessee shall also apply that fair value model to right-of
use assets that meet the definition of investment property in IAS 40.
If right-of-use assets relate to a class of property, plant and equipment to which
the lessee applies the revaluation model in IAS 16, a lessee may elect to apply
that revaluation model to all of the right-of-use assets that relate to that class of
property, plant and equipment.
Illustration:
Debit
Statement of comprehensive income (depreciation
expense)
Accumulated depreciation

Credit

X
X

Example:
Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Jhang Construction incurred initial direct costs of Rs. 2,000 when arranging
the lease.
The estimated residual value of the asset at the end of the lease is Rs. 8,000.
The estimated useful life of the asset is 5 years.
The accounting policy for similar owned machines is to depreciate them over their
useful life on a straight line basis.

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Annual depreciation charge:

Initial cost:

Rs.

Fair value of the machine

80,000

Initial direct costs

2,000
82,000

Residual value

(8,000)

Depreciable amount

74,000

Useful life (shorter of the lease term and the useful life)

5 years

Annual depreciation charge

14,800

The underlying asset is included in the statement of financial position at its

carrying amount (cost less accumulated depreciation less any accumulated
impairment loss (if any)) in the same way as similar assets.
Example:
Year 1

Year 2

Year 3

Year 4

Year 5

Rs..

Rs.

Rs.

Rs.

Rs.

82,000

82,000

82,000

82,000

82,000

nil

14,800

29,600

44,400

59,200

Charge for the

year

14,800

14,800

14,800

14,800

14,800

Carried forward

14,800

29,600

44,400

59,200

74,000

Carrying amount

67,200

52,400

37,600

22,800

8,000

Cost
Accumulated
depreciation:
Brought forward

The asset is depreciated down to a carrying amount at the end of the assets
useful life that is the estimated residual value

3.4 Lease accounting: Subsequent measurement of the liability

After the commencement date, a lessee should measure the lease liability by:
(a) increasing the carrying amount to reflect interest on the lease liability;
(b) reducing the carrying amount to reflect the lease payments made; and
(c) re-measuring the carrying amount to reflect any reassessment or lease
modifications
After initial recognition, the lease liability is measured at amortised cost using the
effective interest method.

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After the commencement date, a lessee should recognise in profit or loss, unless
the costs are included in the carrying amount of another asset applying other
applicable Standards, both:
(a) interest on the lease liability; and
(b) variable lease payments not included in the measurement of the lease liability
in the period in which the event or condition that triggers those payments
occurs.
Reassessment of the lease liability
After the commencement date, a lessee should re-measure the lease liability by
using either unchanged discount rate or should re-measure the lease liability by
discounting the revised discount rate to reflect changes to the lease payments. A
lessee should recognise the amount of the re-measurement of the lease liability
as an adjustment to the right-of-use asset.
However, if the carrying amount of the right-of-use asset is reduced to zero and
there is a further reduction in the measurement of the lease liability, a lessee
should recognise any remaining amount of the re-measurement in profit or loss.
During each year, the lessee makes one or more lease payments. The payment
is recorded in the ledger account as follows.
Illustration:
Debit
Liabilities: lease obligations

Credit

Cash/bank

A lease liability is measured in the same way as any other liability. The balance at
any point in time is as follows:
Illustration:

Amount borrowed at the start of the lease (the amount

recognised on initial recognition of the lease)

Rs.
X

Plus: Interest accrued

Minus: Repayments (lease payments or rentals)

(X)

Repayment of loan principal

(X)

Amount owed now.

In effect, each lease payment consists of two elements:

a finance charge (interest charge) on the liability to the lessor, and
a partial repayment of the liability (the lease obligation).
The finance charge is treated as a finance cost in profit or loss for the period. The
partial repayment of the lease obligation reduces the amount of the liability that
remains unpaid.

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A lessee shall re-measure the lease liability by discounting the revised lease
payments using a revised discount rate, if either:
(a)

there is a change in the lease term. A lessee shall determine the revised
lease payments on the basis of the revised lease term; or

(b)

there is a change in the assessment of an option to purchase the

underlying asset, assessed considering the events and circumstances in
the context of a purchase option. A lessee shall determine the revised
lease payments to reflect the change in amounts payable under the
purchase option.

Finance charge
The total rental payments over the life of the lease will be more than the amount
initially recognised as a liability. The difference is finance charge.
The total finance charge that arises over the life term is the difference between
the amount initially recognised as the lease liability and the sum of the lease
payments from the standpoint of the lessee.
Illustration: Total finance charge
Rs.
Lessees lease payments (sum of all payments made by the
lessee to the lessor)
Amount on initial recognition

X
(X)

Total finance charge

Example: Total finance charge

Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Jhang Construction incurred initial direct costs of Rs. 2,000 when arranging
the lease.
The annual lease payments are Rs. 18,000, payable at the end of each year.
The estimated residual value of the asset at the end of the lease is Rs. 8,000 and
Jhang Construction has guaranteed this amount.
The interest rate implicit in the lease is 11.176751%.
Total finance charge
Lessees lease payments:

Rs.

Annual rentals (6 u 18,000)

Guaranteed residual value

108,000
8,000
116,000

Amount on initial recognition

(80,000)*

Total finance charge (interest)

36,000

* This is the amount of the liability, The asset is recognised at Rs. 82,000

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The finance charge (interest) is recognised over the life of the lease by adding a
periodic charge to the liability for the lease obligation with the other side of the
entry as an expense in profit or loss for the year.
Illustration:

Debit

Statement of comprehensive income: interest

expense
Liabilities: lease obligations

Credit

X
X

Lease modification
Definition: Lease modification
A change in the scope of a lease, or the consideration for a lease, that was not
part of the original terms and conditions of the lease (for example, adding or
terminating the right to use one or more underlying assets, or extending or
shortening the contractual lease term).
A lessee should account for a lease modification as a separate lease if both:
(a) the modification increases the scope of the lease by adding the right to use
one or more underlying assets; and
(b) the consideration for the lease increases by an amount commensurate with
the stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the
particular contract.
For a lease modification that is not accounted for as a separate lease, at the
effective date of the lease modification a lessee should:
(a) allocate the consideration in the modified contract. Following is the guidance
for allocating the consideration received;
i.

For a contract that contains a lease component and one or more

additional lease or non-lease components, a lessee should allocate the
consideration in the contract to each lease component on the basis of the
relative stand-alone price of the lease component and the aggregate
stand-alone price of the non-lease components.

ii. The relative stand-alone price of lease and non-lease components should
be determined on the basis of the price the lessor, or a similar supplier,
would charge an entity for that component, or a similar component,
separately. If an observable stand-alone price is not readily available, the
lessee should estimate the stand-alone price, maximising the use of
observable information.
However, as a practical expedient, a lessee may elect, by class of
underlying asset, not to separate non-lease components from lease
components, and instead account for each lease component and any
associated non-lease components as a single lease component.
(b) determine the lease term of the modified lease; and

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(c) remeasure the lease liability by discounting the revised lease payments using
a revised discount rate. The revised discount rate is determined as the
interest rate implicit in the lease for the remainder of the lease term, if that
rate can be readily determined, or the lessees incremental borrowing rate at
the effective date of the modification, if the interest rate implicit in the lease
cannot be readily determined.
For a lease modification that is not accounted for as a separate lease, the lessee
should account for the re-measurement of the lease liability by:
(a) decreasing the carrying amount of the right-of-use asset to reflect the partial
or full termination of the lease for lease modifications that decrease the scope
of the lease. The lessee should recognise in profit or loss any gain or loss
relating to the partial or full termination of the lease.
(b) making a corresponding adjustment to the right-of-use asset for all other
lease modifications.
Lease term
An entity should determine the lease term as the non-cancellable period of a
lease, together with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably
certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is
reasonably certain not to exercise that option.
(c) re-measure the lease liability by discounting the revised lease payments
using a revised discount rate. The revised discount rate is determined as the
interest rate implicit in the lease for the remainder of the lease term, if that
rate can be readily determined, or the lessees incremental borrowing rate at
the effective date of the modification, if the interest rate implicit in the lease
cannot be readily determined.

3.5 Calculating and allocating finance charges (interest)

The total finance charge for a leased asset is allocated so as to provide a
constant rate of charge on the outstanding obligation.
This means that as the lease liability decreases at each year-end, the interest
charge for the next year will be lower than it was for the previous year.
The method implied by the IFRS 16 guidance is to use an interest rate to allocate
the interest. This method is called the actuarial method. (The sum of digits
method usually gives an acceptable approximation to the actuarial method).
Questions in your exam are likely to require the use of an interest rate (which you
may have to calculate as the interest rate implicit in the lease).
Actuarial method
The actuarial method uses discounting arithmetic to establish the interest rate
that is implicit in the lease. This interest rate is then applied to the opening
balance of the lease liability at the start of each period, in order to calculate the
finance charge.

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Example: Allocation of the finance charge

Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Jhang Construction incurred initial direct costs of Rs. 2,000 when arranging
the lease.
The annual lease payments are Rs. 18,000, payable at the end of each year.
The estimated residual value of the asset at the end of the lease is Rs. 8,000 and
Jhang Construction has guaranteed this amount.
The interest rate implicit in the lease is 11.176751%.

Lease liability:

Year

Opening
liability

Interest
(11.176751%)

Lease
payments

Closing
liability

1
2
3
4

80,000
70,941
60,870
49,674

8,941
7,929
6,803
5,552

(18,000)
(18,000)
(18,000)
(18,000)

70,941
60,870
49,674
37,226

37,226

4,161

(18,000)

23,386

23,386

2,614

(26,000)

36,000
The interest expense is calculated by multiplying the opening liability by
11.176751% in each year (so as to provide a constant rate of charge on the
outstanding obligation).
The lease obligation consists of the capital balance outstanding. This can be
shown as follows:
Example:
Lease liability:

Year

Opening
balance

Lease
payments

Interest

Capital
repayments

Closing
balance

80,000

(18,000)

8,941

(9,059)

70,941

70,941

(18,000)

7,929

(10,071)

60,870

60,870

(18,000)

6,803

(11,197)

49,674

49,674

(18,000)

5,552

(12,448)

37,226

37,226

(18,000)

4,161

(13,839)

23,386

23,386

(26,000)

2,614

(23,386)

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The final payment

In the above example the final payment by the lessee is Rs. 26,000. This is in fact
made up of two amounts, the final rental of Rs. 18,000 and the guaranteed
residual value of Rs. 8,000.
It is worth considering the payment in respect of the guaranteed residual value in
a little more detail.
At the end of the lease, the asset that is the subject of the lease is transferred
back to the lessor. It has been depreciated down to its estimated residual value of
Rs. 8,000.
The transfer is recorded as follows:
Example: Final payment in respect of the guaranteed residual value
Debit
Liabilities: lease obligations

Credit

8,000

Leased Asset

8,000

In other words, the Rs. 8,000 part of the final year payment to the lessor of Rs.
26,000 is not cash but the transfer of the asset.
If the asset is worth less that Rs. 8,000 the lessee must make good any shortfall.
In this case the asset is written down to its value at the date of the transfer (as
agreed between the lessee and the lessor) and the lessee will pay cash to the
lessor to compensate for any difference.
Example (continued): Final payment in respect of the guaranteed residual value
The asset has a carrying amount of Rs. 8,000 at the end of the lease but is only
worth Rs. 5,000.
The lessee would make the following double entries.
Write down the asset

Debit

Statement of comprehensive income

3,000

Leased Asset
Pay the lessor the guaranteed residual value
Liabilities: lease obligations

Credit
3,000

8,000

Leased Asset

5,000

Cash/bank

3,000

Example:
A company leases an asset (as lessee) on 1 January 20X1. The terms of the lease are
to pay:
x

A non-refundable deposit of Rs. 5,800 on inception.

Six annual instalments of Rs. 16,000 payable in arrears.

The fair value of the asset (equivalent to the present value of minimum lease
payments) on 1 January 20X1 is Rs. 80,000. Its useful life to the company is five
years.

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

Financial statement extracts

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31
DECEMBER 20X1 (EXTRACT)
Rs.
Depreciation [(80,000 + 2,000 - 8,000)/5)]

14,800

Finance costs (Working)

7,420

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1

(EXTRACT)
Non-current assets

Rs.

Leased asset [(80,000 + 2,000) - ((80,000 +

2,000 - 8,000)/5)]

67,200

Finance lease liability (Working)

56,182

Current liabilities
Finance lease liability (Working) (65,620 56,182)
WORKING

20X1
20X2
(b)

Bal b/f
Rs.

9,438

Interest accrued
at 10%
Rs.

Payment 31
Dec
Rs.

Bal c/f 31
Dec
Rs.

7,420
6,562

(16,000)
(16,000)

65,620
56,182

80,000
(5,800)
74,200
65,620

Treatment of guaranteed residual value

At the end of the lease, the lessee will have an asset at residual value of
Rs. 8,000 in its statement of financial position and a finance lease
liability of Rs. 8,000 representing the residual value guaranteed to the
lessor.

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i. If the lessor is able to sell the asset for more than the value guaranteed
by the lessee, the lessee has no further liability and derecognises the
asset and lease liability:
Dr Finance lease liability

Rs. 8,000

Cr Asset carrying amount

Rs. 8,000

ii. If the lessor is unable to sell the asset for the value guaranteed by the
lessee, the lessee has a liability to make up the difference of Rs. 8,000 Rs. 6,000 = Rs. 2,000:
Recognise impairment loss on asset (as soon as known during the lease
term):
Dr Profit or loss

Rs. 2,000

Cr Asset carrying amount

Rs. 2,000

Make guaranteed payment to lessor and derecognise the asset and

lease liability:
Dr Finance lease liability

Rs. 8,000

Cr Cash

Rs. 2,000

Cr Asset carrying amount

Rs. 6,000

3.6 Current and non-current elements of the lease liability

The total liability must be divided between:
the current liability (amount payable within the next 12 months), and
the non-current liability.
The easy way to do it is to use the tables to identify the current liability or the noncurrent liability and then find the other as a balancing figure.
Example: Split of current and non-current liability at the end of year 1
Year

Opening
balance

Lease
payments

Interest

Capital
repayments

Closing
balance

80,000

(18,000)

8,941

(9,059)

70,941

70,941

(18,000)

7,929

(10,071)

60,870

n
This is the
current
liability

n
This is the
non-current
liability

Liability:
Current liability

Rs.
10,071

Non-current liability

60,870

Total liability (for proof)

70,941

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3.7 Lease payments made in advance

When the lease payments for a lease are made at the start of each period instead
of the end of the period, the total finance charge is the same (because neither the
amount borrowed nor the total rentals have changed) but the interest must be
recognised over a shorter period. This is because the liability is paid off one
period earlier.
This means that the interest rate used for payments in advance will be bigger
than that used for the same payments in arrears.
Also note that when the lease payments for a lease are made at the start of each
period, the opening liability for the lease obligation is reduced by the lease
payment at the beginning of the year, and the interest charge must be applied to
the remaining balance.
Example: Allocation of finance charge
Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Jhang Construction incurred initial direct costs of Rs. 2,000 when arranging
the lease.
The annual lease payments are Rs. 18,000, payable at the start of each year.
The estimated residual value of the asset at the end of the lease is Rs. 8,000 and
Jhang Construction has guaranteed this amount.
The interest rate implicit in the lease is 16.1434%.
Lease liability:
(Note: Year 0 is the first day of year 1. It would be better to think of it as time 0).
Liability
after day 1 Interest at
Opening
Lease
Closing
payments
payment
liability
liability
16.1434%.
Year
0
1

80,000
72,009

(18,000)
(18,000)

62,000
54,009

10,009
8,719

72,009
62,728

62,728

(18,000)

44,728

7,221

51,948

3
4

51,948
39,429

(18,000)
(18,000)

33,948
21,429

5,480
3,459

39,429
24,888

24,888

(18,000)

6,888

1,112

8,000

8,000

(8,000)

36,000
The interest expense is calculated by multiplying the opening liability by
16.1434% in each year (so as to provide a constant rate of charge on the
outstanding obligation).
In the above example the first payment of Rs. 18,000 is made on the first day of
the lease term. Therefore it does not include any interest and is a repayment of
capital.
The year 1 interest of Rs. 10,009 is recognised at the end of year 1 (31
December Year 1). It is paid the next day by the payment of Rs. 18,000 made on
1 January Year 2.
The closing liability at the end of year 1 is made up of the interest accrued in year
1 and an amount of capital which will be paid off in year 2.

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This can be shown for all of the years below.

Example: Capital repayments
Schedule to show repayment of capital:

Year

Opening
balance

Lease
payments

Interest

Capital
repayments

Closing
balance

1
2

80,000
62,000

(18,000)
(18,000)

10,009

(18,000)
(7,991)

62,000
54,009

51,948

(18,000)

8,719

(9,281)

44,728

39,429

(18,000)

7,221

(10,779)

33,948

24,888

(18,000)

5,480

(12,520)

21,429

6 (start)

8,000

(18,000)

3,459

(14,541)

6,888

6 (end)

6,888

(8,000)

1,112

(6,888)

Current and non-current liability

If payments are made annually in advance, the next payment is a current liability.
Therefore in the above example the Rs. 18,000 paid on 1 January Year 2 is a
current liability.
However, this is made up of two elements, interest of Rs. 10,009 and a capital
repayment of Rs. 7,991. These elements could be shown separately.
This means that the closing liability at the end of year 1 as identified on the
previous page (Rs. 72,009) is made up of three parts:
the interest recognised in year 1 but unpaid at the year-end (Rs. 10,009);
the current element of the capital owed on the lease (Rs. 7,991); and
the non-current element of the capital owed on the lease (Rs. 54,009).
Example: Current and non-current liability
Year
1
2

Opening
balance
80,000
62,000

Lease
payments
(18,000)
(18,000)

Liability:
Current liabilities
Interest expense
Current part of lease liability
Non-current liability
Non-current part of lease liability
Total lease liability (for proof)
Total liability (for proof)

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Interest
10,009

Interest
expense
current
liability

Capital
repayments
(18,000)
(7,991)

lease
current
liability
Rs.

Closing
balance
62,000
54,009

lease noncurrent
liability

10,009
7,991
54,009
62,000
72,009

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Chapter 11: IFRS 16: Leases

Practice question

The fair value of aleased asset, lease commencing on 1 January Year 1 is Rs.
10,000.
The lease is for three years with payments of Rs. 4,021 annually on 1 January Year
1, Year 2 and Year 3.
The interest rate implicit in the lease is 22.25%.
Required
Complete the lease payment table for all three years 1 to 3, and calculate the
current liability and the non-current liability at 31 December Year 1 under the
actuarial method.

3.8 Disclosures
A lessee shall disclose information about its leases for which it is a lessee in a
single note or separate section in its financial statements. However, a lessee
need not duplicate information that is already presented elsewhere in the financial
statements, provided that the information is incorporated by cross-reference in
the single note or separate section about leases.
A lessee shall disclose the following amounts for the reporting period:
(a) depreciation charge for right-of-use assets by class of underlying asset;
(b) interest expense on lease liabilities;
(c) the expense relating to short-term leases. This expense need not include the
expense relating to leases with a lease term of one month or less;
(d) the expense relating to leases of low-value assets. This expense shall not
include the expense relating to short-term leases of low-value assets;
(e) the expense relating to variable lease payments not included in the
measurement of lease liabilities;
(f) income from subleasing right-of-use assets;
(g) total cash outflow for leases;
(h) additions to right-of-use assets;
(i) gains or losses arising from sale and leaseback transactions; and
(j) the carrying amount of right-of-use assets at the end of the reporting period
by class of underlying asset.
A lessee shall provide the disclosures specified in paragraph 53 in a tabular
format, unless another format is more appropriate. The amounts disclosed shall
include costs that a lessee has included in the carrying amount of another asset
during the reporting period.
A lessee shall disclose the amount of its lease commitments for short-term leases
accounted for applying paragraph 6 if the portfolio of short-term leases to which it
is committed at the end of the reporting period is dissimilar to the portfolio of

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short-term leases to which the short-term lease expense disclosed applying

paragraph 53(c) relates.
If right-of-use assets meet the definition of investment property, a lessee shall
apply the disclosure requirements in IAS 40. In that case, a lessee is not required
to provide the disclosures in paragraph 53(a), (f), (h) or (j) for those right-of-use
assets.
If a lessee measures right-of-use assets at revalued amounts applying IAS 16,
the lessee shall disclose the information required by paragraph 77 of IAS 16 for
those right-of-use assets.
ABC Ltd. is a retailer of men apparel. They have entered into a 5 year lease of shop
premises with a XYZ Ltd. on 1 July 2015.
The lease requires 5 yearly payments in advance of Rs. 100,000 (the first payment
is 1 July 2015 and subsequent payments are 30 June).
The interest rate implicit in the lease is 10%
The ABC Ltd. uses straight line depreciation method
IFRS 16 treatment
Years

TOTAL

------------------------------------- Rs ------------------------------------Payments

100,000

100,000

100,000

100,000

100,000

500,000

100,000

90,909

82,645

75,131

68,301

416,987

Lease liability
(CY = Prior year PV Payment during the
year + Interest exp)

316,987

248,685

173,554

90,909

Right to use asset (CY

= Preceding year lease
liability - CY
depreciation)

416,987

333,630

250,273

166,917

83,560

Intest expense - A (CY =

Preceding year lease
liability * Int. rate)

31,699

24,869

17,355

9,091

83,013

Depreciation - B (Right
to use at year 0/ useful
life)

83,357

83,357

83,357

83,357

83,357

416,783

115,055

108,225

100,712

92,448

83,357

499,796

PV

P&L Impact = A+B

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Journal Enteries
At 1 July 2015

Debit

Right to use asset

416,987

Lease liabilty

Credit

416,987

Lease Liabilty

100,000

Cash

100,000

At 30 June 2016
Depreciation expense

83,357

Acc. Depreciation

83,357

Intest expense

31,699

Lease Liability

68,301

Cash

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ACCOUNTING FOR A FINANCE LEASE: LESS0R ACCOUNTING

Section overview

Definitions
Finance lease accounting

Manufacturer/dealer leases

Finance lessor disclosures

4.1 Definitions
The lessor does not record the leased asset in his own financial statements
because he has transferred the risks and rewards of ownership of the leased
asset to the lessee. Instead, he records the amount due to him under the terms of
the finance lease as a receivable.
The receivable is described as the net investment in the lease.
Definitions: Gross and net investment in the lease
Gross investment in the lease is the aggregate of:
(a)

the lease payments receivable by the lessor under a finance lease, and

(b)

any unguaranteed residual value accruing to the lessor.

Net investment in the lease is the gross investment in the lease discounted at the
interest rate implicit in the lease.
An earlier section explained that the interest rate implicit in the lease is the
discount rate that, at the inception of the lease, causes:
the present value of the lease payments and the unguaranteed residual
value; to be equal to
the sum of the fair value of the underlying asset and any initial direct costs of
the lessor.
Therefore the net investment in the lease is the sum of the fair value of the asset
plus the initial direct costs.
Definitions:
Un
nearned finance

The difference between:

income

(a)

the gross investment in the lease; and

(b)

the net investment in the lease.

4.2 Finance lease accounting

Many of the entries to be made in the ledger accounts of the lessor are a mirror
image of those made by the lessee in respect of his lease liability.

Initial recognition &

measurement

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Finance lease receivable

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lease)

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Lessee

Lessor

Finance cost

Finance income

So as to provide a
constant periodic rate of
charge on the outstanding
obligation

So as to provide a
constant periodic rate of
return on the net
investment in the lease.

Subsequent
measurement
Pattern of
recognition

Initial recognition
The lessor records a receivable for the capital amount owed by the lessee. This
should be stated at the amount of the net investment in the lease.
Illustration: Double entry on Initial recognition of a finance lease
Debit
Net investment in the lease

Credit

Cash/bank

For finance leases other than those involving manufacturer or dealer lessors,
initial direct costs are included in the initial measurement of the finance lease
receivable thus reducing the amount of income recognised over the lease term to
below what it would have been had the costs not been treated in this way. The
result of this is that the initial direct costs are recognised over the lease term as
part of the income recognition process.
Initial direct costs of manufacturer or dealer lessors in connection with negotiating
and arranging a lease are excluded from the definition of initial direct costs. As a
result, they are excluded from the net investment in the lease.
The treatment of similar costs incurred by manufacturers and dealers is explained
later.
Subsequent measurement of the receivable
During each year, the lessor receives payments from the lessee. Each receipt is
recorded in the ledger account as follows.
Illustration: Lessor receipts

Debit

Cash/bank

Credit

Net investment in the lease

A finance lease receivable (net investment in the lease) is measured in the same
way as any other financial asset. The balance at any point in time is as follows:
Illustration: Net investment in the lease

Rs.

Amount of loan at the start of the lease (the amount recognised

on initial recognition of the lease)

Plus: Interest accrued

Minus: Repayments (lease payments or rentals)

(X)

Repayment of loan principal

(X)

Amount owed to the lessor now.

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In effect, each lease receipt consists of two elements:

finance income on the receivable; and
a partial repayment of the receivable (net investment in the lease).
The finance charge is recognised as income in profit or loss for the period. The
partial repayment of the lease receivable reduces the amount owed to the lessor.
Finance income
The total rental receipts over the life of the lease will be more than the amount
initially recognised as a receivable. The difference is finance income.
The total finance income that arises over the life of the lease is the difference
between the amount invested in the lease (the amount loaned plus the initial
direct costs) and the sum of all receipts.
Illustration: Total finance income
Rs.
X

Lessors lease payments

Initial direct costs

X
X

Amount on initial recognition

(X)

Total finance income

Example: Total finance income

Sialkot Finance agreed to lease a machine to Jhang Construction commencing on
1 January Year 1.
The lease was a 6 year finance lease of a machine on 1 January Year 1 with annual
lease payments of Rs. 18,000, payable in arrears.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Sialkot Finance incurred initial direct costs of Rs. 2,000 when arranging the
lease.
The estimated residual value of the asset at the end of the lease is Rs. 10,000. The
lessee has guaranteed an amount of Rs. 8,000.
The interest rate implicit in the lease is 10.798%.
Total finance income
Lessors lease payments:

Rs.

Annual rentals (6 u 18,000)

108,000

Guaranteed residual value

8,000

Unguaranteed residual value

2,000
118,000

Amount on initial recognition

(80,000)

Initial direct costs

(2,000)
(82,000)

Total finance income

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The finance income is recognised over the life of the lease by adding a periodic
return to the net investment in the lease with the other side of the entry as income
in profit or loss for the year.
Illustration:
Debit
Net investment in the lease

Credit

Statement of comprehensive income: finance income

Calculating and allocating finance income

Finance income is recognised so as to give a constant periodic rate of return on
the lessor's net investment in the finance lease.
Example: Calculating and allocating finance income
Sialkot Finance agreed to lease a machine to Jhang Construction commencing on
1 January Year 1.
The lease was a 6 year finance lease of a machine on 1 January Year 1 with annual
lease payments of Rs. 18,000, payable in arrears.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Sialkot Finance incurred initial direct costs of Rs. 2,000 when arranging the
lease.
The estimated residual value of the asset at the end of the lease is Rs. 10,000. The
lessee has guaranteed an amount of Rs. 8,000.
The interest rate implicit in the lease is 10.798%.
Proof that interest rate implicit in the lease is 10.798%

Year

Narrative

Cash
flow

Discount
factor
(10.798%)

Present
value

18,000

4.2553

76,595

lease payments
1 to 6

Annual rentals

Guaranteed residual value

8,000

0.54052

4,324

Unguaranteed residual
value

2,000

0.54052

1,081
82,000

Fair value of the asset

Initial direct costs

80,000
2,000
82,000

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Example: Calculating and allocating finance income

Sialkot Finance agreed to lease a machine to Jhang Construction commencing on
1 January Year 1.
The lease was a 6 year finance lease of a machine on 1 January Year 1 with annual
lease payments of Rs. 18,000, payable in arrears.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Sialkot Finance incurred initial direct costs of Rs. 2,000 when arranging the
lease.
The estimated residual value of the asset at the end of the lease is Rs. 10,000 and
the lessee has guaranteed Rs. 8,000 of this amount.
The interest rate implicit in the lease is 10.798%.
Net investment in the lease
Opening net
investment
Year

Interest
(10.798%)

Lease
receipts

Closing net
investment

82,000

8,854

(18,000)

72,854

72,854

7,867

(18,000)

62,721

3
4

62,721
51,494

6,773
5,560

(18,000)
(18,000)

51,494
39,054

39,054

4,217

(18,000)

25,271

25,271

2,729

(26,000)

2,000

36,000
The interest income is calculated by multiplying the opening receivable by 10.798%
in each year (so as to provide a constant rate of return on the net investment in the
lease).
The final balance on the account is the unguaranteed residual value.
Finance lease accounting alternative double entry
There is an alternative approach to finance lessor double entry. Instead of
recognising net investment in a lease as an asset, a company could recognise
the gross investment in a lease as an asset and unearned finance income as a
liability. The balances on these two accounts would be netted off to give the net
investment in a lease at each reporting date.
Illustration: Double entry on Initial recognition of a finance lease
Debit
Gross investment in the lease

Credit

Unearned finance income

Cash/bank (or payable)

The rental receipts reduce the gross investment in the lease. In addition, the
interest income in the period is transferred from the unearned finance income
account to the statement of profit or loss.

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Illustration: Double entry on receipt date

Debit
Cash

Credit

Gross investment in the lease

Unearned finance income

Statement of profit or loss

It is still necessary to construct an amortisation table in order to identify the

interest income.
Example: Finance lessor accounting alternative double entry
Facts as before (key points reproduced for your convenience)
Lease commences on 1 January Year 1.
The lease was a 6 year finance lease of a machine on 1 January Year 1 with annual
lease payments of Rs.18,000, payable in arrears.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and the lessor incurred initial direct costs of Rs. 2,000 when arranging the lease.
The estimated residual value of the asset at the end of the lease is Rs. 8,000 and
the lessee has guaranteed this amount.
The interest rate implicit in the lease is 10.798%.
Gross investment in the lease
Rs.
Annual rentals (6 u 18,000)

108,000

Guaranteed residual value

9,000

Unguaranteed residual value

1,000
118,000

Amount on initial recognition

(80,000)

Initial direct costs

(2,000)
(82,000)

Total finance income

36,000

The double entry at the start of the lease would be as follows:

Start of year 1

Debit

Lease receivable (gross investment in the lease)

Credit

118,000

Unearned finance income

36,000

Cash (or payable)

82,000

Being the initial recognition of the lease

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End of year 1
Cash

18,000

Lease receivable (gross investment in the lease)

18,000

Being the receipt of the year 1 rental

Unearned finance income

8,854

Finance income (statement of profit or loss) W

8,854

Being the recognition of finance income

Year

Opening net
investment

Interest
(10.798%)

Lease
receipts

Closing net
investment

82,000

8,854

(18,000)

72,854

72,854

7,867

(18,000)

62,721

The net investment in the lease is found be netting the unearned finance income
against the lease receivable (gross investment in the lease) at each point in time.
The following table shows the balance on the two accounts at the start and at each
year end and the resulting net figures.
Year

Finance lease
receivable

118,000

36,000

(18,000)

(8,854)

100,000

27,146

(18,000)

(7,867)

82,000

19,279

(18,000)

(6,773)

64,000

12,506

(18,000)

(5,560)

46,000

6,946

(18,000)

(4,217)

28,000

2,729

(27,000)

(2,729)

Unearned
finance income

1,000

Net investment
in the lease
82,000

72,854

62,721

51,494

39,054

25,271

1,000

Note that the net investment in the lease is the same as before.

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Example:
A company leased an asset to another company on 1 January 20X1 on the following
terms.
Lease term

4 years

Inception of lease

1.1.X1

Annual instalments in advance

Rs. 22,000

Residual value of asset as guaranteed by lessee

Rs. 10,000

Expected residual value at end of lease

Rs. 12,000

Fair value of the asset

Rs. 82,966

Initial direct costs incurred by the lessor

Rs. 700

Interest rate implicit in the lease

11%

Requirements
a) Calculate the unguaranteed residual value and the net investment in the lease
as at 1 January 20X1
b) Prepare extracts from the financial statements of the lessor for the year ended
31.12.X1 (excluding notes)
a) Unguaranteed residual value and net investment in the lease at 1 January
20X1
Date

Gross

Discount

Net

investment

factor

investment

Rs.

(11%)

Rs.

1.1.X1

Instalment

22,000

22,000

1.1.X2

Instalment

22,000

0.901

19,822

1.1.X3

Instalment

22,000

0.812

17,864

1.1.X4

Instalment

22,000

0.731

16,082

31.12.X4

Guaranteed residual
value

10,000

0.659

6,590

Minimum lease
payments
31.12.X4

98,000

Unguaranteed
residual value

2,000

Investment in the
lease

100,000

82,358

0.659

Lessee's
liability

1,318
83,676

Lessor's
asset

Note: The net investment in the lease is equal to the fair value of the asset of
Rs. 82,966 plus the lessor's costs of Rs. 700. In this instance there is a
rounding difference of Rs. 10.

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b) Financial statement extracts

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31
DECEMBER 20X1 (EXTRACT)
Rs.
Finance income (Working)
6,784
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)
Rs
Non-current assets
Net investment in finance lease (Working)
46,460
Current assets
Net investment in finance lease (Working) (68,460 - 46,460)
22,000
WORKING
Net investment in finance lease
Interest
Instalments
Bal c/f 31
income at
c/f
Bal b/f
in advance
Dec
11%
Rs.
Rs.
Rs.
Rs.
Rs.
20X1
83,676
(22,000)
61,676
6,784
68,460
20X2
68,460
(22,000)
46,460
For many years an entity has owned a freehold building which it has recognised
as an investment property under the fair value model of IAS 40. This requires
that the property is revalued to fair value at each reporting date with any gains
or losses recognised in profit or loss. At 31 December 20X4, the carrying
amount of the building was Rs. 5 million.
On 1 January 20X5, the entity leased it out under a 40-year finance lease. The
lease included a clause transferring title to the lessee at the end of the lease;
the lease was therefore recognised as a single finance lease comprising both
the land and building elements.
The annual rental is Rs. 400,000 payable in advance and the interest rate
implicit in the lease has been calculated as 8.3%.
Requirement
How should the transaction be recognised on 1 January 20X5 and in the year
ending 31 December 20X5?
The transaction will be recognised by the entity as follows.
1 January 20X5 Derecognise Rs. 5 million investment property asset
Recognise Rs. 5 million finance lease receivable
Recognise Rs. 400,000 cash received as a reduction in the
receivable
Note that the net investment in the lease is equal to the fair value of the asset
plus any costs incurred by the lessor. In this case there were no such costs and
therefore the fair value of the asset is the net investment in the lease.
31 December 20X5
Increase the receivable by Rs. 381,800
(8.3% x (Rs. 5,000,000 - Rs. 400,000))
Recognise finance income of Rs. 381,800 in profit
or loss

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Lease modifications
A lessor shall account for a modification to a finance lease as a separate lease if
both:
a. the modification increases the scope of the lease by adding the right to use
one or more underlying assets; and
b. the consideration for the lease increases by an amount commensurate with
the stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the
particular contract.
For a modification to a finance lease that is not accounted for as a separate
lease, a lessor shall account for the modification as follows:
a. if the lease would have been classified as an operating lease had the
modification been in effect at the inception date, the lessor shall:
i.

account for the lease modification as a new lease from the effective date
of the modification; and

ii. measure the carrying amount of the underlying asset as the net
investment in the lease immediately before the effective date of the lease
modification.
b. otherwise, the lessor shall apply the requirements of IFRS 9.

4.3 Manufacturer/dealer lessors

Manufacturers or dealers often offer to customers the choice of either buying or
leasing an asset. A finance lease of an asset by a manufacturer or dealer lessor
gives rise to two types of income:
profit or loss equivalent to the profit or loss resulting from an outright sale of
the asset being leased, at normal selling prices, reflecting any applicable
volume or trade discounts; and
finance income over the lease term.
Revenue
The sales revenue recognised at the commencement of the lease term is the lower of:
the fair value of the underlying asset; and
the present value of the lease payments accruing to the lessor discounted at
market rate of interest.
Cost of sale
The cost of sale recognised at the commencement of the lease term is the
carrying amount of the underlying asset less the present value of the
unguaranteed residual value.
The deduction of the present value of the unguaranteed residual value
recognises that this part of the asset is not being sold. This amount is transferred
to the lease receivable. The balance on the lease receivable is then the present
value of the amounts which the lessor will collect off the lessee plus the present
value of the unguaranteed residual value. This is the net investment in the lease
as defined in section 5.2.

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Costs incurred by manufacturer or dealer lessors in connection with negotiating

and arranging a lease must be recognised as an expense when the selling profit
is recognised.
Profit or loss on the sale
The difference between the sales revenue and the cost of sale is the selling profit
or loss. Profit or loss on these transactions is recognised in accordance with the
policy followed for recognising profit on outright sales.
The manufacturer or dealer might offer artificially low rates of interest on the
finance transaction. In such cases the selling profit is restricted to that which
would apply if a market rate of interest were charged.
Example: Manufacturer or dealer leases
Multan Motors is a car dealer.
It sells cars and offers a certain model for sale by lease.
The following information is relevant:
Price of the car in a cash sale

Rs. 2,000,000

Cost of the car

Rs. 1,500,000

Finance option:
Annual rental

Rs. 804,230

Lease term

3 years

Interest rate

10%

Estimated residual value

nil

Lessors cost of setting up the lease

Rs. 20,000

Discount factor
t1 to t3 @ 10%

2.486852 (written as 2.487)

Working: Revenue lower of:

Rs.

Fair value of the asset

2,000,000

Present value of the lease payments

804,230 u 2.487

2,000,000

Initial double entry:

Revenue

Debit

Lease receivable (Net investment in the lease)

2,000,000

Statement of comprehensive income

Cost of sale
Statement of comprehensive income

2,000,000
1,500,000

Asset (Inventory)
Cost of setting up the lease

1,500,000

Statement of comprehensive income

Cash/bank

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Example: Manufacturer or dealer lease (continued)

Net investment in the lease (over its life):

Year

Opening net
investment

Interest (10%)

Lease
receipts

Closing net
investment

2,000,000

200,000

(804,230)

1,395,770

1,395,770

139,577

(804,230)

731,117

731,117

73,113

(804,230)

nil

The interest income is calculated by multiplying the opening receivable

by 10% in each year (so as to provide a constant rate of return on the net
investment in the lease).
Summary of double entry in year 1:

Bank

Inventory

B/f

Net
investment in
the lease

Profit or loss

2,000,000Dr

2,000,000Cr

1,500,000Dr

Revenue
Cost of sales
Set up cost

(1,500,000)Cr

(1,500,000)Dr

(20,000)Cr

(20,000)Dr

Profit on sale

480,000Cr

Lease income
Lease rental

200,000Dr
804,230Dr

200,000Cr

(804,230)Cr
1,395,770Dr

680,000Cr

Example: Manufacturer or dealer leases with unguaranteed residual value

The following information is relevant:
Price of the car in a cash sale

Rs. 2,000,000

Cost of the car

Rs. 1,500,000

Finance option:
Annual rental

Rs. 764,018

Lease term

3 years

Interest rate

10%

Estimated residual value

Rs. 133,100

Lessors cost of setting up the lease

Rs. 20,000

Discount factors:
t3 @ 10%

0.7513148 (written as 0.751)

t1 to t3 @ 10%

2.486852 (written as 2.487)

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Workings
W1: Revenue lower of:

Rs.

Fair value of the asset

2,000,000

Present value of the lease payments

1,900,000

764,018u 2.487
W2: Present value of the unguaranteed residual value

Rs.

Present value of the lease payments

133,156 u 0.751

100,000

Initial double entry:

Revenue

Debit

Lease receivable (Net investment in the lease)

Credit

1,900,000

Statement of comprehensive income

Cost of sale

1,900,000

Statement of comprehensive income

1,400,000

Asset (Inventory)
Transfer

1,400,000

Lease receivable (Net investment in the lease)

Asset (Inventory)

100,000
100,000

Cost of setting up the lease

Statement of comprehensive income
Cash/bank

20,000

Interest (10%)

Lease
receipts

Closing net
investment

2,000,000

200,000

(764,018)

1,435,982

1,435,982

143,598

(764,018)

815,562

815,562

81,556

(764,018)

133,100

Year
1

Opening net
investment

20,000

1,900,000
100,000

The interest income is calculated by multiplying the opening receivable by

10% in each year (so as to provide a constant rate of return on the net
investment in the lease).
The balance on the account at the end of the lease term is the unguranteed
residual value.

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Example: Manufacturer or dealer lease (continued)

Net investment in the lease (over its life):
Summary of double entry in year 1:

Bank
B/f

Inventory

Profit or loss

1,900,000Dr

1,900,000Cr

1,500,000Dr

Revenue
Cost of sales
Set up cost

Net
investment in
the lease

(1,400,000)Cr

(1,400,000)Dr

(20,000)Cr

(20,000)Dr

Profit on sale

480,000Cr

Transfer

(100,000)Cr

Lease income
Lease rental

100,000Dr
200,000Dr

764,018Dr

200,000Cr

(764,018)Cr
1,435,982Dr

680,000Cr

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

Cash flow
Rs.
8,750

20X6

8,750

20X7

8,750

Discount factor at 8%
1.000
1
(1.08)= 0.926
1
2
(1.08) =0.857

Present value
Rs.
8,750
8,102
7,499
24,351

Requirement
How should the transaction be recognised by the dealer in the year ending 31
December 20X5?
Statement of comprehensive income
Revenue (lower of FV Rs. 26,250 and PV of MLPs Rs. 24,351)
24,351
Cost of sales (lower of cost and CV PV of unguaranteed residual
(21,000)
value)
Profit
3,351
Finance income: (Working)
1,248
Statement of financial position
Receivable (Working)
16,849

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WORKING

20X5

Bal b/f

Instalments
in advance

c/f

Interest
income at

Bal c/f 8%
31 Dec

Rs.

Rs.

Rs.

Rs.

Rs.

24,351

(8,750)

15,601

1,248

16,849

4.4 Finance lessor disclosures

A finance lessor must disclose the following:
selling profit or loss;
finance income on the net investment in the lease; and
income relating to variable lease payments not included in the measurement
of the net investment in the lease.
a reconciliation between the gross investment in the lease at the end of the
reporting period, and the present value of lease payments receivable at the
end of the reporting period;
the gross investment in the lease and the present value of lease payments
receivable at the end of the reporting period, for each of the following periods:
x

not later than one year;

later than one year and not later than five years;

later than five years;

unearned finance income;

the unguaranteed residual values accruing to the benefit of the lessor;
the accumulated allowance for uncollectible lease payments receivable;
contingent rents recognised as income in the period;
a general description of the lessor's material leasing arrangements.
Maturity analysis of lease payment receivables
A lessor shall provide a qualitative and quantitative explanation of the significant
changes in the carrying amount of the net investment in finance leases.
A lessor shall disclose additional qualitative and quantitative information about;
the nature of the lessors leasing activities; and
how the lessor manages the risk associated with any rights it retains in
underlying assets. In particular, a lessor shall disclose its risk management
strategy for the rights it retains in underlying assets, including any means by
which the lessor reduces that risk.

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ACCOUNTING FOR AN OPERATING LEASE

Section overview

Operating leases in the financial statements of the lessor

Operating lessor disclosures

5.1 Operating leases in the financial statements of the lessor

Because the lessor has not transferred the risks and rewards of ownership of the
physical asset to the lessee, the lessor shows the leased asset as a non-current
asset in its statement of financial position.
It will be shown in an appropriate category of property, plant and equipment as an
investment property at its carrying value (cost/valuation minus accumulated
depreciation).
In respect of the leased asset, the lessors annual statement of comprehensive
income will include in profit or loss:
depreciation on the asset as an expense, and
rental income (as for the lessee, this is usually calculated on a straight-line
basis).
Lease income from operating leases is recognised in income on a straight-line
basis over the lease term, unless another systematic basis is more representative
of the time pattern in which use benefit derived from the leased asset is
diminished.
Initial direct costs incurred by lessors in negotiating and arranging an operating
lease are added to the carrying amount of the leased asset and recognised as an
expense over the lease term on the same basis as the lease income.
The depreciation policy for depreciable leased assets must be consistent with the
lessor's normal depreciation policy for similar assets, and calculated in
accordance with IAS 16 and IAS 38.
A lessor shall apply IAS 36 to determine whether an underlying asset subject to
an operating lease is impaired and to account for any impairment loss identified.
Manufacturer/dealer leases
A manufacturer or dealer lessor must not recognise any selling profit on entering
into an operating lease. It is not the equivalent of a sale as the risks and benefits
of ownership do not pass.
A lessor shall account for a modification to an operating lease as a new lease
from the effective date of the modification, considering any prepaid or accrued
lease payments relating to the original lease as part of the lease payments for the
new lease.

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5.2 Operating lessor presentation and disclosures

A lessor shall present underlying assets subject to operating leases in its
statement of financial position according to the nature of the underlying asset.
Operating lessors must disclose the following:
the future lease payments under non-cancellable operating leases in the
aggregate and for each of the following periods:
x

not later than one year;

later than one year and not later than five years;

later than five years.

total contingent rents recognised as income in the period.

a general description of the lessor's leasing arrangements.

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Chapter 11: IFRS 16: Leases

SALE AND LEASEBACK TRANSACTIONS AND SUB-LEASE

Section overview

Sale and leaseback transactions

Sale and finance leaseback (finance lease)

Sale and operating leaseback (operating lease)

Sub-lease

6.1 Sale and leaseback transactions

Sale and leaseback transactions involve one entity selling an asset, normally to a
bank or finance company, and then immediately leasing it back. The main
purpose is to allow the entity to release cash that is tied up in the asset, whilst
retaining use of the asset.
For example, a company may own an office building that it uses for its
administrative operations. It may decide to sell and lease back the building, to
raise cash. By selling the building, it raises cash. By leasing back the building, it
retains the use of the building for its operational activities.
The leaseback could be arranged either as a finance lease or an operating lease,
and this will affect the accounting treatment of the transaction.

6.2 Sale and finance leaseback (finance lease)

To determine how to account for a sale-and-leaseback transaction, a company
first considers whether the initial transfer of the underlying asset from the sellerlessee to the buyer-lessor is a sale. The company applies IFRS 15 to determine
whether a sale has taken place. This assessment determines the accounting by
both the seller-lessee and the buyer-lessor, as follows.
Lessee (Seller)

Lessor (Buyer)

Transfer to buyer-lessor
is a sale

Derecognise the
underlying asset and
apply the lessee
accounting model to the
leaseback
Measure the ROU
asset at the retained
portion of the previous
carrying amount (i.e. at
cost)
Recognise a gain or
loss related to the rights
transferred to the lessor

Recognise the
underlying asset and
apply the lessor
accounting model to the
leaseback

Transfer to buyer-lessor
is not a sale

Continue to recognise
the underlying asset
Recognise a financial
liability under IFRS 9 for
any amount received
from the buyer-lessor

Do not recognise the

underlying asset
Recognise a financial
asset under IFRS 9 for
any amount paid to the
seller-lessee

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Before the transaction, the owner has the risks and rewards of ownership. The
owner sells the asset and then leases it back under a finance lease. The owner
has retained the risks and rewards of ownership. In substance this is not a sale
so profit should not be recognised. The accounting treatment is as follows.
There are two stages, the disposal (sale) and the finance leaseback:
The sale:
x

On disposal, the asset should be removed from the sellers statement

of financial position.

Any surplus from the sale in excess of the carrying amount should be
deferred and amortised over the term (life) of the lease.

Any deficit from the sale in shortage of the carrying amount should
also be deferred and amortised over the term (life) of the lease. (IFRS
16 does not prescribe any treatment for a loss on such transactions
but in practice it is also deferred).

The leaseback: The normal finance lease rules are then applied, to
reintroduce the asset to the statement of financial position of the lessee at its
fair value, and to establish a leasing obligation.
Example: Sale and finance leaseback
In 20X6 a company sold an asset and leased it back under a finance lease. The
asset had a carrying value of Rs. 70,000 and was sold for its market value of Rs.
120,000.
At the date of sale it had a remaining life of five years and was leased back for
the whole of this period at a rental of Rs. 28,000 per annum in arrears.
Debit
Rs.
120,000

The sale
Cash
Asset
Deferred income

Credit
Rs.
70,000
50,000

The leaseback
Asset
Lease obligation

120,000
120,000

6.3 Sale and operating leaseback (operating lease)

Again, there are two stages to the transaction, the sale and the operating
leaseback. The substance and legal form of the transaction are the same. The
asset has been sold by the lessee (known as the seller/lessee) and the risks and
rewards have been permanently transferred to the lessor as the leaseback is an
operating lease in nature.
On sale, the asset should be removed from the seller/lessees statement of
financial position.
The gain or loss on disposal should be recognised in profit or loss. (See
below for details of how the gain is calculated).
The normal operating lease rules are then applied to account for the rental
payments.

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IFRS 16 outlines specifies treatments for accounting for the profit or on the sale
of the asset, depending on whether the asset was sold for its fair value, for more
than fair value or for less than fair value and depending on whether the fair value
is less than the carrying amount of the asset that is the subject of the transaction.
Sale at fair value
This is just a normal sale. If an asset is sold at fair value, the gain or loss on
disposal is recognised immediately in profit or loss in the usual way.
Example: Sale and operating leaseback Sale at fair value
In early 20X7 a company sold an asset for Rs. 1.5 million and leased it back
under a five-year operating lease.
The asset had a carrying value of Rs. 1 million.
Debit
Rs.
Cash
Asset
Statement of comprehensive income

Credit
Rs.

1,500,000
1,000,000
500,000

Sale at more than fair value (fair value greater that carrying amount)
If an asset is sold at more than fair value, the normal gain or loss on disposal
(based on the difference between the carrying amount and fair value) is
recognised immediately in profit or loss.
The excess profit (based on the difference between the fair value and actual sale
value) should be deferred and released to profit or loss over the expected period
of use (the lease period).
Example: Sale and operating leaseback Sale above fair value
In early 20X7 a company sold an asset for Rs. 1.5 million and leased it back
under a five-year operating lease.
The asset had a carrying value of Rs. 1 million and a remaining useful life of ten
years.
The fair value of the asset at the date of sale was Rs. 1.2 million.
Debit
Rs.
Cash
Asset
Statement of comprehensive income
(Normal profit of Rs. 1.2m Rs. 1m)
Cr Deferred income
(Excess profit: this is Rs. 1.5m Rs. 1.2m)

Credit
Rs.

1,500,000
1,000,000
200,000
300,000

Note: The deferred income will be released to profit or loss over the lease term of
5 years.

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Sale at less than fair value (fair value greater that carrying amount)
If an asset is sold at less than fair value, the gain or loss on disposal is
recognised immediately in profit or loss.
However, if the sale makes a loss and this is compensated for by future lease
payments at below market price, the loss should not be recognised immediately,
but deferred and then released to profit or loss over the expected period of use
(the lease period).
Example: Sale and operating leaseback Sale below fair value
In early 20X7 a company sold an asset for Rs. 1.5 million and leased it back
under a five-year operating lease.
The asset had a carrying value of Rs. 2 million and a remaining useful life of ten
years.
The fair value of the asset was Rs. 2.1 million.
Debit
Rs.
Cash

Credit
Rs.

1,500,000

Asset
Statement of comprehensive income

2,000,000
500,000

Example: Sale and operating leaseback Sale below fair value compensated by
lower future rentals
In early 20X7 a company sold an asset for Rs. 1.5 million and leased it back
under a five-year operating lease.
The asset had a carrying value of Rs. 2 million and a remaining useful life of ten
years.
The fair value of the asset was Rs. 2.1 million.
The company accepted an offer below the fair value of the asset because it was
able to negotiate rentals at below the market rate in compensation.

Cash
Asset
Deferred loss (on the statement of financial position)

Debit
Rs.
1,500,000

Credit
Rs.
2,000,000

500,000

The deferred loss amortised in proportion to the lease payments over the period
for which the asset is expected to be used.
In each case above the difference between the fair value of the asset and the
carrying amount is not recognised.
Sale where fair value is less than carrying amount
If the fair value at the time of a sale and leaseback transaction is less than the
carrying amount of the asset, the difference must be recognised immediately as a
loss. This means that the asset is written down to its fair vale before accounting
for the sale and operating leaseback. The earlier rules concerning the recognition
of a profit or loss on disposal then apply.

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This only applies to sale and operating leaseback transactions.

Example: Sale and operating leaseback Fair value less than carrying amount
and sale at more than fair value.
In early 20X7 a company sold an asset for Rs. 1.8 million and leased it back
under a five-year operating lease.
The asset had a carrying value of Rs. 2 million and a remaining useful life of ten
years.
The fair value of the asset was Rs. 1.7 million.
Debit
Rs.
Step 1: Write down the asset:
Statement of comprehensive income
(Rs. 2m Rs. 1.7m)

Credit
Rs.

300,000

Asset
Step 2: Sale and leaseback:

300,000

Cash
Asset
Cr Deferred income
(Excess profit: this is Rs. 1.8m Rs. 1.7m)

1,800,000
1,700,000
100,000

(Profit is deferred as the sale proceeds are above fair value)

Example: Sale and operating leaseback Fair value less than carrying amount
and sale at less than fair value.
In early 20X7 a company sold an asset for Rs. 1.6 million and leased it back
under a five-year operating lease.
The asset had a carrying value of Rs. 2 million and a remaining useful life of ten
years.
The fair value of the asset was Rs. 1.7 million.
Debit
Rs.
Step 1: Write down the asset:
Statement of comprehensive income
(Rs. 2m Rs. 1.7m)
Asset
Step 2: Sale and leaseback:
Cash
Asset
Statement of comprehensive income

Credit
Rs.

300,000
300,000
1,600,000
1,700,000
100,000

(The loss would be deferred if it were compensated by lower future rentals)

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6.4

Sub-lease
A sub-lease is a transaction in which a lessee (or intermediate lessor) grants a
right to use the underlying asset to a third party, and the lease (or head lease)
between the original lessor and lessee remains in effect.
A company applies IFRS 16 to all leases of right-of-use assets in a sub-lease.
The intermediate lessor accounts for the head lease and the sub-lease as two
different contracts.
Head Office

Original lessee/intermediate lessor

Sub-lessee
An intermediate lessor classifies the sub-lease as a finance lease or as an
operating lease with reference to the right-of-use asset arising from the head
lease. That is, the intermediate lessor treats the right-of-use asset as the
underlying asset in the sub-lease, not the item of property, plant or equipment
that it leases from the head lessor.
At the commencement date of the sub-lease, if the intermediate lessor cannot
readily determine the rate implicit in the sub-lease, then it uses the discount rate
that it uses for the head lease to account for the sub-lease, adjusted for any initial
direct costs associated with the sub-lease.
However, if the head lease is a short-term lease for which the company, as a
lessee, has elected the short-term lease exemption, then as an intermediate
lessor the company classifies the sub-lease as an operating lease.
Example Sub-lease classified as a finance lease with reference to the right-ofuse asset in the head lease
Head lease: Intermediate lessor L enters into a five-year lease for 5,000 million of
office space (the head lease) with Company M (the head lessor).
Sub-lease: At the beginning of Year 3, L sub-leases the 5,000 M of office space for
the remaining three years of the head lease to Sub-lessee N.office
L classifies the sub-lease with reference to the right-of-use asset arising from the
head lease. Because the sub-lease is for the whole of the remaining term of the
head lease i.e. the sub-lease is for the major part of the useful life of the rightof-use asset L classifies it as a finance lease.
At the commencement date of the sub-lease, L:

derecognises the right-of-use asset relating to the head lease that it transfers
to N and recognises the net investment in the sub-lease;
recognises any difference between the carrying amounts of the right-of-use
asset and the net investment in the sub-lease in profit or loss; and
continues to recognise the lease liability relating to the head lease, which
represents the lease payments owed to the head lessor.

During the term of the sub-lease, L recognises both interest income on the
sublease and interest expense on the head lease.

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IMPACT ON PRESENTATION
Section overview

The effect of classifying a lease incorrectly

7.1 The effect of classifying a lease incorrectly

If a finance lease is treated as an operating lease, the financial statements do not
fairly present the financial position of the entity:
The leased asset is not recognised in the statement of financial position, even
though the substance of the lease is that the entity owns it.
The liability for the lease payments is not recognised in the statement of
financial position.
Therefore both assets and liabilities are understated. The lease becomes a form
of off balance sheet finance, hidden from the users of the financial statements.
The entitys (lessees) liabilities can appear to be much lower than they actually
are.
Classifying a lease incorrectly affects the numbers in the financial statements.
An example seen earlier in the chapter is used to illustrate this.
Example:
The fair value of a leased asset, commencing on 1 January Year 1 is Rs. 12,886.
The lease is for three years with payments of Rs. 5,000 annually in arrears on 31
December Year 1, Year 2 and Year 3. The interest rate implicit in the lease is 8%.
Lease liability (given again for your convenience)
Year

Opening
balance

Interest
(8%)

Lease
payment

Closing
balance

12,886

1,031

(5,000)

8,917

8,917

713

(5,000)

4,630

4,630

370

(5,000)

2,114
The numbers that would appear in the financial statements for year 1 if
the lease were treated as finance lease or as an operating lease are
shown below:
Statement of financial position
Non-current asset

Operating
lease

Rs.

Leased Asset
[(12,886 (1/3 of 12,866= 4,289)]

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Example:
The fair value of a leased asset, commencing on 1 January Year 1 is Rs. 12,886.
The lease is for three years with payments of Rs. 5,000 annually in arrears on 31
December Year 1, Year 2 and Year 3. The interest rate implicit in the lease is 8%.
Lease liability (given again for your convenience)
Liability:

Rs.

Non-current liability

4,630

Current liability

4,287

Total liability

8,917

Depreciation charge (1/3 of 12,866)

4,289

Finance charge

1,013

5,000

5,302

5,000

Statement of comprehensive income

Rental

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

The lease is a finance lease.

Reasons
The lease is for a major part of the life of the asset (6 out of 7 years).
Jhang Construction must ensure the asset. It is exposed to one of the
major risks of ownership of the asset (its loss).
The present value of the lease payments is 95.3%
(4.767 u 600,000/3,000,000) of the fair value of the asset at the inception of the
lease.

Solution

Total lease payments (3 Rs. 4,021)

Minus: Cash price of the asset
Total finance charge

Rs.
12,063
(10,000)

2,063

Actuarial method
Year ended
31
December
Year 1
Year 2
Year 3

Opening
balance

Lease
payment

Capital
outstanding

Rs.
10,000
7,309
4,021

Rs.
(4,021)
(4,021)
(4,021)

Rs.
5,979
3,288

Interest at
22.25%

Closing
balance

Rs.
1,330
733

Rs.
7,309
4,021

The year-end liability at the end of Year 1 is Rs. 7,309 in total.

The non-current liability is the liability at the start of the next year after
deducting the first payment (Rs. 3,288).
The current liability is the payment in year 2 less any interest contained in it
that has not yet accrued.
Current liability, end of Year 1
Non-current liability, end of Year 1

Rs.
4,021*
3,288

Total liability, end of Year 1

7,309

* 4,021 can be divided into 1,330 of interest payable and 2691 of principal
payable

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

12

IAS 37: Provisions, contingent

liabilities and contingent assets
Contents
1 Provisions: Recognition
2 Provisions: Measurement
3 Provisions: Double entry and disclosure
4 Guidance on specific provisions
5 Interpretations
6 Contingent liabilities and contingent assets

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions on

the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 28

IAS 37: Provisions, contingent liabilities and contingent assets

B (a) 36

IFRIC 5: Rights to interests arising from decommissioning, restoration and

environmental rehabilitation funds

B (a) 37

IFRIC 6: Liabilities arising from participating in a specific market waste

electrical and electronic equipment

B (a) 49

IFRIC 21: Levies

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PROVISIONS: RECOGNITION
Section overview

Introduction

Recognition criteria for provisions

Present obligation

Obligation arising out of a past event

Probable outflow of economic benefits

1.1 Introduction
The first five sections of this chapter explain rules set out in IAS 37: Provisions,
contingent liabilities and contingent assets.
Definitions
Provisions are liabilities of uncertain timing or amount.
A liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits.
An obligating event is an event that creates a legal or constructive obligation that
results in an enterprise having no realistic alternative to settling that obligation.
Provisions differ from other liabilities because there is uncertainty about the
timing or amount of the future cash flows required to settle the liability.
Accruals are liabilities to pay for goods or services that have been received or
supplied but not yet invoiced. There is often a degree of estimation in the
measurement of accruals but any inherent uncertainty is much less than for
provisions.
IAS 37 applies to all provisions and contingencies apart from those covered by
the specific requirements of other standards.
In some countries the term provision is also used to describe the reduction in
the value of an asset. For example accountants might talk of provision for
depreciation, provision for doubtful debts and so on. These provisions are not
covered by this standard which is only about provisions that are liabilities.
Major accounting issues
There are three issues to address in accounting for provisions:

whether or not a provision should be recognised;

how to measure a provision that is recognised; and

what is the double entry on initial recognition of a provision and how is it

remeasured on subsequent reporting dates.

1.2 Recognition criteria for provisions

A provision should be recognised when:

a company has a present obligation (legal or constructive) as a result of a

past event;

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it is probable that an outflow of economic benefits will be required to settle

the obligation; and

a reliable estimate can be made of the amount of the obligation.

If any of these conditions is not met then a provision cannot be recognised.

1.3 Present obligation

An obligation must exist in order for a provision to be recognised.
An obligation may be legal or constructive.

A legal obligation is one arising from a contract, or some other aspect of

the law.
A constructive obligation is one arising from the companys actions,
whereby
x
through established past practice, published policies, or a specific
current statement, the company has indicated to other parties that it
will accept certain responsibilities; and
x
as a result, the company has created a valid expectation that it will
discharge those responsibilities.

Example: Constructive obligation

A clothing retailer has a policy of taking back items of clothing that customers
have purchased, and refunding the purchase price, simply because the purchaser
has changed his or her mind about the item.
The retailer does not have a legal obligation to do this under the consumer
protection legislation that applies in the jurisdiction in which it operates.
If this is the usual practice of a particular retailer, and the retailers policy is wellknown or has been made known to customers, then a constructive obligation exists
whenever a sale is made.
A provision would be recognised for sales returns subject to the other two criteria
being satisfied.
In most cases it will be clear that a past event has given rise to a present
obligation. However, in rare cases this may not be the case. In these cases, the
past event is deemed to give rise to a present obligation if it is more likely than
not that a present obligation exists at the end of the reporting period. This
determination must be based on all available evidence,

1.4 Obligation arising out of a past event

A past event that leads to a present obligation is called an obligating event. For
this to be the case it is necessary that the company has no realistic alternative to
settling the obligation created by the event.
This is the case only:

where the settlement of the obligation can be enforced by law; or

in the case of a constructive obligation, where the event (which may be an

action of the company) creates valid expectations in other parties that the
company will discharge the obligation.

The event leading to the obligation must be past, and must have occurred before
the end of the reporting period when the provision is first recognised. No
provision is made for costs that may be incurred in the future but where no
obligation yet exists.

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Illustration:
A company is planning a reorganisation. These plans are in an early stage.
There is no obligation (legal or constructive) to undertake the reorganisation. The
company cannot create a provision for reorganisation costs.
Only obligations arising from past events that exist independently of a company's
future actions are recognised as provisions.
Example:
Shan Properties owns a series of high rise modern office blocks in several major
cities in Pakistan.
The government introduces legislation that requires toughened safety glass to be
fitted in all windows on floors above the ground floor. The legislation only applies
initially to new buildings but all buildings will have to comply within 5 years.
Analysis:
There is no obligating event.
Even though Shan Properties will have to comply within 5 years it can avoid the
future expenditure by its future actions, for example by selling the buildings. There
is no present obligation for that future expenditure and no provision is recognised.
Example:
Jhang Energy Company operates in a country where there is no environmental
legislation. Its operations cause pollution in this country.
Jhang Energy Company has a widely published policy in which it undertakes to
clean up all contamination that it causes and it has a record of honouring this
published policy.
Analysis:
There is an obligating event. Jhang Energy Company has a constructive obligation
which will lead to an outflow of resources embodying economic benefits regardless
of the future actions of the company. A provision would be recognised for the
clean-up subject to the other two criteria being satisfied.
An obligation always involves another party to whom the obligation is owed.
However, it is not necessary to know the identity of that party. It is perfectly
possible to have an obligation to the public at large or to a group of people.
Example:
Shekhupura Household Appliances Corporation gives warranties at the time of sale
to purchasers of its products. Under the terms of the sale contract the company
undertakes to make good any manufacturing defects that become apparent within
three years from the date of sale.
In the period it has sold 250,000 appliances and estimates that about 2% will
prove faulty.
Analysis:
There is an obligating event being the sale of an item with the promise to repair it
as necessary. The fact that Shekhupura Household Appliances Corporation does
not know which of its customers will seek repairs in the future is irrelevant to the
existence of the obligation.
A provision would be recognised for the future repairs subject to the other two
criteria being satisfied.
Note that the estimate that only 2% will be faulty is irrelevant in terms of
recognising a provision. However, it would be important when it came to measuring
the size of the provisions. This is covered in the next section.

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An obligation always involves a commitment to another party. Therefore, a

management decision does not give rise to a constructive obligation unless it has
been communicated before the end of the reporting period to those affected by it
in a sufficiently specific manner to raise a valid expectation in them that the
company will discharge its responsibilities.
Example:
On 13 December Kasur Engineering decided to close a factory. The closure will
lead to 100 redundancies at a significant cost to the company.
At 31 December no news of this plan had been communicated to the workforce.
Analysis:
There is no obligating event. This will only come into existence when
communication of the decision and its consequences are communicated to the
workforce.
An event may not give rise to an obligation immediately but may do so at a later
date due to a change in circumstances. These include:

changes in the law; or

where an act of the company (for example, a sufficiently specific public

statement) gives rise to a constructive obligation.

If details of a proposed new law have yet to be finalised, an obligation arises only
when the legislation is virtually certain to be enacted or is enacted

1.5 Probable outflow of economic benefits

The outflow of benefits must be probable. Probable is defined by IAS 37 as
more likely than not to occur.
Illustration:
A company may have given a guarantee but may not expect to have to honour it.
No provision arises because a payment under the guarantee is not probable.
More likely than not implies a greater than 50% chance but be careful to think
about this in the right way.
Example:
Shekhupura Household Appliances Corporation gives warranties at the time of sale
to purchasers of its products. Under the terms of the sale contract the company
undertakes to make good any manufacturing defects that become apparent within
three years from the date of sale.
In the period it has sold 250,000 appliances and estimates that about 2% will
prove faulty.
Analysis:
The outflow of benefits is probable. It is more likely than not that 2% will be faulty.
(In other words there is more than a 50% chance that 2% of items will prove to be
faulty).

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PROVISIONS: MEASUREMENT
Section overview

Introduction

Uncertainties

Time value

Future events

Reimbursements

2.1 Introduction
The amount recognised as a provision must be the best estimate, as at the end of
the reporting period, of the future expenditure required to settle the obligation.
This is the amount that the company would have to pay to settle the obligation at
this date. It is the amount that the company would have to pay a third party to
take the obligation off its hands.
The estimates of the outcome and financial effect of an obligation are made by
management based on judgement and experience of similar transactions and
perhaps reports from independent experts.
Risks and uncertainties should be taken into account in reaching the best
estimate. Events after the reporting period will provide useful evidence. (Events
after the reporting period are dealt with in more detail later.)

2.2 Uncertainties
Uncertainties about the amount to be recognised as a provision are dealt with by
various means according to the circumstances.
In measuring a single obligation, the best estimate of the liability may be the most
likely outcome. However, other possible outcomes should be considered. If there
are other possibilities which are mostly higher or mostly lower than the most likely
outcome, then the best estimate will be a higher or lower amount.
Example:
Gujrat Prefabricators Limited (GPL) has won a contract to provide temporary
accommodation for workers involved in building a new airport. The contract
involves the erection of accommodation blocks on a public park and two years
later the removal of the blocks and the reinstatement of the site.
The blocks have been built and it is now GPLs year-end.
GPL estimates that the task of removing the blocks and reinstating the park to its
present condition might be complex, resulting in costs with a present value of Rs.
2,000,000, or straightforward, resulting in costs with a present value of Rs.
1,300,000.
GPL estimates that there is a 60% chance of the job being straightforward.
Should a provision be recognised and if so at what value?
Analysis
Should a provision be recognised?
Is there a present obligation as a
Yes. A present obligation arises
due to the existence of a
result of a past event?
contractual term and the building
of the block.

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Is it probable that there will be an

Yes. This is certain.
outflow of economic benefits to
settle the obligation
Can a reliable estimate be made of Yes. Data is available.
the amount of the obligation?
A provision should be recognised.
How should the provision be measured? (What is the best estimate of
expenditure required to settle the obligation?)
The most likely outcome is that the job will be straightforward. In this
case the provision would be recognised at Rs. 1,300,000.
However there is a significant chance that the job will be complex so
perhaps GPL should measure the liability at the higher amount. This may
sound a little vague but in practice this comes down to a matter of
judgement.
When there is a large population of potential obligations (for example, a provision
for multiple claims under guarantees) the obligation should be estimated by
calculating an expected value of the cost of the future obligations. This is done by
weighting all possible outcomes by their associated probabilities.
Example:
Sahiwal Manufacturing has sold 10,000 units in the year. Sales accrued evenly
over the year.
It estimates that for every 100 items sold, 20 will require small repairs at a cost of
Rs. 100, 10 will require substantial repairs at a cost of Rs. 400 each and 5 will
require major repairs or replacement at a cost of Rs. 800 each.
On average the need for a repair becomes apparent 6 months after a sale.
What is the closing provision?
A provision will be required for the sales in the second six months of the year as
presumably the repairs necessary in respect of the sales in the first six months
have been completed by the year end.
Sales accrue evenly, therefore, the sales in the second six months are 5,000 units
(6/12 u 10,000).
Re
epair
Small

Number
20% u 5,000 = 1,000

Cost per repair (R

Rs.)
100

Substantial

10% u 5,000 = 500

400

200,000

Major

5% u 5,000 = 250

800

200,000

Provision

Total (R
Rs.)
100,000

500,000

Note that this would be reduced by the repairs already made by the year end

2.3 Time value

Where the effect of the time value of money is material, a provision is measured
at the present value of the expenditures expected to be required to settle the
obligation.

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The discount rate used should be a pre-tax rate (or rates) that reflect(s) current
market assessments of the time value of money and the risks specific to the
liability.
The need to discount is often found when accounting for decommissioning
liabilities. These are discussed in section 4.4.
Example:
Gujrat Prefabricators Limited (GPL) has won a contract to provide temporary
accommodation for workers involved in building a new airport. The contract
involves the erection of accommodation blocks on a public park and two years
later the removal of the blocks and the reinstatement of the site.
The blocks have been built and it is now 31 December 2015 (GPLs year-end).
GPL estimates that in two years it will have to pay Rs. 2,000,000 to remove the
blocks and reinstate the site.
The pre-tax discount rate that reflects current market assessments of the time
value of money and the risks specific to the liability is 10%.
The provision that should be recognised at 31 December 2015 is as follows:

 u


2.4 Future events

Expected future events may be important in measuring provisions. For example,
a company may believe that the cost of cleaning up a site at the end of its life will
be reduced by future changes in technology.
The measurement of an obligation must take expected future changes into
account where there is sufficient objective evidence that they will occur. In such
cases the measurement of the provision should be based on the reasonable
expectations of technically qualified, objective observers, taking account of all
available evidence as to the technology that will be available at the time of the
clean-up.
This means that a company might include expected cost reductions associated
with increased experience in applying existing technology or the expected cost of
applying existing technology to a larger or more complex clean-up operation than
has previously been carried out.
One future event might be the effect of possible new legislation.
The measurement process should take this into account when there is sufficient
objective evidence that the legislation is virtually certain to be enacted.
In practice, the proceeds of the sale of an asset in the future might be used to pay
for an event for which a provision is recognised today. However, gains from the
expected disposal of assets must not be taken into account in measuring a
provision.

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2.5 Reimbursements
In some cases, a part or all of a companys provision may be recoverable from a
third party. For example, a company paying out to a customer under the terms of
a guarantee may itself be able to claim money back from one of its own suppliers.
IAS 37 requires that such a reimbursement:

should only be recognised where receipt is virtually certain; and

should be treated as a separate asset in the statement of financial position

(i.e. not netted off against the provision) at an amount no greater than that
of the provision.

However, IAS 37 allows the expense relating to a provision to be presented net of

the amount recognised for a reimbursement in the statement of comprehensive
income.

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PROVISIONS: DOUBLE ENTRY AND DISCLOSURES

Section overview

Introduction

Measurement on initial recognition

Use of provisions

Subsequent measurement

Disclosures about provisions

3.1 Introduction
IAS 37 is about the recognition and measurement of provisions which are of
course a credit balance. It gives little guidance on the recognition of the debit
entry on initial recognition of a provision saying that whether an expense or asset
is recognised is left to guidance in other standards.

3.2 Measurement on initial recognition

In most cases the debit entry that arises when a provision is recognised is an
expense. There is one important case where it is capitalised as an asset (on
recognition of a decommissioning liability) and this is discussed later.
Illustration: Usual double entry on initial recognition of a provision
Debit
Profit or loss (expense)

Credit

Provision

3.3 Use of provisions

A provision is set up to recognise an expense (usually) that exists at the reporting
date. When the expense is paid the following double entry is used:
Illustration: Using a provision.
Debit
Provision

Credit

Cash

If the provision is more than the amount needed to settle the liability the balance
is released as a credit back through the income statement.
If the provision is insufficient to settle the liability an extra expense is recognised.
IAS 37 also states that a provision may be used only for expenditures for which
the provision was originally recognised.

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Example: Use of provisions

A company has created a provision of Rs. 300,000 for the cost of warranties and
guarantees.
The company now finds that it will probably have to pay Rs. 250,000 to settle a
legal dispute.
It cannot use the warranties provision for the costs of the legal dispute. An extra
Rs. 250,000 expense must be recognised.

3.4 Subsequent measurement

Each provision must be reviewed at the end of each reporting period. This might
result in derecognition of a provision that no longer meets the recognition criteria
or in the re-measurement of a provision. An increase in a provision would result in
the recognition of a further expense or a reduction in expense as the previously
recognised provision is reduced through a credit to profit or loss.
Illustration: Subsequent re-measurement of provisions.
Debit

Credit

Derecognition of a provision that is no longer needed.

Provision

Income statement

Increase in a provision::
X

Profit or loss (expense)

Provision

Decrease in a provision:
X

Provision

Profit or loss

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Example: Subsequent measurement

31 December 2014
A company was sued by a customer in the year ended 31 December 2014.
Legal advice is that the customer is virtually certain to win the case as several
similar cases have already been decided in the favour of the injured parties.
At 31 December 2014, the companys lawyer was of the opinion that, the cost of
the settlement would be Rs. 1,000,000.
A provision is recognised in the amount of Rs. 1,000,000 as follows (reducing
profit for the year by that amount).
Debit (R
Rs.)
Credit (R
Rs.)
Expenses
Provision

1,000,000
1,000,000

31 December 2015
The claim has still not been settled. The lawyer now advises that the claim will
probably be settled in the customers favour at Rs. 1,200,000.
The provision is increased to Rs. 1,200,000 as follows.
Debit (R
Rs.)
Expenses
Provision

Credit (R
Rs.)

200,000
200,000

31 December 2016
The claim has still not been settled. The lawyer now believes that the claim will be
settled at Rs. 900,000.
The provision is reduced to Rs. 900,000 as follows.
Debit (R
Rs.)
Provision
Expenses

Credit (R
Rs.)

300,000
300,000

The reduction in the provision increases profit in the year and the provision in the
statement of financial position is adjusted down to the revised estimate of Rs.
900,000.
31 December 2016
The claim is settled for Rs. 950,000. On settlement, the double entry in the ledger
accounts will be:
Debit (R
Rs.)
Expenses
Provision
Cash

Credit (R
Rs.)

50,000
900,000
950,000

The charge against profit on settlement of the legal claim is Rs. 50,000.
The provision no longer exists. The total amount charged against profit over the
four years was the final settlement figure of Rs. 950,000.
When a provision is included in the statement of financial position at a discounted
value (at present value) the amount of the provision will increase over time, to
reflect the passage of time. In other words, as time passes the amount of the
discount gets smaller, so the reported provision increases. This increase in value
is included in borrowing costs for the period.

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3.5 Disclosures about provisions

IAS 37 requires the following disclosures about provisions in notes to the financial
statements.
For each class of provision:

the opening and closing balances and movements in the provision during
the year;

a brief description of:

x

the nature of the obligation;

the expected timing of any settlement; and

an indication of the uncertainties surrounding the amount and timing

of any settlement.

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GUIDANCE ON SPECIFIC PROVISIONS

Section overview

Onerous contracts

Future operating losses

Restructuring

Decommissioning liabilities and similar provisions

Future repairs to assets

IAS 37 explains how its rules apply in given circumstances. Some of the guidance is in
the body of the standard and some in an appendix to the standard.

4.1 Onerous contracts

Definition
An onerous contract is a contract where the unavoidable costs of
fulfilling/completing the contract now exceed the benefits to be received (the
contract revenue).
A provision should be made for the additional unavoidable costs of an onerous
contract. (The additional unavoidable costs are the amount by which costs that
cannot be avoided are expected to exceed the benefits).
The example in IAS 37 relates to an operating lease.
Example: Onerous contract
On 31 December 2015, Company H is half way through an eight year operating
lease on its factory when it moves to a new factory due to an expansion of
demand for its products.
It cannot cancel the lease or sub-let the factory and there is no prospect of being
able to sub-let it.
Annual lease payments are Rs. 60,000.
Analysis
A present legal obligation exists as a result of a past event (the signing of the
lease).
An outflow of resources is probable. (These are the rentals for the remainder of
the term of the lease, which cannot be avoided.)
The amount can be measured reliably (Rs. 60,000 4 years, discounted to a
present value).
The discounted value of the future lease payments for four years may therefore
be recognised as a provision.
Other circumstances that might lead to the recognition of a provision in respect of
an onerous contract relate to supply contracts.

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Example: Onerous contract

Nawabasha Clothing has a contract to buy 300 metres of silk from a supplier each
month for Rs. 3,000 per metre.
Nawabasha Clothing had a contract with a Dubai retailer to sell each dress for Rs.
5,000 only. The retailer has fallen into administration and the administrators have
cancelled the contract, as they were entitled to do this under one of its clauses.
Nawabasha Clothing cannot sell the dresses to any other customer.
The contract to buy the silk can be cancelled with three months notice.
Analysis
The company can cancel the contract but must pay for the next three months
deliveries:
Cost (300m Rs. 3,000 3 months)
Rs. 2,700,000
A provision should be recognised for this amount.

4.2 Future operating losses

A company may forecast that it will make a substantial operating loss in the next
year or several years. If so, its directors might want to take all the bad news
immediately, and create a provision for the future losses.
Provisions cannot be made for future operating losses. This is because they arise
from future events, not past events.

4.3 Restructuring
A company may plan to restructure a significant part of its operations. Examples
of restructuring are:

the sale or termination of a line of business

the closure of business operations in a country or geographical region, or

relocation of operations from one region or country to another

major changes in management structure, such as the removal of an entire

layer of management from the management hierarchy

fundamental reorganisations changing the nature and focus of the

companys operations.

A provision is recognised for the future restructuring costs only if a present

obligation exists.
A constructive obligation to restructure arises only when a company:

has a detailed formal plan for the restructuring identifying at least:

x

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 expenditures that will be undertaken; and

when the plan will be implemented; and

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has raised a valid expectation in those affected that it will carry out the
restructuring by starting to implement that plan or announcing its main
features to those affected by it.

A restructuring decision made before the end of the reporting period does not
give rise to a constructive obligation unless the company has:

started to implement the plan; or

announced the main features of the plan to those affected by it in a

sufficiently specific manner to raise a valid expectation in them that the
restructuring will occur.

A company might start to implement a restructuring plan, or announces its main

features to those affected, after the reporting period but before the financial
statements are authorised for issue.
Disclosure is required under IAS 10 Events after the Reporting Period if the
restructuring is material.
A restructuring provision must only include the direct expenditures arising from
the restructuring. These are those that are both:

necessarily entailed by the restructuring; and

not associated with the ongoing activities of the company.

A restructuring provision would not include costs that are associated with ongoing
activities such as:

retraining or relocating continuing staff;

marketing; or

investment in new systems etc.

4.4 Decommissioning liabilities and similar provisions

A company may be required to clean up a location where it has been working
when production ceases.
This is often the case in industries where companies are only granted licenses to
operate on condition that they undertake to perform future clean-up operations.
Such industries include, oil and gas, mining and nuclear power.
For example, a company that operates an oil rig may have to repair the damage it
has caused to the sea bed once the oil has all been extracted.
The normal rules apply for the recognition of a provision: a company recognises a
provision only where it has an obligation to rectify environmental damage as a
result of a past event.
A company has an obligation to clean-up a site if:

it is required to do so by law (a legal obligation); or

its actions have created a constructive obligation to do so.

A constructive obligation might exist if (for example) a company has actually

promised to decontaminate a site or if it has adopted environmentally friendly
policies and has made the public aware of this.

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Accounting for a provision for a decommissioning liability

IAS 16 Property, plant and equipment identifies the initial estimate of the costs of
dismantling and removing an item and restoring the site upon which it is located
as part of the cost of an asset.
Future clean-up costs often occur many years in the future so any provision
recognised is usually discounted to its present value.
Illustration: Initial recognition of a provision for a decommissioning liability
Debit
Non-current asset

Credit

Provision

The asset is depreciated over its useful life in the same way as other non-current
assets.
The provision is remeasured at each reporting date. If there has been no change
in the estimates (i.e. the future cash cost, the timing of the expenditure and the
discount rate) the provision will increase each year because the payment of the
cash becomes one year closer. This increase is described as being due to the
unwinding of the discount.
The amount due to the unwinding of the discount must be expensed.
Example: Deferred consideration
A company has constructed an oil rig which became operational on 1 January
2015.
The company has contracted to remove the oil rig and all associated infrastructure
and to restore the site to repair any environmental damage to the site on
completion of drilling activity. This is estimated to be at a cost of Rs. 8,000,000 in
10 years time.
The pre-tax rate that reflects current market assessments of the time value of
money and the risks specific to the liability is 10%.
1 January 2015 Initial measurement




Debit
Credit
Asset
3,084,346
Provision

3,084,346

31 December 2015
The provision is remeasured as:


Provision:

Rs.

Balance b/f

3,084,346

Interest expense (the unwinding of the discount)

Balance c/f

308,435
3,392,781

The asset is depreciated (say on a straight line)

Asset:

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Cost
Depreciation (

8,000,000
Rs.8,000,000

(800,000)

/10 years)

Carrying amount

7,200,000

Double entry:
Profit or loss (interest expense)

Debit
308,435

Provision

Credit
308,435

Profit or loss (depreciation expense)

Accumulated depreciation

800,000
800,000

A provision for making good environmental damage might be recognised both on

when an asset is installed and then increased as the asset is used.
Example:
A company is about to begin to operate a coal mine. At the end of the reporting
period, the mineshaft has been prepared and all the necessary equipment has
been constructed and is in place, but no coal has yet been extracted.
Under local law, the company is obliged to rectify all damage to the site once the
mining operation has been completed (this is expected to be several years from
now).
Management estimates that 20% of the eventual costs of performing this work
will relate to plugging the mine and removing the equipment and various
buildings and the remaining 80% will relate to restoring the damage caused by
the actual extraction of coal.
Analysis
The company has a legal obligation to rectify the environmental damage caused
by the actual digging of the mineshaft and construction of the site. An outflow of
economic benefits is probable.
Therefore the company should recognise a provision for the best estimate of
removing the equipment and rectifying other damage which has occurred to date.
This is expected to be about 20% of the total cost of restoring the site.
Because no coal has yet been extracted, the company has no obligation to rectify
any damage caused by mining. No provision can be recognised for this part of the
expenditure (estimated at about 80% of the total).

4.5 Future repairs to assets

Some assets need to be repaired or to have parts replaced at intervals during
their lives.
For example, suppose that a furnace has a lining that has to be replaced every
five years. If the lining is not replaced, the furnace will break down.
Before IAS 37 was issued, companies would often recognise provisions for the
cost of future repairs or replacement parts. These might be built up in instalments
over the life of the asset or the relevant part of the asset.
IAS 37 effectively prohibits this treatment. The reasoning behind this is that a
company almost always has an alternative to incurring the expenditure, even if it
is required by law (for example, for safety reasons). For example, the company

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which has to replace the lining of its furnace could sell the furnace or stop using
it, although this is unlikely in practice.
IAS 37 states that a provision cannot be recognised for the cost of future repairs
or replacement parts unless the company has an obligation to incur the
expenditure, which is unlikely. The obligating event is normally the actual repair
or purchase of the replacement part.
Instead of recognising a provision, a company should capitalise expenditure
incurred on replacement of an asset and depreciate this cost over its useful life.
This is the period until the part needs to be replaced again. For example, the cost
of replacing the furnace lining should be capitalised, so that the furnace lining is a
non-current asset; the cost should then be depreciated over five years. (Note: IAS
16: Property, plant and equipment states that where an asset has two or more
parts with different useful lives, each part should be depreciated separately.)
Normal repair costs, however, are expenses that should be included in profit or
loss as incurred.

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INTERPRETATIONS
Section overview

IFRIC 21: Levies

IFRIC 5: rights to interests arising from decommissioning, restoration and

environmental rehabilitation funds

IFRIC 6: Liabilities arising from participating in a specific market: waste electrical

and electronic equipment

5.1 IFRIC 21: Levies

Background
A public authority (national/regional/local government and their agencies) may
impose a levy on entities that operate in a specific market.
IFRIC 21 provides guidance on the recognition of such liabilities under IAS 37
Scope
IFRIC 21 provides guidance on the accounting for levies recognised in
accordance with the definition of a liability provided in IAS 37 (even allowing for
the fact the amount may be certain).
Typical characteristics of levies within scope of this interpretation include the
following:

they require a transfer of resources to a public authority in accordance with

law/regulations (e.g. money);;

they are paid by entities that operate in a specific market identified by the
legislation (e.g. the entity is a bank);

they are non-exchange transactions (i.e. the paying entity receives no

goods/asset in exchange);

they are triggered when a specific activity occurs (e.g. the entity operates
as a retail bank) or threshold is passed;

the amount is calculated based on current or preceding period data (e.g.

gross revenues).

The following transactions are not within the scope of this interpretation:

taxes under IAS 12;

fines/penalties for breaching legislation; and

contracts between a public authority and a private entity

liabilities arising under emissions trading schemes

Issues
IFRIC 21 addresses the following issues:

What constitutes the obligating event for the recognition of a levy liability?

Does the economic compulsion to continue to operate in a future period

create a constructive obligation to pay a levy that will arise from operating in
that future period?

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Does the going concern principle imply the need for a discounted present
value obligation for future operating?

Can the liability arise at a point in time, or over time?

What is the obligating event when the liability is triggered by exceeding a

minimum threshold?

How should the demand for interim reporting affect the accounting
deferral or anticipation?

Consensus
The obligating event is the activity that triggers the payment of the levy as defined
in the legislation. For example, the obligating event may be the generation of
revenue from signing customers to an insurance contract.
Even though the obligating event may be the generation of revenue in the current
period from the prescribed activity, the amount may be calculated by reference
to revenue generated in the previous period.
An entity does not have a constructive obligation to pay a levy that will arise in a
future period as a result of being economically compelled to operate in that
period.
The going concern principle does not imply that an entity has a present obligation
to continue to operate in the future and therefore does not lead to the entity
recognising a liability at a reporting date for levies that will arise in a future period
(discounted or not!).
The liability is recognised progressively if the obligating event occurs over time.
For example, the liability to pay a levy from banking activity is based on the
revenue earned over time from that activity. However, if the obligating event is
earning revenue from banking on 31 December 2016, then the liability is
recognised at that instant based on the fact that the prescribed activity was going
on at 31 Dec 2016
If an obligation to pay is triggered by the passing of a threshold, then the
obligating event is the passing of that threshold (for example a minimum activity
threshold such as revenue or output produced)
The other side of the double entry for the recognition of a liability is typically to
expenses, but an asset might be recognised if an entity prepays the liability
before it has a present obligation.
The same recognition principle is applied to interim reporting. There is no:

anticipation of the liability/expense if there is no obligating event at the end

of the interim period; or

deferral if a present obligation exists at the end of the interim period

5.2 IFRIC 5: Rights to interests arising from decommissioning, restoration and

environmental rehabilitation funds
Background
An entity facing future decommissioning cost might segregate assets to fund this
cost.
Contributions to these funds may be voluntary or required by regulation or law.

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The funds may be established by a single contributor to fund its own

decommissioning obligations or by multiple contributors to fund their individual or
joint decommissioning obligations.
Contributors retain the obligation to pay decommissioning costs but are able to
obtain reimbursement of the costs from the fund.
Typical features of decommissioning funds include the following:

they are separately administered by independent trustees;

contributions to the fund are invested to help pay decommissioning costs

of contributors; and

contributors may have restricted access (if any) to any fund surplus

Scope
IFRIC 5 applies to accounting by a contributor for interests arising from
decommissioning funds that have both of the following features:

the assets are administered separately (either by being held in a separate

legal entity or as segregated assets within another entity); and

a contributors right to access the assets is restricted.

A residual interest in a fund that extends beyond a right to reimbursement may be

an equity instrument within the scope of IAS 39 and not IFRIC 5
The issue
The issues are as follows:

How should a contributor account for its interest in a fund?

When a contributor has an obligation to make additional contributions (e.g.

in the event of the bankruptcy of another contributor) how should that
obligation be accounted for?

Consensus: Accounting for an interest in a fund

A contributor must recognise its obligation to pay decommissioning costs as a
liability and recognise its interest in the fund separately.
A contributor must determine whether it has control, joint control or significant
influence over the fund by reference to IFRS 10 and IFRS 11 and account for any
interest accordingly.
Otherwise the interest in the fund is recognised as the right to receive
reimbursement (IAS 37) and measured at the lower of:

the amount of the decommissioning obligation recognised; and

the contributors share of the fair value of the net assets of the fund
attributable to contributors.

Change in carrying value of this right (other than contributions to and payments
from the fund) is recognised in P&L.
Consensus: Obligations to make additional contributions
A contributor may have an obligation to make additional contributions in certain
circumstances, e.g.:

bankruptcy of another contributor; or

value of fund assets being insufficient to fulfil the funds reimbursement

obligations.

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Such an obligation is a contingent liability within the scope of IAS 37.A liability is
recognised only if it is probable that additional contributions will be made.
Disclosure
The nature of an interest in a fund and any restrictions on access to its assets
must be disclosed.
Also the disclosure requirements of IAS 37 apply when:

an interest in a fund is accounted for as a right to receive reimbursement; or

an obligation to make potential additional contributions is not recognised as

a liability.

5.3 IFRIC 6: Liabilities arising from participating in a specific market: waste

electrical and electronic equipment
Background
This interpretation was written to give guidance on how companies trading in
electrical appliances in the European Union should account for a new legal
requirement.
The EU Directive on Waste Electrical and Electronic Equipment (WE&EE)
requires that the cost of waste management for historical household equipment
must be borne by producers of that type of equipment who are in the market
during a measurement period. This means that if a person buys a new cooker,
the supplier must take the old cooker away and dispose of it.
Each member state must:

define the measurement period; and

establish a mechanism for producers to contribute costs proportionately

This will affect the measurement of any obligation

IAS 37 defines an obligating event as a past event that leads to a present
obligation that an entity has no realistic alternative to settling. A provision is
recognised only for obligations arising from past events existing independently of
an entitys future actions.
Although the following rules were written with the EU in mind remember that they
would apply to a Pakistani business making supplies in the EU and they would
also apply to similar legislation (if enacted) elsewhere.
Scope
IFRIC 6 provides guidance on the recognition of waste management liabilities
under the EU directive in respect of sales of historical household equipment
The issue
When should the liability for the decommissioning of WE&EE be recognised?
What constitutes the obligating event for the recognition of WE&EE liability by
producers?

The manufacture or sale of the historical household equipment?

Participation in the market during the measurement period?

The incurrence of costs in the performance of waste management

activities?

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Consensus
No liability arises for waste management costs for household electrical equipment
following from manufacture or sale
There is no obligation unless (and until) a market share exists during the
measurement period.
The obligating event is participation in the market during the measurement
period.

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CONTINGENT LIABILITIES AND CONTINGENT ASSETS

Section overview

Definitions

Recognising contingent liabilities or contingent assets

Disclosures about contingent liabilities and contingent assets

Summary: liabilities, provisions, contingent liabilities and contingent assets

6.1 Definitions
Contingent means dependent on something else happening.
Contingent liability
A contingent liability is one that does not exist at the reporting date but may do so
in the future or it is a liability that exists at the reporting date but cannot be
recognised because it fails one of the IAS 37 recognition criteria.
Definition: Contingent liability
A contingent liability is either of the following:
A contingent liability is a possible obligation that arises from past events and
whose existence will be confirmed only by the occurrence or non-occurrence of one
or more uncertain future events not wholly within the control of the entity.
OR
A contingent liability is a present obligation that arises from past events but is not
recognised because it is not probable that an outflow of economic benefits will be
required to settle the obligation or the amount of the obligation cannot be
measured with sufficient reliability.
IAS 37 makes a distinction between:

provisions which are recognised as liabilities (assuming that a reliable

estimate can be made) because they are present obligations and it is
probable that an outflow of resources embodying economic benefits will be
required to settle the obligations; and

contingent liabilities which are not recognised as liabilities because they

are either:
x

possible obligations;

present obligations that do not meet the recognition criteria for

provisions because either:

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economic benefits will be required to settle the obligation; or

a sufficiently reliable estimate of the amount of the obligation

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Example:
Company G is involved in a legal dispute with a customer, who is making a claim
against Company G for losses it has suffered as a consequence of a breach of
contract.
If Company Gs lawyers believe that the likelihood of the claim succeeding is
possible rather than probable, then the claim should be treated as a contingent
liability and not as a provision.
Contingent asset
Definition: Contingent asset
A contingent asset is a possible asset that arises from past events whose existence
will be confirmed only by the occurrence or non-occurrence of one or more
uncertain future events not wholly within the control of the entity.
An example of a contingent asset might be a possible gain arising from an
outstanding legal action against a third party. The existence of the asset (the
money receivable) will only be confirmed by the outcome of the legal dispute.

6.2 Recognising contingent liabilities or contingent assets

Contingent liabilities and contingent assets are not recognised in the financial
statements.
In some circumstances, information about the existence of a contingent asset or
a contingent liability should be disclosed in the notes to the financial statements.

Contingent liabilities should be disclosed unless the possibility of any

outflow in settlement is remote (the meaning of remote is not defined in
IAS 37).

Contingent assets should be disclosed only if an inflow in settlement is

probable. Probable is defined by IAS 37 as more likely than not. (And if
an inflow is certain, the item is an actual asset that should be recognised in
the statement of financial position.)

6.3 Disclosures about contingent liabilities and contingent assets

Where disclosure of a contingent liability or a contingent asset is appropriate, the
following disclosures are required:

A brief description of the nature of the contingent liability/asset

Where practicable:

an estimate of its financial effect

an indication of the uncertainties.

For contingent liabilities, the possibility of any reimbursement.

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6.4 Summary: liabilities, provisions, contingent liabilities and contingent assets

The following table provides a summary of the rules about whether items should
be treated as liabilities, provisions, contingent liabilities or contingent assets.
Criteria
Present
obligation/
asset arising
from past
events?

Provision

Contingent liability

Contingent
asset

Yes

Yes

No (but may
come into
existance in
the future)

Only a
possible
asset

Will
settlement
result in
outflow/
inflow of
economic
benefits?

Probable
outflow and
a reliable
estimate can
be made of
the obligation

Not probable
outflow or a
reliable
estimate
cannot be
made of the
obligation

Outflow to be
confirmed by
uncertain
future events

Inflow to be
confirmed by
uncertain
future events

Treatment in
the financial
statements

Recognise a
provision

Disclose as a
contingent
liability
(unless the
possibility of
outflow is
remote)

Disclose as a
contingent
liability
(unless the
possibility of
outflow is
remote)

Only disclose
if inflow is
probable

Decision tree
An Appendix to IAS 37 includes a decision tree, showing the rules for deciding
whether an item should be recognised as a provision, reported as a contingent
liability, or not reported at all in the financial statements.

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Practice question

Sahiwal Transformers Ltd (STL) is organised into several divisions.

The following events relate to the year ended 31 December 2015.
1 A number of products are sold with a warranty. At the beginning of the
year the provision stood at Rs. 750,000.
A number of claims have been settled during the period for Rs.
400,000.
As at the year-end there were unsettled claims from 150 customers.
Experience is that 40% of the claims submitted do not fulfil warranty
conditions and can be defended at no cost.
The average cost of settling the other claims will be Rs. 7,000 each.
2

A transformer unit supplied to Rahim Yar Khan District Hospital

exploded during the year.
The hospital has initiated legal proceedings for damages of Rs. 10
million against STL.
STLs legal advisors have warned that STL has only a 40% chance of
defending the claim successfully. The present value of this claim has
been estimated at Rs. 9 million.
The explosion was due to faulty components supplied to STL for
inclusion in the transformer. Legal proceedings have been started
against the supplier. STLs legal advisors say that STL have a very good
chance of winning the case and should receive 40% of the amount that
they have to pay to the hospital.
On 1 July 2015 STL entered into a two-year, fixed price contract to
supply a customer 100 units per month.
The forecast profit per unit was Rs. 1,600 but, due to unforeseen cost
increases and production problems, each unit is anticipated to make a
loss of Rs. 800.
On 1 July 2014 one of STLs divisions has commenced the extraction of
minerals in an overseas country. The extraction process causes
pollution progressively as the ore is extracted.
There is no environmental clean-up law enacted in the country.
STL made public statements during the licence negotiations that as a
responsible company it would restore the environment at the end of
the licence.
STL has a licence to operate for 5 years. At the end of five years the
cost of cleaning (on the basis of the planned extraction) will be Rs.
5,000,000.
Extraction commenced on 1 July 2015 and is currently at planned
levels.
Required
Prepare the provisions and contingencies note for the financial
statements for the year ended 31 December 2015, including narrative
commentary.

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SOLUTION TO PRACTICE QUESTION

Solution: Provisions and contingencies

At 1 January
2015
Used in the
year
Statement of
comprehensive
income
(balance)
At 31
December
2015

Warranty

Legal
claim

Onerous
contract

Clean-up
costs

Total

Rs. 000

Rs. 000

Rs. 000

Rs. 000

Rs. 000

500

1,250

750

nil

nil

(400)

(400)

280

9,000

1,440

1,000

11,720

630

9,000

1,440

1,500

12,570

W1
W2
W3
W4
Warranty: The company grants warranties on certain categories of goods.
The measurement of the provision is on the companys experience of the
likelihood and cost of paying out under the warranty.
Legal claim: The legal claim provision is in respect of a claim made by a
customer for damages as a result of faulty equipment supplied by the
company. It represents the present value of the amount at which the
company's legal advisors believe the claim is likely to be settled.
Onerous contract: The provision for the onerous contract is in respect of a
two-year fixed-price contract which the company entered into on 1 July
2015. Due to unforeseen cost increases and production problems, a loss on
this contract is now anticipated. The provision is based on the amount of
this loss up to the end of the contract.
Clean--up costs: The provision for clean-up costs is in respect of the
company's overseas mineral extraction operations.
The company is 18 months into a five year operating licence. The estimated
cost of cleaning up the site at the end of the five years is Rs.5,000,000. A
provision of Rs.1,000,000 per annum is recognised.
Contingent asset: The company is making a claim against a supplier of
components. These components led in part to the legal claim against the
company for which a provision has been made above. Legal advice is that
this claim is likely to succeed and should amount to around 40% of the
total damages (Rs.3.6 million).
W1 Warranty provision: 150 u Rs.7,000 u 60% = Rs.630,000.
W2

Onerous contract: 18 months u 100 units u Rs.800 = Rs.1,440,000.

W3

Clean up costs: Rs.1,000,000 per annum as it is the extraction that

causes the cost.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

13

IAS 19: Employee benefits

Contents
1 IAS 19: Employee benefits
2 Post-employment benefits
3 IFRIC 14: IAS19 The limit on a defined benefit
asset, minimum funding requirements and their
interaction

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 20

IAS 19: Employee benefits

B (a) 42

IFRIC 14: IAS 19 The limit on a defined benefit asset, minimum funding
requirements and their interaction

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IAS 19: EMPLOYEE BENEFITS

Section overview

The scope and basic principles of IAS 19

Short-term employee benefits

Termination benefits

Other long term benefits

1.1 The scope and basic principles of IAS 19

Definition
Employee benefits are all forms of consideration given by an entity in exchange
for service rendered by employees or for the termination of employment.
A company may reward its employees in ways other than payment of a basic
salary. Employers often provide entitlements to paid holidays, or pay an annual
cash bonus to some employees, or provide employees with a company car,
medical insurance and pension benefits. (Some employees also receive share
options under company pension schemes: these are classified as share-based
payments.)
IAS 19 provides guidance on accounting for all forms of employee benefits,
except for share-based payments. Share-based payments are dealt with by IFRS
2.
IAS 19 sets out rules of accounting and disclosure for:

short term employee benefits;

x

wages, salaries and social security contributions;

paid annual leave and paid sick leave;

profit-sharing and bonuses; and

non-monetary benefits (such as medical care, housing, cars and free

or subsidised goods or services) for current employees;

post-employment benefits, such as the following:

x

retirement benefits (e.g. pensions and lump sum payments on

retirement); and

other post-employment benefits, such as post-employment life

insurance and post-employment medical care;

other long-term employee benefits, such as the following:

x

long-term paid absences such as long-service leave or sabbatical

leave;

jubilee or other long-service benefits; and

long-term disability benefits; and

termination benefits.

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Accounting principle
The basic principle in IAS 19 is that the cost of providing benefits to employees
should be matched with the period during which the employees work to earn the
benefits. This principle applies even when the benefits are payable in the future,
such as pension benefits.
IAS 19 requires an entity:

to recognise a liability when an employee has provided a service in

exchange for a benefit that will be paid in the future, and

to recognise an expense when the entity makes use of the service provided
by the employee.

The basic double entry may therefore be (depending on the nature of the
employee benefits):

Debit: Employment cost (charged as an expense in the statement of profit

or loss)

Credit: Liability for employee benefits

1.2 Short-term employee benefits

Definition
Short-term employee benefits are employee benefits that expected to be settled
wholly within twelve months after the end of the period in which the employee
provides the service.
Short-term employee benefits include:

wages, salaries and social security contributions

paid annual holiday and paid absences due to sickness

profit-sharing payments and bonuses

other benefits not in a monetary form, such as medical insurance, free

accommodation in a house or flat owned by the entity and company cars.

The expense must be accounted for on an accruals basis and any unpaid
entitlement should be recognised as a short-term liability. Discounting the liability
to a present value is not required, because it is payable within 12 months.
Short-term paid absences
Sometimes an entity may pay employees for absence for various reasons. These
include holidays, sickness and maternity leave.
Entitlement to paid absences falls into two categories:

accumulating
x

carried forward for use in future periods if the current periods

entitlement is not used in full;

expense and liability is recognised when employees render service

that increases their entitlement to future paid absences

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measured at the additional amount expected to be paid as a result of

the unused entitlement that has accumulated at the end of the
reporting period.

non-accumulating.
x

unused amounts cannot be carried forward;

expense and liability is recognised when the absences occur.

Profit-sharing and bonus plans

The expected cost of profit-sharing and bonus payments must be recognised
when, and only when:

the entity has a present legal or constructive obligation to make such

payments as a result of past events; and

a reliable estimate of the obligation can be made.

A reliable estimate of its legal or constructive obligation under a profit-sharing or

bonus plan can be made when, and only when:

the formal terms of the plan contain a formula for determining the amount of
the benefit;

the entity determines the amounts to be paid before the financial

statements are authorised for issue; or

past practice gives clear evidence of the amount of the entitys constructive
obligation.

A present obligation exists when, and only when, the entity has no realistic
alternative but to make the payments.

1.3 Termination benefits

Definition
Termination benefits are employee benefits provided in exchange for the
termination of an employees employment as a result of either:
a.

an entitys decision to terminate an employees employment before the

normal retirement date; or

b.

an employees decision to accept an offer of benefits in exchange for the

termination of employment.

Recognition
An entity must recognise a liability and expense for termination benefits at the
earlier of the following dates:

when the entity can no longer withdraw the offer of those benefits; and

when the entity recognises costs for a restructuring within the scope of IAS
37 that involves the payment of termination benefits.

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Measurement
Termination benefits are measured in accordance with the nature of the
employee benefit, that is to say short term benefits, other long term benefits or
post-employment benefits.

1.4 Other long term benefits

Definition
Other long-term employee benefits are all employee benefits other than shortterm employee benefits, post-employment benefits and termination benefits.
An entity must recognise a net liability (asset) for any other long term benefit.
This is measured as:

the present value of the obligation for the benefit; less

the fair value of assets set aside to meet the obligation (if any).

Movements in the amount from one year to the next are recognised in P&L.

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POST-EMPLOYMENT BENEFITS
Section overview

Post-employment benefits

Defined contribution pension plans

Defined benefit pension plans

Introduction to accounting for defined benefit pension plans

Accounting for defined benefit pension plans

Accounting for defined benefit pension plans Alternative approach

Asset ceiling example

Multi-employer plans

2.1 Post-employment benefits

Definition
Post-employment benefits are employee benefits (other than termination
benefits and short-term employee benefits) that are payable after the completion
of employment.
The most significant post-employment benefit is a retirement pension, but there
may also be post-employment life insurance and medical care.
Definition
Post-employment benefit plans are formal or informal arrangements under which
an entity provides post-employment benefits for one or more employees.
There are two types of post-employment benefit plan:

defined contribution plans; and

defined benefit plans.

Definitions
Defined contribution plans are post-employment benefit plans under which an
entity pays fixed contributions into a separate entity (a fund) and will have no
legal or constructive obligation to pay further contributions if the fund does not
hold sufficient assets to pay all employee benefits relating to employee service in
the current and prior periods.
Defined benefit plans are post-employment benefit plans other than defined
contribution plans.

2.2 Defined contribution pension plans

In a defined contribution pension plan, the employer pays an agreed amount of
money (defined contributions) at regular intervals into a pension fund for the
employee. The amount of money that the employer contributes is usually a fixed
percentage of the employees wages or salary (e.g. 5% of the employees basic
salary).
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The contributions to the fund are invested to earn a return and increase the value
of the fund. When an employee retires, he or she is paid a pension out of the
fund. The amount of pension received by the employee is not pre-determined,
but depends on the size of the employees share of the fund at retirement.
As the name defined contribution implies, the companys obligation to pay a
pension to the employee is limited to the agreed amounts of contribution. The
company is not required to make good any shortfalls if the pension fund does not
have enough assets to pay the pension benefits that the employee would like to
have. In effect, the employee bears the risk of a poor-performing fund, not the
employer.
Accounting treatment: contributions to defined contribution schemes
Accounting for the employers contributions to a defined contribution scheme is
straightforward. Using the accruals concept:

the contributions payable for the reporting period are charged to profit or
loss as an expense (an employee cost) in the statement of profit or loss.

any unpaid contributions at the end of the year will be shown in the
statement of financial position as an accrual/liability and any prepaid
contributions will be shown as an asset (a prepayment).

2.3 Defined benefit pension plans

Under a defined benefit plan, the employer guarantees the amount of pension
that its employees will receive after they retire. A company might save cash into a
separate fund (just as for defined contribution plans) in order to build up an asset
that can be used to pay the pensions of employees when they retire. This would
be known as a funded plan. If an employer does not save up in this way the plan
is described as being unfunded.
The amount that an employee will receive is usually linked to the number of years
that he or she has worked for the company, and the size of his/her annual salary
at retirement date (or on leaving the company). Defined benefit plans are often
known as final salary schemes
If there are insufficient funds in the plan to provide employees with the
guaranteed pensions then the employer must make up the shortfall. The risk
remains with the employer.
Role of an actuary
An actuary is a highly qualified specialist in the financial impact of risk and
uncertainty. They advise companies on the conduct of their pension plans.
An actuary will advise the company how much to pay in contributions into the
pension plan each year, in order to ensure there are sufficient funds to cover the
companys obligation to make the pension payments. This involves making a
large number of estimates. For example, the actuary has to estimate the average
life expectancy of retired employees, the expected number of years of service
that retired employees will have given when they retire, their final salary and the
expected returns on investments in the pension fund.

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It is very unlikely that the actuarys estimates will be 100% accurate so whenever
the value of the pension fund assets and the employers pension obligations are
measured, the company may find that there is a deficit or a surplus.

When the amount of the employers future pension obligations is more than
the value of the investments in the pension fund, the fund is in deficit.

When the value of the investments in the pension fund is higher than the
value of the employers obligations to make future pension payments, the
fund is in surplus.

When a surplus or deficit occurs an employer might take no action. This would be
the case when the company believes that the actuarial assumptions may not be
true in the short term but will be true over the long term. Alternatively, the
company might decide to eliminate a deficit (not necessarily immediately) by
making additional contributions into the fund.
When the fund is in surplus, the employer might stop making contributions into
the fund for a period of time (and take a pension holiday). Alternatively, in some
jurisdictions the company may withdraw the surplus from the fund for its own
benefit though this is not allowed in Pakistan.

2.4 Introduction to accounting for defined benefit pension plans

Pensions are paid by the defined benefit plan which is a separate legal entity
from the company. However, the company has the legal obligation to pay the
pensions.
The defined benefit plan is a special entity set up in order to handle a large
number of complex and long term transactions for the company and to separate
the plans assets from those of the company (the pensions of the employees are
protected if the company runs into difficulties).
Statement of financial position
IAS 19 requires that an entity must recognise a defined benefit item (net liability
due to a deficit or net asset due to a surplus) in the statement of financial
position.
The net defined benefit liability (asset) is the deficit or surplus and is measured
as:

the present value of the defined benefit obligation; less

the fair value of plan assets (if any).

A surplus in a defined benefit plan is measured at the lower of:

the surplus in the defined benefit plan; and

the asset ceiling (which 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).

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Definition
The present value of a defined benefit obligation is the present value, without
deducting any plan assets, of expected future payments required to settle the
obligation resulting from employee service in the current and prior periods.
The obligation is estimated by an actuary, and is based on actuarial estimates
and assumptions. IAS 19 requires that it must be measured using the projected
unit credit method (you may need to know this term but do not need to apply it)
using a discount rate available on high quality corporate bonds.
Movement for the period
The movements on the defined benefit item are due to:

cash contributions to the plan

current service cost (to P&L);

past service cost (to P&L);

gains or loss on settlement (to P&L);

net interest (expense or income) (to P&L); and

remeasurement (to OCI);

Note that the benefit paid has no effect as it reduces the plan assets and plan
obligations by the same amount.
Definitions Movements recognised through P&L
Definitions
Current service cost is the increase in the present value of the defined benefit
obligation resulting from employee service in the current period;
Past service cost is the change in the present value of the defined benefit
obligation for employee service in prior periods, resulting from a plan amendment
(the introduction or withdrawal of, or changes to, a defined benefit plan) or a
curtailment (a significant reduction by the entity in the number of employees
covered by a plan).
Net interest on the net defined benefit liability (asset) is the change during the
period in the net defined benefit liability (asset) that arises from the passage of
time.
A settlement is a transaction that eliminates all further legal or constructive
obligations for part or all of the benefits provided under a defined benefit plan,
other than a payment of benefits to, or on behalf of, employees that is set out in
the terms of the plan and included in the actuarial assumptions.

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Definitions Movements recognised through OCI

Definitions
Remeasurements of the net defined benefit liability (asset) comprise:
a.

actuarial gains and losses;

b.

any change in the effect of the asset ceiling, excluding amounts included in
net interest on the net defined benefit liability (asset).

Actuarial gains and losses are changes in the present value of the defined benefit
obligation resulting from:
a.

experience adjustments (the effects of differences between the previous

actuarial assumptions and what has actually occurred); and

b.

the effects of changes in actuarial assumptions.

2.5 Accounting for defined benefit pension plans

Step 1
Construct a note to show the net liability (net asset) that is recognised on the face
of the statement of financial position. This note should include both amounts for
the current year and comparatives.
Illustration: Defined benefit net liability (asset)
Opening

Closing

Present value of plan obligation

Fair value of plan assets

This is used to identify the movement on the defined benefit liability (asset) which
is journalised at step 2
Step 2
Construct the following journal and enter the movement on the defined benefit
liability (asset) and the cash paid to the plan by the company (contributions).
Illustration: Journal
Debit
Profit or loss

Other comprehensive income

(remeasurement)
Cash (contributions)

Defined benefit net liability

Credit

X
X

The above illustration assumes an increase in the liability. This would not be the
case in all examples. (In other words, the movement might be a debit or a credit,
depending on circumstance).
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Step 3
Identify the profit and loss entries. These comprise:

current service cost;

past service cost (if any);

interest (an interest rate applied to the opening net liability (asset); and

settlement gain/loss

Enter the total into the journal.

Step 4
Calculate the remeasurement as a balancing figure.
Example: Defined benefit accounting
The following information relates to the defined benefit plan of Company X for the
year to 31 December 20X6.
At 1 January 20X6:
Fair value of the plan assets

Rs. 000
900

Present value of the plan obligations

1,850

During 20X6:
Current service cost

Rs. 000
90

Contributions paid into the plan

150

Benefits paid out by the plan

60

Actuarial assumptions:
Discount rate

10%

New actuarial valuation at 31 December 20X6:

Fair value of the plan assets

Rs. 000
850

Present value of the plan obligations

1,960

Construct a journal to show the movement on the defined benefit account.

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Answer: Defined benefit accounting

Step 1: The opening position
1 January
20X6
Rs. 000
Present value of plan obligation
Fair value of plan assets

31 December
20X6
Rs. 000

1,850

1,960

(900)

(850)

950

1,110

Note that the movement on the defined benefit liability is an increase of Rs.
160,000 (1,110,000 950,000)
Step 2: Construct the journal and fill in the blanks as far as possible
Debit

Credit

Rs. 000

Rs. 000

Profit or loss
Other comprehensive income
(remeasurement)
Cash (contributions)

150

Defined benefit net liability

160

Step 3: Identify amounts to be recognised in profit or loss

Rs. 000
Current service cost

90

Interest (10% u Rs. 950,000)

95
185

Step 4: Complete the journal by calculating the remeasurement as a balancing

figure
Debit

Credit

Rs. 000

Rs. 000

Profit or loss

185

Other comprehensive income

(remeasurement as a balancing figure)
Cash (contributions)

125
150

Defined benefit net liability

160
310

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2.6 Accounting for defined benefit pension plans Alternative approach

Steps 1 and 2 are as before. The difference is in the calculation of the
remeasurement.
This involves rolling the opening figures forward to the year end. The approach is
to calculate what the closing defined benefit net liability (net asset) should be by
adjusting the opening defined benefit net liability (asset) by what has happened in
the period and by applying the actuarial assumptions.
This balance can then be compared with the actual closing balance and the
remeasurement identified as a balancing figure.
This accounting treatment can best be explained using an example:
Example: Defined benefit accounting
The following information relates to the defined benefit plan of Company X for the
year to 31 December 20X6.
At 1 January 20X6:
Fair value of the plan assets

Rs. 000
900

Present value of the plan obligations

1,850

During 20X6:
Current service cost

Rs. 000
90

Contributions paid into the plan

150

Benefits paid out by the plan

60

Actuarial assumptions:
Discount rate

10%

New actuarial valuation at 31 December 20X6:

Fair value of the plan assets

Rs. 000
850

Present value of the plan obligations

1,960

Construct a journal to show the movement on the defined benefit account.

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Answer: Defined benefit accounting

Step 1: The opening position (as before)

Present value of plan obligation

Fair value of plan assets

1 January
20X6
Rs. 000

31 December
20X6
Rs. 000

1,850

1,960

(900)

(850)

950

1,110

Step 2: Construct the journal and fill in the blanks as far as possible (as before)
Debit

Credit

Rs. 000

Rs. 000

Profit or loss
Other comprehensive income
(remeasurement)
Cash (contributions)

150

Defined benefit net liability

160

Step 3: Construct a working to identify the movements on the defined benefit net
liability (asset)
Rs. 000
(950)
(95)
150
(90)
0

At start of year
1 Net interest (10% 950,000)
2 Contributions paid (given)
3 Current service cost (given)
4 Benefits paid out (given)
Expected year end position

(985)

Remeasurement (balancing figure)

(125)

Actual year end position

(1,110)

Step 4: Complete the journal by entering in the profit and loss amounts and the
remeasurement from the above working.
Debit

Credit

Rs. 000

Rs. 000

Profit or loss (Rs. 95,000 + Rs. 90,000)

185

Other comprehensive income

125

Cash (contributions)

150

Defined benefit net liability

160
310

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Possible complication
In the above illustration the opening defined benefit net liability (asset) was rolled
forward.
IAS 19 requires disclosure of reconciliations of the present value of the defined
benefit obligation and the fair value of the defined benefit assets.
This is done by constructing a similar working to that shown in step 3 above but
including further columns for both the defined benefit liability and the defined
benefit asset.
Example:
Using the facts from the previous example the working would be as follows:
Step 3: Construct a working to identify the movements on the defined benefit net
liability (asset)
Fund position
Liabilityy
Assets
Rs. 000
(1,850)

At start of year
1 Interest expense (10% 1,850,000)
1 Interest earned (10% 900,000)
1 Net interest (10% 950,000)
2 Contributions paid (given)
3 Current service cost (given)
4 Benefits paid out (given)
Expected year end position
Remeasurement (balancing figure)
Actual year end position

Rs. 000
900

(185)

Company
position
Net
Rs. 000
(950)

(90)
60

(60)

(185)
90
(95)
150
(90)
0

(2,065)

1,080

(985)

105

(230)

(125)

(1,960)

850

(1,110)

90
150

Note, that this explains why the benefits paid do not figure in the double entry.
When benefit is paid it reduces both the asset and the liability and in
consequence has no impact on the net position.

2.7 Asset ceiling example

IAS 19 requires that an entity must recognise a defined benefit item (net liability
due to a deficit or net asset due to a surplus) in the statement of financial
position.
The net defined benefit liability (asset) is the deficit or surplus and is measured
as:

the present value of the defined benefit obligation; less

the fair value of plan assets (if any).

However, if the net item is a surplus it is subject to a test which puts a ceiling on
the amount that can be recognised. This is known as the asset ceiling test.
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A surplus in a defined benefit plan is measured at the lower of:

the surplus in the defined benefit plan; and

the asset ceiling (which 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).

The approach is exactly the same as before except that net defined benefit
assets recognised at step 1 must be adjusted downwards to the asset ceiling.
Example: Defined benefit accounting with asset ceiling
The following information relates to the defined benefit plan of Company X for the
year to 31 December 20X6.
At 1 January 20X6:
Fair value of the plan assets

Rs. 000
1,150

Present value of the plan obligations

1,100

Present value of economic benefits available due to

rules in the jurisdiction
During 20X6:
Current service cost

40
Rs. 000
125

Contributions paid into the plan

80

Benefits paid out by the plan

130

Actuarial assumptions:
Discount rate

10%

New actuarial valuation at 31 December 20X6:

Rs. 000

Fair value of the plan assets

1,395

Present value of the plan obligations

1,315

Present value of economic benefits available due to

rules in the jurisdiction

65

Construct a journal to show the movement on the defined benefit account.

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Answer: Defined benefit accounting with asset ceiling

Step 1: The opening position
1 January
20X6
Rs. 000

31 December
20X6
Rs. 000

1,150

1,395

(1,100)

(1,315)

50

80

Asset ceiling adjustment (balancing figure)

(10)

(15)

Asset ceiling (PV of economic benefits

available

40

65

Fair value of plan assets

Present value of plan obligation

Note that the movement on the defined benefit asset is an increase of Rs.
25,000 (65,000 40,000)
Step 2: Construct the journal and fill in the blanks as far as possible (as before)
Debit
Credit
Rs. 000

Rs. 000

Profit or loss
Other comprehensive income
(remeasurement)
Cash (contributions)
Defined benefit net asset

80
25

Step 3: Identify amounts to be recognised in profit or loss

Rs. 000
Current service cost

(125)

Interest credit (10% u 40,000)

4
121

Step 4: Complete the journal by calculating the remeasurement as a balancing

figure
Debit
Credit
Rs. 000
Profit or loss

121

Other comprehensive income

(remeasurement as a balancing figure)
Cash (contributions)
Defined benefit net asset

66
80
25
146

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2.8 Multi-employer plans

Multi-employer plans are defined contribution plans (other than state plans) or
defined benefit plans that:

pool the assets contributed by various entities that are not under common
control; and

use those assets to provide benefits to employees of more than one entity,
on the basis that contribution and benefit levels are determined without
regard to the identity of the entity that employs the employees.

Any multi-employer plan must be classified as a defined contribution plan or a

defined benefit plan.
If an entity participates in a multi-employer defined benefit plan it must account
for its proportionate share of the defined benefit obligation, plan assets and cost
associated with the plan in the same way as for any other defined benefit plan.
If sufficient information is not available to use defined benefit accounting for a
multi-employer defined benefit plan, an entity must account for it as if it were a
defined contribution plan.
Group plans
Defined benefit plans that share risks between entities under common control
(e.g. a parent and its subsidiaries) are not multi-employer plans.
Any entity participating in a defined benefit plan that shares risks between entities
under common control must disclose:

the contractual agreement or stated policy for charging the net defined
benefit cost or the fact that there is no such policy.

the policy for determining the contribution to be paid by the entity.

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IFRIC 14: IAS19 THE LIMIT ON A DEFINED BENEFIT ASSET,

MINIMUM FUNDING REQUIREMENTS AND THEIR INTERACTION
Section overview

IFRIC 14: IAS 19 The limit on a defined benefit asset, minimum funding
requirements and their interaction

Consensus Availability of benefits

Consensus Impact of minimum funding requirement and future benefits

available in the form of refunds

Consensus Impact of minimum funding requirement and future benefits

available in the form of a reduction in future contributions

3.1 IFRIC 14: IAS 19 The limit on a defined benefit asset, minimum funding
requirements and their interaction
Background
As explained above, IAS 19 limits the measurement of a net defined benefit asset
to the lower of the surplus in the defined benefit plan and the asset ceiling (the
present value of any economic benefits available in the form of refunds from the
plan or reductions in future contributions to the plan).
However, IAS 19 does not give guidance on when refunds or reductions in future
contributions should be regarded as available, particularly when a minimum
funding requirement exists.
Minimum funding requirement
The law in a jurisdiction might result in a minimum funding requirement. This is a
requirement for a company to make contributions to fund a defined benefit plan.

The existence of a minimum funding requirement might result in a legal

requirement to make a payment to a plan that is an asset according to IAS
19.

A minimum funding requirement might result in a payment to a plan that

would turn a plan deficit into a plan surplus as discussed in IAS 19.

The interaction of a minimum funding requirement and the limit in the IAS 19
asset ceiling test has two possible effects:

it might restrict the economic benefits available as a reduction in future

contributions;

may give rise to a liability if the contributions required under the minimum
funding requirement will not be available to the entity once they have been
paid (either as a refund or as a reduction in future contributions). The
minimum funding requirement becomes onerous

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Issues
The issues addressed by IFRIC 14:

when refunds or reductions in future contributions should be regarded as

available;

how a minimum funding requirement might affect the availability of

reductions in future contributions; and

when a minimum funding requirement might give rise to a liability

3.2 Consensus Availability of benefits

An economic benefit (as a refund or reduction in future contributions) is available
if the entity can realise it at some point during the life of the plan or when the plan
liabilities are settled.
It does not have to be realisable immediately at the reporting date.
Economic benefit available as a refund:
Economic benefit is only available as a refund if a company has an unconditional
right to that refund.
An unconditional right to a refund:

can exist whatever the funding level of a plan at the reporting date; but

cannot exist subject to occurrence or non-occurrence of one or more

uncertain future events not wholly within its control.

Any such right should be measured as the amount of the surplus at the reporting
date that the entity has a right to receive as a refund, less any associated costs.
Economic benefit available as a reduction in future contributions:
Economic benefit available as a reduction in future contributions is measured
with reference to the amount that the entity would have been required to pay had
there been no surplus. This is represented by the future IAS 19 service cost.
There are three situations to consider:

availability if there is no minimum funding requirement;

whether the minimum funding requirement may give rise to a liability; and

availability if there is a minimum funding requirement.

No minimum funding requirement

Where there is no minimum funding requirement the economic benefit available
is the lower of:

the surplus in the plan; and

the present value of the future service cost to the entity (excluding any part
borne by employees) for each year over the shorter of the expected life of
the plan and the expected life of the entity

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Minimum funding requirement

If an entity has an obligation to pay contributions to cover an existing shortfall (on
the minimum funding basis) in respect of services already received, it must
determine whether these contributions will be available as a refund or reduction
in future contributions after they are paid into the plan.

3.3 Consensus Impact of minimum funding requirement and future benefits

available in the form of refunds
A minimum funding requirement might result in cash being owed to a plan.
Whether a liability should be recognised depends on the recoverability of the
amounts that are to be paid.
A liability is recognised for any amounts not available after they are paid into the
plan. Any such liability would reduce the net defined benefit asset or increase the
net defined benefit liability.
Example: Recognition of liability for a minimum funding requirement
X Limited has a post-employment plan subject to a minimum funding
requirement (MFR) as a result of which it has a statutory obligation to contribute
Rs. 200m to the plan as at the reporting date.
The plan rules permit a full refund of any surplus to the entity at the end of the
life of the plan.
Year-end valuation of the plan is set out below:
2015
Rs. m
Market value of plan assets

1,200

Present value of plan obligations

(1,100)

Defined benefit asset (before accounting for

the MFR in accordance with IFRIC 14).
Liability recognised for MFR

100
nil

Defined benefit net asset

100

The amounts in the plan will be available for refund in the future so there
is no need to recognise a liability in respect of the minimum funding
requirement.

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Example: Recognition of liability for a minimum funding requirement

X Limited has a post-employment plan subject to a minimum funding
requirement (MFR) as a result of which it has a statutory obligation to contribute
Rs. 200m to the plan as at the reporting date.
The plan rules do not allow the refund of surplus.
Year-end valuation of the plan is set out below:
2015
Rs. m
Market value of plan assets

1,200

Present value of plan obligations

(1,100)
100

Adjustment for asset ceiling

(100)

Defined benefit balance (before accounting

for the MFR in accordance with IFRIC 14).

nil

Liability recognised for MFR

(200)

Defined benefit net liability

(200)

The amounts in the plan are not available for refund in the future so
there a liability in respect of the minimum funding requirement is
required.

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Example: Recognition of liability for a minimum funding requirement

X Limited has a post-employment plan subject to a minimum funding
requirement (MFR) as a result of which it has a statutory obligation to contribute
Rs. 200m to the plan as at the reporting date.
The plan rules allow for the refund of 60% of any IAS 19 surplus arising.
Year-end valuation of the plan is set out below:
2015
Rs. m
Market value of plan assets

1,200

Present value of plan obligations

(1,100)
100

Adjustment for asset ceiling

(40)

Defined benefit balance (before accounting

for the MFR in accordance with IFRIC 14).

60

Liability recognised for MFR

(80)

Defined benefit net liability

(20)

The plan rules allow for a refund of 60% of a surplus. Therefore 40% is
not refundable.
X Limited must recognise a liability of Rs. 80m (40% of Rs. 200m). This
is netted against the defined benefit asset of Rs. 60m that would have
been recognised in the absence of the minimum funding requirements.
The amounts in the plan are not available for refund in the future so a
liability in respect of the minimum funding requirement is required.

The impact of paying the MFR amount is as follows:

2015
Rs. m
Defined benefit net liability

(20)

Asset arising from payment of MFR

200

Defined benefit net asset

180

Payment of the MFR results in a defined benefit net asset of Rs. 180m.
This is 60% of the original asset of Rs. 100m and the cash introduced
(Rs. 200m) as a result of the MFR.

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A defined benefit net liability (indicating a shortfall) might be turned into a net
asset by a minimum funding requirement.
Example: Recognition of liability for a minimum funding requirement
X Limited has a post-employment plan subject to a minimum funding
requirement (MFR) as a result of which it has a statutory obligation to contribute
Rs. 300m to the plan as at the reporting date.
The plan rules allow for the refund of 60% of any IAS 19 surplus arising.
Year-end valuation of the plan is set out below:
2015
Rs. m
Market value of plan assets

1,000

Present value of plan obligations

(1,100)

Defined benefit balance (before accounting

for the MFR in accordance with IFRIC 14).

(100)

Liability recognised for MFR

(80)

Defined benefit net liability

(180)

Payment of the 300 will change the deficit of 100 into a surplus of 200
of which only 120 (60%) is refundable. Therefore, Rs. 80m (40% of Rs.
200m) must be recognised as a liability resulting in a total defined
benefit liability of Rs. 180m.
The impact of paying the MFR amount is as follows:
2015
Rs. m
Defined benefit net liability

(180)

Asset arising from payment of MFR

300

Defined benefit net asset

120

Payment of the MFR results in a defined benefit net asset of Rs. 120m.
This is 60% of the surplus that will come into existence when the amount
is paid.

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3.4 Consensus Impact of minimum funding requirement and future benefits

available in the form of a reduction in future contributions
A minimum funding requirement might affect the economic benefit available as a
reduction in future contributions.
When this is the case the minimum funding requirement at a given date must be
analysed into contributions that are required to cover:

any existing shortfall for past service on the minimum funding basis; and

future accrual of benefits.

The economic benefit available as a reduction in future contributions when there

is a minimum funding requirement for contributions relating to future service, is
the sum of:

any prepayment that reduces future minimum funding requirement

contributions for future service; and

the estimated future service cost in each period less the estimated
minimum funding requirement contributions that would be required for
future service in those periods if there were no prepayment as described
above.

Example: Recognition of liability for a minimum funding requirement

X Limited has a post-employment plan subject to a minimum funding
requirement.
X Limited is required to make contributions over the next three years in respect of
an existing shortfall. The present value of these contributions is Rs. 300m.
It is also required to make further minimum funding payments in the future. The
present value of the difference between these cash flows and the IAS 19 service
costs is Rs. 56m.
Year-end valuation of the plan is set out below:
2015
Rs. m
Market value of plan assets

1,000

Present value of plan obligations

(1,000)

Defined benefit balance (before accounting

for the MFR in accordance with IFRIC 14).

Liability recognised for MFR (300 56)

(244)

Defined benefit net liability

(244)

The liability for the shortfall is Rs. 300m and this should be recognised
as a liability. However, this is reduced by the PV of the economic benefit
available in the form of a reduction in future contributions of Rs. 56m.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

14

IFRS 2: Share-based payments

Contents
1 Introduction
2 Equity settled share-based payment transactions:
measurement
3 Equity settled share-based payment transactions:
expense recognition
4 Modifications to equity settled share-based payment
transactions
5 Accounting for cash settled share-based payment
transactions
6 Accounting for share-based payment transaction with
cash alternatives
7 Disclosures

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 3

IFRS 2: Share-based payment

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INTRODUCTION
Section overview

Introduction

Scope

Types of share-based payments

Recognition

Grants of share options to employees: the accounting problem

1.1 Introduction
IFRS 2 Share-based payment explains the accounting treatment for share-based
payment transactions.
Definition
A share-based payment transaction is defined as a transaction in which an entity:
a.

receives goods or services as consideration for equity instruments of the

entity, or

b.

receives goods or services from a supplier by incurring a liability to the

supplier for an amount that is based on the entitys share price.

1.2 Scope
Included in scope
The IFRS applies to share-based payment transactions in which an entity
acquires or receives goods or services unless the transaction is specifically
excluded from its scope.
Excluded from the scope
Transfers of an entitys equity instruments by its shareholders to parties that have
supplied goods or services to the entity when such a transfer is clearly for a
purpose other than payment for goods or services supplied (in which case it is
within the scope of IFRS 2)
Transactions with an employee (or other party) in their capacity as a shareholder.
Transactions where equity instruments are issued in exchange for control of an
acquiree in a business combination.
Share-based payment transactions in which the entity receives or acquires goods
or services under a contract to buy or sell a non-financial item that is within the
scope of IFRS on financial instruments. (IAS 32 Presentation and IAS 39
Financial Instruments: Recognition and Measurement).

1.3 Types of share-based payments

IFRS 2 identifies three types of share-based payment transaction:

equity-settled share-based payment transactions

x

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instruments including both:

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shares; and,

share options;

cash-settled share-based payment transactions

x

where an entity incurs a liability for goods or services and the

settlement amount is based on the price (or value) of the entitys
shares or other equity instruments.

transactions where an entity acquires goods or receives services and either

the entity or the supplier can choose payment to be:
x

a cash amount based on the price (or value) of the entitys shares or
other equity instruments, or

equity instruments of the entity

IFRS 2 uses the generic term equity instruments. In most cases the equity
instruments in question are either shares or share options.
IFRS 2 uses the term fair value in a way that differs in some respects from the
IFRS 13 definition. When applying IFRS 2, fair value is measured in accordance
with the guidance in IFRS 2 not that in IFRS 13.

1.4 Recognition
Goods and services must be recognised when the goods and services are
received.
This might result in the recognition of an asset or expense depending on the
nature of the transaction. If the goods or services received or acquired in a sharebased payment transaction do not qualify for recognition as assets (determined
by rules in other standards), they must be recognised as expenses:.

if the goods or services are received or acquired through an equity-settled

share-based payment transaction the credit entry to match the recognition
of the debit is to equity.

if the goods or services are received or acquired through a cash-settled

share-based payment transaction the credit entry to match the recognition
of the debit is to a liability.

1.5 Grants of share options to employees: the accounting problem

The nature of employee share options
Occasionally shares may be used instead of cash to pay suppliers for goods or
services. These are described as share-based payments, and until IFRS 2, there
was no accounting standard addressing the recognition and measurement of
these transactions.
However, the main reason for the publication of IFRS 2 was to introduce rules of
accounting for employee share options.
In an employee share option scheme, an employee is given the right to subscribe
for new shares in the company at a future date, at a price that is usually fixed
when the share options are awarded.

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The accounting problem

The award of share options to an employee is a reward for services given by the
employee.

If the employee is rewarded with a cash bonus, the cost of the cash bonus
would be included in total employment costs and charged as an expense in
the relevant accounting period.

A problem in the past with accounting for share options was that although
share options are a similar type of reward for service, the cost of the
options were not charged as an expense in the statement of profit or loss.

An award of share options to an employee is consideration given by the entity to

the employee in return for the employees services. Before IFRS 2 was published
this was not accounted for.
As the following sections explain in detail, the IFRS 2 rules on share-based
payment result in the recognition of an expense in profit or loss.
Controversy
When the standard was in its development phase, many argued that there was
no expense because no cash passes hands. However, IFRS 2 is based on the
concept that the expenses represent a consumption of benefit that usually
happens to be measured in terms of a cash cost but need not be in all cases.
The IFRS 2 expense represents the consumption of the benefit of the employees
service.

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EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS:

MEASUREMENT
Section overview

Introduction

Direct or indirect measurement

Measurement date

Measurement of fair value of equity instruments granted

2.1 Introduction
When an entity acquires goods or receives services it must measure them at fair
value with a corresponding increase in equity.
This raises several issues:

how should the fair value be measured?

when should the fair value be measured?

when should the transaction be recognised?

In answering these questions IFRS 2 distinguishes between:

transactions with employees (and others providing similar services); and

transactions with other parties.

The IFRS 2 approach is summarised in the following table:

Transactions with
other parties

Transactions with
employees

How is the fair value of

the transaction
measured?

With reference to the fair

value of the goods and
services received

With reference to the fair

value of the equity
instrument granted

When is the transaction

measured?

At the date when the

goods and services are
received

At the date when the

equity instruments are
granted

At date the goods and

services are received

At grant date

As the service is
rendered over the
vesting period

As the service is
rendered over the
vesting period

When is the transaction

recognised?
No vesting conditions

Vesting conditions

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(there is a presumption
that the services have
been received in full)

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Chapter 14: IFRS 2: Share-based payments

2.2 Direct or indirect measurement

There are two possible approaches which could be followed to measure the fair
value of the transaction:

estimate the fair value of the debit:

x

this is known as direct measurement;

this uses the fair value of the goods and services themselves;

there is a rebuttable presumption that this can be estimated reliably;

it must be used except for:

those rare cases in which the fair value of goods and services
received cannot be estimated reliably; and,

transactions with employees.

estimate the fair value of the equity instrument credit:

x

this is known as indirect measurement;

this uses the fair value of the equity instruments themselves;

it must be used:

when the fair value of goods and services received cannot be

estimated reliably; or

for transactions with employees.

2.3 Measurement date

The measurement date is the date at which the fair value of the equity
instruments granted is measured for the purposes of this IFRS.
The measurement date is:

the grant date for transactions with employees (and others providing similar
services);

the date on which goods are obtained or services received for transactions
with parties other than employees (and those providing similar services).

2.4 Measurement of fair value of equity instruments granted

This is needed when the indirect method is being used (i.e. when shares or share
options are granted to employees).
Fair value is measured taking into account all relevant terms and conditions upon
which the equity instruments are granted.
Grant of shares
The market price of the shares is used.
If the shares are not publicly traded an estimated market price should be used
adjusted to take into account the terms and conditions upon which those shares
were granted.

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Options
The fair value of options granted is measured at the market price of traded
options with similar terms and conditions.
In most cases there will not be a traded option with similar terms and conditions
because the options granted are subject to terms and conditions that do not
apply to traded options. For example, typically, employee share options are:

non-transferable and

subject to vesting conditions.

Fair value is then estimated by applying an option pricing model, for example:

the Black-Scholes-Merton model; or,

a binomial model.

In applying the model the entity must take into account all relevant factors. These
include:

the exercise price of the option;

the life of the option;

the current price of the underlying shares;

the expected volatility of the share price;

the dividends expected on the shares;

the risk-free interest rate for the life of the option;

vesting conditions that are market conditions.

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EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS: EXPENSE

RECOGNITION
Section overview

Introduction

Vesting conditions

Basic recognition model

Recognition when there are changes in estimates over the vesting period

No reversal after equity instruments have vested

Market conditions

3.1 Introduction
Often, when equity instruments are granted they are subject to conditions that
must be satisfied before the counterparty becomes unconditionally entitled to the
instrument.

These are known as vesting conditions.

The period during which the vesting conditions are met is called the vesting
period.

No vesting conditions
If the counterparty is not required to complete a specified period of service before
becoming unconditionally entitled to the equity instruments they are said to vest
immediately.
In the absence of evidence to the contrary, the entity must presume that services
rendered by the counterparty as consideration for the equity instruments have
been received.
In this case the entity must recognise the services received in full on the grant
date.

3.2 Vesting conditions

IFRS 2 distinguishes different categories of vesting condition. These are:

service conditions which require the counterparty to complete a specified

period of service before the option vests; and

performance conditions which require the counterparty to complete a

specified period of service and specified performance targets to be met.

There are two broad categories of performance targets:

market conditions; and

non-market conditions

This distinction is very important. The probability of achieving each type of

condition affects the accounting treatment of equity-settled share-based
payments but in different ways.

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Market conditions

Non-market conditions

Definition

Any condition that

relates to share price.

Any other condition.

Examples

Increase in share price

to a specified value.

Increase in profitability
to a specified amount.

Total shareholder return

to a specified
percentage (total
shareholder return refers
to dividends and share
value)

Launch of a new
product.

Probability of meeting
the condition is a
measurement attribute.

Probability of meeting
the condition is a
recognition attribute.

Probability of meeting
the condition is taken
into account when
measuring the fair value
of the instrument at the
grant date.

Probability of meeting
the condition plays no
part in measuring the
fair value of the
instrument at the grant
date.

Subsequent changes in
the probability of
meeting the condition
have no impact and are
ignored.

Subsequent changes in
the probability of
meeting the condition
have no impact and are
ignored.

Probability of meeting
the condition is a
measurement attribute.

Probability of meeting
the condition is a
recognition attribute.

Probability of meeting
the condition is taken
into account when
measuring the fair value
of the instrument at the
grant date.

Probability of meeting
the condition plays no
part in measuring the
fair value of the
instrument at the grant
date.

Subsequent changes in
the probability of
meeting the condition
have no impact and are
ignored.

Subsequent changes in
the probability of
meeting the condition
are taken into account in
estimating the expense
to be recognised.

How the probability of

achieving the condition
affects the accounting
treatment.

Impact of the probability

of achieving the
condition on the
accounting treatment.

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Achieving quality
improvement.

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Chapter 14: IFRS 2: Share-based payments

For clarity
A market condition is any condition that relates to share price. Any other type of
condition is non-market.
For example, a performance condition might be that the shares will vest as long
as an employee stays with the company for three years from the grant date and
the share price increases by 20% in this period.
The probability of achieving a market condition is taken into account when
estimating the fair value of the equity instrument granted. Subsequent changes in
this probability play no part in the recognition.
For clarity, this means that an option may not vest due to failure to meet the
market condition but an expense is recognised as if the condition had been met.

3.3 Basic recognition model

A vesting period will usually cover several reporting periods.
If a grant of share options is conditional upon the completion of three years
service, recognition is based on the assumption that the services rendered by the
employee in consideration for these share options will be received over that
three-year vesting period.
The fraction of the total equity-settled share based payment expense that relates
to a reporting period is recognised in that reporting period. This continues until
the end of the vesting reporting period.
Example: Equity settled share-based payment
X Limited is a company with a 31 December year end.
On 1 January Year 1 X Limited grants 100 options to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next
three years.
At the grant date the fair value of each option is Rs.15.
X Limited estimates that 20% of employees will leave over the vesting period (i.e.
80% of employees will receive the equity instruments).
Assuming that the estimate of the leavers does not change and is correct (i.e.
80% of employees become entitled to the equity instruments at the end of the
vesting period), expense recognition over the vesting period is as follows:
Amount recognised each year:
(80% u 500) employees u 100 options u Rs.15 u 1/3
Double entry in each year
Statement of profit or loss
Equity
Balance accumulated in equity
at end of year 1
at end of year 2
at end of year 3

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Dr
200,000

Rs. 200,000
Cr
200,000
Rs.
200,000
400,000
600,000

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Advanced accounting and financial reporting

There is no requirement to set up a separate reserve in equity for the completion

of the double entry. Although an entity might do this, many companies in practice
complete the double entry into retained profits.

3.4 Recognition when there are changes in estimates over the vesting period
The above example is based on the assumption that there is no change in the
estimate of the number of leavers over the vesting period and that the estimate
turns out to be correct. This is rarely the case. A number of variables might
change the estimated total expense at each year-end including:

the number of employees expected to meet the service condition;

the number of options to which the employees will become entitled

the length of the vesting period.

Changes in estimate of the outcome of the service and non-market performance

conditions are taken into account in the calculation of the number of equity
instruments that are expected to vest at the end of the vesting period.
The necessary expense is calculated as follows.
Step 1: At each year end an entity must estimate the total expense expected to
arise in respect of a grant of equity instruments by the end of the vesting period.

At each year end an entity must make the best available estimate of the
number of equity instruments expected to vest taking account of nonmarket vesting conditions (including service conditions and non-market
performance conditions).

The number of shares is then valued using the fair value at the grant date.

Step 2: The entity then estimates the fraction of this total amount that relates to
the vesting period to date. For example, if the total expected expense by the end
of the 3 year vesting period is Rs.1,500,000 and it is the end of the second year,
then only Rs. 1,000,000 (2/3 of the total) relates to the vesting period to date.
Step 3: The annual expense is the calculated by comparing the total that relates
to the vesting period to date to the amount previously recognised.
The difference is recognised as an expense:
On rare occasions the process might show that the total expense relating to the
vesting period to date is smaller than that previously recognised. In that case the
previously recognised expense is reversed as follows:
Illustration: Equity-settled share-based payment reversal of expense
Debit
X

Equity
Statement of profit or loss

Credit
X

At the vesting date the actual number of equity instruments that vest (or that
would have vested except for the failure of a market condition) is the basis for the
overall cumulative charge (and the corresponding balance in equity).

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Ultimately, the amount recognised for goods or services received as

consideration for the equity instruments granted is based on the number of equity
instruments that eventually vest (or that would have vested except for the failure
of a market condition see below)
No amount is recognised on a cumulative basis for goods or services received if
the equity instruments granted do not vest because of failure to satisfy nonmarket vesting conditions.
Grant with changes in the probability of meeting the service condition
The estimated total expense is revised at the end of each reporting period to take
account of the estimate of the number of employees expected to meet the
service condition. (This is sometimes described as truing up).
Example: Equity-settled share-based payment
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 100 options to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next
three years.
At the grant date the fair value of each option is Rs.15.
31 December Year 1
X Limited estimates that 20% of employees will leave over the vesting period
(including those who have actually left in year 1).
The expense recognised at the end of year 1 is as follows:
Year 1 expense
(80% u 500) employees u 100 options u Rs.15 u 1/3
Amount previously recognised

Rs.
200,000
nil

Year 1 expense
31 December Year 2

200,000

X Limited estimates that only 15% of employees will leave over the vesting period
(including those who have actually left in years 1 and 2).
The expense recognised at the end of year 2 is as follows:
Year 2 expense
(85% u 500) employees u 100 options u Rs.15 u 2/3
Amount previously recognised
Year 2 expense
31 December Year 3

Rs.
425,000
(200,000)
225,000

418 employees satisfy the service condition.

The expense recognised at the end of year 3 is as follows:
Year 3 expense
418 employees u 100 options u Rs.15 u 3/3
Amount previously recognised

Rs.
627,000
(425,000)

Year 3 expense

202,000

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Practice question

X Limited is a company with a 31 December year end.

On 1 January Year 1 X Limited grants 100 options to each of its 500
employees.
Each grant is conditional upon the employee working for X Limited over the
next three years.
At the grant date X Limited estimates that the fair value of each option is
Rs.15.
Required:
Calculate the income statement charge for the year ended:
1.
31 December Year 1 if at that date, X Limited expects 85% of
employees to be with the company at the end of the vesting period.
2.
31 December Year 2 if at that date, X Limited expects 88% of
employees to be with the company at the end of the vesting period.
3.
31 December Year 3 if at that date 44,300 share options vest.
Grant with a non- market performance condition in which the length of the vesting
period could vary
If a grant of share options is conditional on staying with an entity until a nonmarket performance condition is achieved the length of the vesting period could
vary.
The length of the expected vesting period is estimated at grant date and revised
if subsequent information indicates that the length of the vesting period differs
from previous estimates (but not if the performance condition is a market
condition).
Example: Performance condition where the length of the vesting period could
vary
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 10,000 shares to each of its 10 directors on condition that they
remain with the company in the vesting period and subject to the following
performance condition.
The shares will vest at:
a.

31 December Year 1 if X Limiteds earnings grow by 20% or more; or

b.

31 December Year 2 if X Limiteds earnings grow by an average of 15% or

more over the two years; or

c.

31 December Year 3 if X Limiteds earnings grow by an average of 12% or

more over the three years.

At the grant date X Limited estimates that the fair value of each share is Rs. 50.
31 December Year 1
Earnings have grown by 16% therefore the shares do not vest at this date.
X Limited makes the following estimates:

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a)

earnings will increase at 16% in the next year with the result that the
shares are expected to vest at the next year-end (because the average
growth would be over 15%).

b)

9 directors are expected to be with the company at that time.

Year 1 expense
9 directors u 10,000 u Rs. 50 u 1/2
Amount previously recognised

Rs.
2,250,000
nil

Year 1 expense

2,250,000

Example (continued): Performance condition where the length of the vesting

period could vary
31 December Year 2
Earnings have grown by 10% giving an average growth of 13% (16% + 10%)/2
years). This is less than the 15% specified as a performance condition therefore
the shares do not vest at this date.
X Limited makes the following estimates:
a)

earnings will increase at 10% in the next year resulting in an average

growth rate of 12% ((16% + 10% + 10%)/3 years) so the shares are
expected to vest at the next year end.

b)

9 directors are expected to be with the company at that time.

Year 2 expense
9 directors u 10,000 u Rs. 50 u 2/3
Amount previously recognised
Year 2 expense

Rs.
3,000,000
(2,250,000)
750,000

31 December Year 3
Earnings have grown by 15% resulting in an average growth rate of 13.7% ((16%
+ 10% + 15%)/3 years) so the shares vest.
There are 8 directors who receive shares.
Year 3 expense
8 directors u 10,000 u Rs. 50 u 3/3
Amount previously recognised
Year 3 expense

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Rs.
4,000,000
(3,000,000)
1,000,000

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Grant with a non-market performance condition in which the number of equity

instruments to which the employees become entitled could vary
Example: Performance condition where the number of equity instruments could
vary
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants share options to each of its 10 directors on condition that they
remain with the company over a 3 year vesting period and subject to the
following performance condition.
a)

Each director will receive 5,000 share options if profit grows by an average
of 10% to 15% per annum over the 3 year period.

b)

Each director will receive 10,000 share options if profit grows by an

average of at least 15% to 20% per annum over the 3 year period.

c)

Each director will receive 15,000 share options if profit grows by an

average of over 20% per annum over the 3 year period.

At the grant date X Limited estimates that the fair value of each share is Rs. 50.
31 December Year 1
Profit has grown by 17% in Year 1.
X Limited makes the following estimates:
a)

Profit will continue to increase by at least 16% over the vesting period.

b)

9 directors are expected to be with the company at the end of the vesting
period.
Year 1 expense
9 directors u 10,000 u Rs. 50 u 1/3

Rs.

Amount previously recognised

1,500,000
nil

Year 1 expense

1,500,000

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Example (continued): Performance condition where the number of equity

instruments could vary
31 December Year 2
Profit has grown by 23% in Year 2 giving an average growth of 20% (17% +
23%)/2 years).
X Limited makes the following estimates:
a)

Profit will increase by at least 20% next year.

b)

9 directors are expected to be with the company at the end of the vesting
period.
Year 2 expense
9 directors u 15,000 u Rs. 50 u 2/3

Rs.

Amount previously recognised

4,500,000
(1,500,000)

Year 2 expense

3,000,000

31 December Year 3
Profit grew by 18% in Year 3 giving an average growth of 18.3% (17% + 23%
+18%/3 years). Therefore each director receives 10,000 share options.
There are 8 directors who receive shares.
Year 3 credit
8 directors u 10,000 u Rs. 50 u 3/3

Rs.
4,000,000
(4,500,000)

Amount previously recognised

Year 3 credit

(500,000)

In this case, a previously recognised expense is reversed in year 3 as

follows:
Dr
Cr
Equity
Statement of profit or loss

500,000
500,000

3.5 No reversal after equity instruments have vested

Once goods or services have been recognised in accordance with IFRS 2 (with a
corresponding increase in equity) an entity is not allowed to adjust total equity.
For example an entity is not allowed to reverse the transaction if options are not
exercised perhaps because they are out of the money (i.e. where the exercise
price is greater than the share value).
However an entity is allowed to recognise a transfer from one component of
equity to another.

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3.6 Market conditions

As explained earlier any condition that relates to share values is a market
condition and the probability of achieving such a condition is a measurement
attribute rather than a recognition attribute. This means that it is taken into
account in the initial grant date valuation of the equity instrument and that
subsequent changes in the probability of achieving the condition have no effect
on the expense recognition.
Example: Equity settled share-based payment with market condition
X Limited is a company with a 31 December year end.
X Limited grants 10,000 share options to each of its 10 directors on condition
that they remain with the company over a 3 year vesting period and that share
price increases by 10% per annum over that period.
At the grant date the fair value of each share option (taking account of the
probability of achieving the share price increase) is Rs. 40.
Early in Year 1 X Limiteds profitability was adversely affected by a fall in world oil
price making it extremely unlikely that the share price condition will be met. This
has no impact on the recognition of the expense which proceeds as follows:
31 December Year 1
9 directors are expected to be with the company at the end of the vesting period.
The expense recognised at the end of year 1 is as follows:
Year 1 expense
9 directors u 10,000 options u Rs. 40 u 1/3
Amount previously recognised

Rs.
1,200,000
nil

Year 1 expense

1,200,000

31 December Year 2
9 directors are expected to be with the company at the end of the vesting period.
The expense recognised at the end of year 2 is as follows:
Year 2 expense
9 directors u 10,000 options u Rs. 40 u 2/3
Amount previously recognised

Rs.
2,400,000
(1,200,000)

Year 2 expense

1,200,000

31 December Year 3
8 directors are still employed by the company.
The share price condition is not met.
The expense recognised at the end of year 3 is as follows:
Year 3 expense
8 directors u 10,000 options u Rs. 40 u 3/3
Amount previously recognised
Year 3 expense

Emile Woolf International

Rs.
3,200,000
(2,400,000)
800,000

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Grant with a market performance condition where the date on which the target is
achieved might vary
If a grant of share options is conditional on staying with an entity until a market
performance condition is achieved the time taken to achieve the target could
vary.
The length of the expected vesting period is estimated at grant date and is not
revised subsequently.
Example: Performance condition where the length of the vesting period could
vary
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 10,000 shares to each of its 10 directors on condition that they
remain with the company in the vesting period and subject to the following
performance condition.
The shares vest when the share price increases by 50% above its value at the
grant date. It is estimated that this will occur in 4 years after the grant date.
At the grant date X Limited estimates that the fair value of each share is Rs. 50.
X Limited estimates that all 10 directors will remain with the firm.
The following amounts will be recognised as an expense in each of the next 4
years.
10 directors u 10,000 options u Rs. 50 u 1/4

Rs. 1,250,000

Note that the date at which the increase in share value is actually
achieved is irrelevant. The original estimate of the length of the vesting
period is not revised. (This is different from cases involving non-market
conditions).

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Advanced accounting and financial reporting

MODIFICATIONS TO EQUITY-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS
Section overview

Introduction

Modifications that increase the fair value of the equity instruments granted

Modification that increase the number of equity instruments granted

Modifications that decrease the total fair value of the share-based arrangement

Modification to reduce the vesting period

Cancellation

4.1 Introduction
The terms and conditions upon which an option was granted may be modified
subsequently. For example, the entity might reduce the exercise price of options
granted to employees (i.e. reprice the options), which increases the fair value of
those options.
Any changes to the terms and conditions on which the options were granted must
be taken into account when measuring the services received.
Background
As a minimum an entity must recognise services received measured at the grant
date fair value of the equity instruments granted, unless those equity instruments
do not vest because of failure to satisfy a non-market vesting condition.
In addition, the entity must recognise the effects of modifications that increase
the total fair value of the share-based payment arrangement or are otherwise
beneficial to the employee. In other words, modifications that are unfavourable
for employees are ignored while favourable modifications are accounted for.

4.2 Modifications that increase the fair value of the equity instruments granted
The entity must calculate the incremental fair value of the equity instruments
brought about by the modification.
This incremental fair value is included in the measurement of the amount
recognised for services received as consideration for the equity instruments
granted.
The incremental fair value granted is calculated as the difference between the
following as at the date of the modification:

the fair value of the modified equity instrument; and

that of the original equity instrument, both estimated as at the date of the
modification.

When a modification occurs during the vesting period the incremental fair value
granted is included in the measurement of the amount recognised over the period
from the modification date until the date when the equity instruments vest. This is
in addition to the amount based on the grant date fair value of the original equity

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instruments, which is recognised over the remainder of the original vesting

period.
Example: Modification reduction of exercise price
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited granted 1,000 share options at an exercise price of Rs. 50 to each of its
30 key management personnel.
The options vest if the managers were still employees on 31 December Year 4.
The fair value of the share options was estimated at Rs. 20.
31 December Year 1
X Limited estimated that the options will vest with 20 managers.
Year 1 expense
20 managers u 1,000 options u Rs. 20 u 1/4
Amount previously recognised

Rs.
100,000
nil

Year 1 expense

100,000

1 July Year 2
X Limiteds share price collapsed early in Year 2.
On 1 July Year 2 X Limited modified the share option scheme by reducing the
exercise price to Rs. 15.
The fair value of an option was Rs. 2 immediately before the price reduction and
Rs. 11 immediately after.
31 December Year 2
X Limited estimates that the options will vest with 20 managers.
The expense recognised at the end of year 2 is as follows:
Year 2 expense
Original grant
20 managers u 1,000 options u Rs. 20 u 2/4
Modification
20 managers u 1,000 options u (Rs. 11 Rs. 2) u 0.5/2.5*

Rs.
200,000
36,000
236,000

Amount previously recognised

(100,000)

Year 2 expense

136,000

* At the date of the modification there were 6 months to the year-end and
2 years and 6 months to the vesting date

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Example (continued): Modification reduction of exercise price

31 December Year 3
X Limited estimates that the options will vest with 20 managers.
The expense recognised at the end of year 3 is as follows:
Year 3 expense
Original grant
20 managers u 1,000 options u Rs. 20 u 3/4
Modification
20 managers u 1,000 options u (Rs. 11 Rs. 2) u 1.5/2.5

Rs.
300,000
108,000
408,000

Amount previously recognised

(236,000)

Year 3 expense

172,000

Year 4 expense
Original grant
20 managers u 1,000 options u Rs. 20 u 4/4
Modification
20 managers u 1,000 options u (Rs. 11 Rs. 2) u 2.5/2.5
Amount previously recognised
Amount previously recognised

Rs.

580,000
(408,000)

Year 4 expense

172,000

400,000
180,000

In summary, the original grant is accounted for as if nothing had happened and
the modification results in a new expense. The annual expenses could have been
calculated as follows:
Example: Modification reduction of exercise price
All facts as above.
Original grant expense in years 1 to 4
20 managers u 1,000 options u Rs. 20 u 1/4

100,000

Modification expense in year 2

20 managers u 1,000 options u (Rs. 11 Rs. 2) u 0.5/2.5

Rs.
36,000

Modification expense in years 3 and 4

20 managers u 1,000 options u (Rs. 11 Rs. 2) u 0.5/2.5

Rs.

Summary
Original grant
Modification
Annual expense

Emile Woolf International

Rs.

72,000

Year 1
100,000

Year 2
100,000

Year 3
100,000

Year 4
100,000


100,000

36,000

72,000

72,000

136,000

172,000

172,000

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Chapter 14: IFRS 2: Share-based payments

4.3 Modification that increase the number of equity instruments granted

This is similar to the above.
The fair value of the additional equity instruments granted (measured at the date
of the modification) is included in the measurement of the amount recognised for
services received as consideration for the equity instruments granted.
When a modification occurs during the vesting period the fair value of the
additional equity instruments granted is included in the measurement of the
amount recognised for services received over the period from the modification
date until the date when the additional equity instruments vest. This is in addition
to the amount based on the grant date fair value of the equity instruments
originally granted, which is recognised over the remainder of the original vesting
period.
Example: Modification reduction of exercise price
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 1,000 shares for no consideration to its CEO subject to a 3 year
service condition. At grant date the fair value of the shares is Rs. 15.
During the year, the share price decreases significantly.
1 January Year 2
The share price is Rs. 5.
X Limited grants an additional 2,000 shares for no consideration worth Rs.
10,000 to compensate the CEO for the price fall of Rs. 10 per share.
Original grant expense in years 1 to 3
1 CEO u 1,000 shares u Rs. 15 u 1/3

Rs.
5,000

Modification expense in years 2 to 3

1 CEO u 2,000 shares u Rs. 5 u 1/2

Rs.
5,000

Summary
Original grant
Modification
Annual expense

Year 1
5,000

Year 2
5,000

Year 3
5,000


5,000

5,000

5,000

10,000

10,000

4.4 Modifications that decrease the total fair value of the share-based
arrangement
In effect such modifications are ignored. The entity must continue to account for
the services received as consideration for the equity instruments granted as if
that modification had not occurred.

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4.5 Modification to reduce the vesting period

Expense recognition is accelerated over the new vesting period.
Example: Modification reduction of vesting period
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 1,000 share options to its finance director subject to a 5 year
service condition.
The grant date fair value of a share option is Rs. 10.
1 July Year 2
X Limited reduces the service period to 4 years.
The finance director remains in service over the five year period.
The following amounts will be recognised as an expense in each of the next 4
years.
Exxpense in year 1
1 u 1,000 options u Rs. 10 u 1/5

Rs.
2,000

Exxpense in year 2
1 u 1,000 options u Rs. 10 u 2/4
Amount previously recognised

Rs.
5,000
(2,000)

Year 2 expense

3,000

Exxpense in year 3
1 u 1,000 options u Rs. 10 u 3/4
Amount previously recognised

Rs.
7,500
(5,000)

Year 3 expense

2,500

Exxpense in year 4
1 u 1,000 options u Rs. 10 u 4/4
Amount previously recognised
Year 4 expense

Emile Woolf International

Rs.
10,000
(7,500)
2,500

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Chapter 14: IFRS 2: Share-based payments

4.5 Cancellation
A cancellation is accounted for as an acceleration of vesting. The amount that
would otherwise have been recognised over the vesting period is recognised
immediately.
Example: Cancellation
X Limited is a company with a 31 December year-end.
1 January Year 1
X Limited grants 100 options to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next
five years.
The grant date fair value of each option is Rs. 10.
31 December Year 1
X Limited expects 80% of employees to leave over the vesting period.
The expense recognised at the end of year 1 is as follows:
Year 1 expense
(80% u 500 employees) u 100 options u Rs. 10 u 1/5
Amount previously recognised

Rs.
80,000
nil

Year 1 expense

80,000

31 December Year 2
X Limited expects 80% of employees to leave over the vesting period
The expense recognised at the end of year 2 is as follows:
Year 2 expense
(80% u 500 employees) u 100 options u Rs. 10 u 2/5

Rs.
160,000

Amount previously recognised

(80,000)

Year 2 expense

80,000

Year 3
X Limited cancelled the scheme when 460 employees were still in the scheme.
The expense recognised at the end of year 3 is as follows:
Year 3 expense
460 u 100 options u Rs. 10 u 5/5

Rs.
460,000

Amount previously recognised

(160,000)

Year 3 expense

300,000

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Cancellation with cash compensation

An entity may make a payment to the employee in compensation for the
cancellation. Such a payment is accounted for as the repurchase of an equity
interest and deducted from equity. However if the payment exceeds the fair value
of the equity instruments repurchased any excess is recognised as an expense.
Example: Cancellation with payment to the employee
X Limited is a company with a 31 December year-end.
1 January, Year 1
X Limited granted 1,000 share options to an employee subject to a 3 year service
condition.
The grant date fair value of each option was Rs. 9.
31 December, Year 2
Fair value of each share option is Rs. 18.
X Limited offered to cancel the arrangement in return for a pro rata cash
compensation based on the current fair value that reflects the proportion of the
services provided to the services required under the plan.
The offer amounts to Rs. 12,000 (1,000 x 18 x 2/3).
The employee accepted the offer and payment was made immediately.
The expense for each of the two years is as follows:
Year 1 expense
Amount to be recognised by end of year 1:
1,000 options u Rs.9 u 1/3
Amount previously recognised

3,000
nil

Year 1 expense

3,000

Year 1 double entry

Statement of profit or loss
Equity

Rs.

Debit
3,000

Credit
3,000

Year 2 expense
Amount to be recognised by end of year 2:
1,000 options u Rs.9 u 2/2
Amount previously recognised

Rs.
9,000
(3,000)

Year 2 expense

6,000
Debit

Year 2 double entry

Statement of profit or loss
Equity

6,000
6,000

The cash payment would be accounted for as follows:

Equity
12,000
Cash

Emile Woolf International

Credit

374

12,000

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Chapter 14: IFRS 2: Share-based payments

Cancellation with new grant identified as a replacement award

An entity may grant new equity instruments to the employee and identify them as
a replacement for those cancelled on the date when those new equity
instruments are granted. When this happens the grant of the new instruments is
accounted for in the same way as a modification.
The incremental fair value granted is calculated at the date the replacement
equity instruments are granted as the difference between:

the fair value of the replacement equity instruments; and

the net fair value of the cancelled equity instruments which is:
x

the fair value of the cancelled instruments immediately before the

cancellation, less

the amount of any payment made to the employee on cancellation of

the equity instruments that is accounted for as a deduction from
equity.

Example: Cancelation with replacement award

X Limited is a company with a 31 December year-end.
1 January Year 1
X Limited grants 1,000 share options to its CEO subject to a 4 year service
condition.
The grant date fair value of each share option is Rs. 8.
1 January Year 3
The fair value of the share options has decreased to Rs. 3.
In order to restore the economic position of the CEO, X Limited cancels the
original award and grants a new award as a replacement.
The new grant is for 1,000 share options with a fair value at date of replacement
of Rs. 8 subject to a remaining service period until the end of the original vesting
period (i.e. 31 December Year 4 being 2 years after the replacement date).
X Limited identifies the new award as a replacement award for the original
award. The incremental fair value per equity instrument is Rs. 5 (Rs. 8  Rs. 3).
The annual expenses are as follows:
Original grant expense in years 1 to 4
1 CEO u 1,000 options u Rs. 8 u 1/4

Rs.
2,000

Modification Replacement award in years 3 and 4

1 CEO u 1,000 options u (Rs. 8 Rs. 3) u 1/2

Rs.
2,500

Summary
Original grant
Modification
Annual expense

Emile Woolf International

Year 1
2,000

Year 2
2,000

Year 3
2,000

Year 4
2,000


2,000


2,000

2,500

2,500

4,500

4,500

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Advanced accounting and financial reporting

Cancellation with new grant not identified as a replacement award

If the new grant is not identified as a replacement award the first grant is
accounted for as a cancellation and the new grant accounted for in the usual
way.
Example: Cancelation with new grant not identified as a replacement award
X Limited is a company with a 31 December year-end.
1 January Year 1
X Limited grants 1,000 share options to its CEO subject to a 4 year service
condition.
The grant date fair value of each share option is Rs. 8.
1 January Year 3
The fair value of the share options has decreased to Rs. 3.
In order to restore the economic position of the CEO, X Limited cancels the
original award and grants a new award not specifically identified as a
replacement for the now cancelled award.
The new grant is for 1,000 share options with a fair value at date of replacement
of Rs. 8 subject to a remaining service period until the end of the original vesting
period (i.e. 31 December Year 4 being 2 years after the replacement date).
The annual expenses are as follows:
Original grant expense in year 1
1 CEO u 1,000 options u Rs. 8 u 1/4

Rs.
2,000

Original grant expense in year 2 (cancellation)

1 CEO u 1,000 options u Rs. 8 u 4/4
Amount previously recognised

8,000
(2,000)

Year 2 expense

6,000

Modification New grant in years 3 and 4

1 CEO u 1,000 options u Rs. 8 u 1/2

Rs.
4,000

Summary
Original grant

Year 1
2,000

8,000

Modification


2,000


8,000

Annual expense

Emile Woolf International

376

Year 2

Rs.

Year 3

Year 4


4,000


4,000

4,000

4,000

The Institute of Chartered Accountants of Pakistan

Chapter 14: IFRS 2: Share-based payments

ACCOUNTING FOR CASH-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS
Section overview

Introduction

Share appreciation scheme as an illustration

5.1 Introduction
A cash-settled share-based payment transactions is where an entity incurs a
liability for goods and services and the settlement amount is based on the price
(or value) of the entitys shares or other equity instruments.
The basic rules are:

The liability incurred is measured at its fair value at each reporting date until
it is settled. (There is no locking of fair value at grant date).

Any change in the fair value of the liability is recognised in profit or loss.

5.2 Share appreciation scheme as an illustration

An entity might grant share appreciation rights to employees as part of their pay
package, whereby the employees will become entitled to a future cash payment
(rather than an equity instrument), based on the increase in the entitys share
price from a specified level over a specified period of time.
Immediate recognition
An entity must recognise services received, and a liability to pay for those
services, as the employees render service.
Some share appreciation rights vest immediately (the employees are not required
to complete a specified period of service to become entitled to the cash
payment).

In the absence of evidence to the contrary, the entity must presume that the
services rendered by the employees in exchange for the share appreciation
rights have been received

The entity must recognise immediately the services received and a liability
to pay for them.

Recognition over a period

Some share appreciation schemes do not vest until the employees have
completed a specified period of service.
The entity must recognise the services received, and a liability to pay for them, as
the employees render service during that period.
Measurement
The liability is measured, initially and at each reporting date until settled, at the
fair value of the share appreciation rights.

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This is done by applying an option pricing model, taking into account:

the terms and conditions on which the share appreciation rights were
granted, and

the extent to which the employees have rendered service to date.

If the share appreciation rights granted are conditional upon the employees
remaining in the entitys employ for the next three years and the employees have
completed only one years service at the reporting date, the entity must measure
the fair value of the liability at the reporting date and multiplying the resulting
amount by one-third.
Example: Cash-settled share-based payment transaction
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 100 cash share appreciation rights (SARs) to each of its 500
employees.
Each grant is conditional upon the employee working for X Limited over the next
three years.
Further information
Actual leavers
Estimate of further
in the year
leavers in the future
Year 1
20
40
Year 2
30
30
Year 3
25
The entity estimates the fair value of the SARs at the end of each year in which a
liability exists as shown below.
Year
Fair value
1
15
2
18
3
20
4
23
5
25
As at 31 December Year 5 the employees had not exercised their rights to receive
cash.
The number of employees whose interest is expected to vest and whose interest
does is as follows:
Number of employees whose interest is expected to vest
Year 1
Year 2
Number at grant date
500
500
Number of leavers in year 1
20
20
Number of leavers in year 2
30

Number of leavers in year 3


Expected future number of leavers
40
30
Total expected leavers
Actual leavers

(60)

Expected to vest
Actually vest

440

Emile Woolf International

Year 3
500
20
30
25


(80)
(75)
420
425

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Chapter 14: IFRS 2: Share-based payments

Example (continued): Cash settled share-based payment

The closing liability and the expense recognised at each year end are as follows:
31 December Year 1
Year 1 expense
Liability b/f
Year 1 expense (balancing figure)

Rs.
nil
220,000

Liability c/f:
440 employees (W) u 100 options u Rs.15 u 1/3

220,000

31 December Year 2
Year 2 expense
Liability b/f
Year 2 expense (balancing figure)
Liability c/f:
420 employees (W) u 100 options u Rs.18 u 2/3

Rs.
220,000
284,000
504,000

31 December Year 3
Year 3 expense
Liability b/f

Rs.
504,000

Year 3 expense (balancing figure)

Liability c/f:
425 employees (W) u 100 options u Rs.20 u 3/3

346,000
850,000

31 December Year 4
Year 4 expense
Liability b/f
Year 4 expense (balancing figure)
Liability c/f:
425 employees (W) u 100 options u Rs.23 u 3/3

Rs.
850,000
127,500
977,500

31 December Year 5
Year 5 expense
Liability b/f
Year 5 expense (balancing figure)
Liability c/f:
425 employees (W) u 100 options u Rs.25 u 3/3

Emile Woolf International

379

Rs.
977,500
85,000
1,062,500

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Advanced accounting and financial reporting

The liability is reduced as the company pays out cash to employees who exercise
their rights.
Example: Cash-settled share-based payment transaction
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 100 cash share appreciation rights (SARs) to each of its 500
employees.
Each grant is conditional upon the employee working for X Limited over the next
three years.
Further information
Actual leavers
Estimate of further
in the year
leavers in the future
Year 1
20
40
Year 2
30
30
Year 3
25
The fair values of the SARs at the end of each year in which a liability exists and
the intrinsic values of the SARs (which equals the cash paid to the employees) are
shown below.
Year
Fair value
Intrinsic value
1
15
2
18
3
20
16
4
23
22
5
25
24
Employees cashed in their SARs as follows:
Year
Employees
3
100
4
125
5
200
The number of employees whose interest is expected to vest and whose interest
does vest is as before (shown in the previous example).

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Chapter 14: IFRS 2: Share-based payments

Example (continued): Cash settled share-based payment

The closing liability and the expense recognised at each year end are as follows:
31 December Year 1
Year 1 expense
Liability b/f
Year 1 expense (balancing figure)

Rs.
nil
220,000

Liability c/f:
440 employees u 100 options u Rs.15 u 1/3

220,000

31 December Year 2
Year 2 expense
Liability b/f
Year 2 expense (balancing figure)
Liability c/f:
420 employees u 100 options u Rs.18 u 2/3

Rs.
220,000
284,000
504,000

31 December Year 3
Year 3 expense
Liability b/f

Rs.
504,000

Cash paid (100 employees u 100 options u Rs.16)

Year 3 expense (balancing figure)
Liability c/f
325 employees (W below) u 100 options u Rs.20 u 3/3

(160,000)
306,000
650,000

31 December Year 4
Year 4 expense
Liability b/f

Rs.
650,000

Cash paid (125 employees u 100 options u Rs.22)

Year 4 expense (balancing figure)
Liability c/f:
200 employees (W below) u 100 options u Rs.23 u 3/3

(275,000)
85,000
460,000

31 December Year 5
Year 5 expense
Liability b/f

Rs.
460,000

Cash paid (200 employees u 100 options u Rs.24)

Year 5 expense (balancing figure)
Liability c/f:
Nil employees u 100 options u Rs.25 u 3/3

(480,000)
20,000
0

Note: The total expense over the 5 year period is equal to the cash paid.

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Example (continued): Cash settled share-based payment

W: Number of employees with vested interest
Year 3
Number vested
425
Number cashing out in year 3
100
Number cashing out in year 4

Number cashing out in year 5

Employees with unexercised
rights

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382

Year 4
425
100
125


Year 5
425
100
125
200

(100)

(225)

(425)

325

200

The Institute of Chartered Accountants of Pakistan

Chapter 14: IFRS 2: Share-based payments

ACCOUNTING FOR SHARE-BASED PAYMENT TRANSACTIONS WITH

CASH ALTERNATIVES
Section overview

Introduction

Transactions in which the counterparty has the choice of settlement

Share-based payment transactions in which the entity has the choice of

settlement

6.1 Introduction
Some employee share-based payment arrangements give the employees (or the
employer) the right to choose to receive (or pay) cash instead of shares or
options, or instead of exercising options.
The standard contains different accounting methods for cash-settled and equitysettled share-based payment transactions. Where there is a choice of
settlement, it is necessary to determine which accounting method should be
applied.
This depends on whether:

the employee has the choice of settlement; or

the entity has the choice of settlement.

6.2 Transactions in which the counterparty has the choice of settlement

Background
The counterparty has been granted rights to a compound financial instrument,
(i.e. a financial instrument that includes both debt and equity components). Thus
the counterparty has:

the right to be paid in cash; with,

an option to take shares.

The entity must measure the fair value of the compound financial instrument at
grant date identifying a value to both components.
The goods or services received or acquired in respect of each component of the
compound financial instrument are accounted for separately.

For the debt component, the goods or services acquired, and a liability to
pay for those goods or services are recognised as they are supplied in the
same way as other cash-settled share-based payment transactions.

For the equity component (if any) the goods or services received and an
increase in equity are recognised as they are supplied in the same way as
other equity-settled share-based payment transactions.

Transactions where the fair value of goods and services is measured directly
This category will not include transactions with employees.

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The equity component is measured as the difference between the fair value of
the goods or services received and the fair value of the debt component, at the
date when the goods or services are received. In other words, the equity
component is the residual amount.
The liability and equity component are measured at the date the goods and
services are received for transactions where the direct method applies.
Therefore, there is no subsequent remeasurement of the equity component (as
no further goods and services are received). However, the liability component is
remeasured as it is usually linked to a share value which will change over time.
Date of settlement
The liability is remeasured at its fair value at the date of settlement.

If the entity issues equity instruments on settlement (instead of paying

cash), the liability is transferred direct to equity, as the consideration for the
equity instruments issued.

If the entity pays cash on settlement (instead of issuing equity instruments),

any equity component previously recognised remains in equity. (The entity
is allowed to recognise a transfer within equity, i.e. a transfer from one
component of equity to another).

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Example: Counter party has choice of settlement (direct measurement)

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited acquired a machine with a fair value of Rs. 500,000.
The contract for the purchase of the machine allows the supplier to choose
whether to receive as payment 30,000 ordinary shares or cash equivalent to the
value of 40,000 ordinary shares. In either case, the payment would be made on
31 December Year 1.
The fair values of the shares at various dates were as follows:
1 January
30 June
31 December

Rs. 12 per share

Rs. 15 per share
Rs. 13 per share

The transaction would be accounted for as follows:

1 January Year 1
Dr
500,000

Machine
Liability (40,000 shares u Rs. 12)
Equity (balance)

Cr
480,000
20,000

30 June Year 1
Statement of profit or loss
Liability:
(40,000 shares u Rs. 15)  Rs. 480,000

Dr
120,000

Cr

120,000

31 December
Dr
Liability:
(40,000 shares u Rs. 13)  Rs. 600,000

Cr

80,000

Statement of profit or loss

80,000

31 December payment if settled in cash

Dr
520.000

Liability
Cash

Cr
520,000

31 December payment if settled in equity

Dr
520.000

Liability
Equity

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Transactions using indirect measurement

This category includes transactions with employees.
The debt component and the equity component are measured separately. The
fair value of the compound financial instrument is the sum of the fair values of the
two components.
Share-based payment transactions in which the counterparty has the choice of
settlement are often structured so that the fair value of one settlement alternative
is the same as the other. (For example, the counterparty might have the choice
of receiving share options or cash-settled share appreciation rights).
In such cases, the fair value of the equity component is zero, and hence the fair
value of the compound financial instrument is the same as the fair value of the
debt component. (This is because the fair value of the equity component must
take into account the fact that the holder forfeits the right to receive cash in order
to exercise the option).
Example: Counter party has choice of settlement (indirect measurement)
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants share based compensation to each of its 600 employees.
Each employee has an option to select either 200 shares or the cash equivalent
to the value of 200 shares on condition that they remain in service for 3 years.
The fair values of the components of the compound instrument were as follows:
Equity
Liability

Rs.
3
15

Compound instrument

18

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Example (continued) : Counter party has choice of settlement (indirect

measurement)
31 December Year 1
The fair value of the liability component is estimated at Rs. 20.
X Limited expects 75% of its employees will qualify to receive the compensation.
Year 1 expense re liability
Liability b/f
Year 1 expense (balancing figure)

Rs.
nil
600,000

Liability c/f:
(75% u 600) employees u 200 shares u Rs. 20 u 1/3

600,000

Year 1 expense re equity

Rs.

Equity balance b/f

Year 1 expense (balancing figure)

nil
90,000

Equity balance c/f:

(75% u 600) employees u 200 shares u Rs. 3 u 1/3

90,000

Dr
690,000

Statement of profit or loss

Liability
Equity

Cr
600,000
90,000

31 December Year 2
The fair value of the liability component is estimated at Rs. 25.
X Limited expects 80% of its employees will qualify to receive the compensation
Year 2 expense re liability
Liability b/f
Year 2 expense (balancing figure)

Rs.
600,000
1,000,000

Liability c/f:
(80% u 600) employees u 200 shares u Rs. 25 u 2/3

1,600,000

Year 2 expense re equity

Equity balance b/f
Year 2 expense (balancing figure)

Rs.
90,000
102,000

Equity balance c/f:

(80% u 600) employees u 200 shares u Rs. 3 u 2/3

192,000
Dr

Statement of profit or loss

Liability
Equity

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Cr

1,102,000
1,000,000
102,000

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Example (continued): Choice of settlement with counter party (indirect

measurement)
31 December Year 3
The fair value of the liability component is estimated at Rs. 30.
500 employees meet the vesting condition.
Year 3 expense re liability
Liability b/f
Year 3 expense (balancing figure)

Rs.
1,600,000
1,400,000

Liability c/f:
500 employees u 200 shares u Rs. 30 u 3/3

3,000,000

Year 3 expense re equity

Rs.

Equity balance b/f

Year 3 expense (balancing figure)

192,000
108,000

Equity balance c/f:

500 employees u 200 shares u Rs. 3 u 3/3

300,000
Dr
1,508,000

Statement of profit or loss

Liability
Equity

Cr
1,400,000
108,000

Settlement
31 December payment if settled in cash
Dr
520.000

Liability
Cash

Cr
520,000

31 December payment if settled in equity

Dr
520.000

Liability
Equity

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6.3 Share-based payment transactions in which the entity has the choice of
settlement
Where an obligation exists
The entity must determine whether it has a present obligation to settle in cash
and account for the share-based payment transaction accordingly.
The entity has a present obligation to settle in cash if the choice of settlement in
equity instruments

has no commercial substance; or,

if the entity has a past practice or a stated policy of settling in cash.

Where an obligation exists, the entity must account for the transaction according
to the rules applied to cash-settled share-based payment transactions.
Where there is no obligation
Where an obligation does not exist the entity must account for the transaction
according to the rules applied to equity-settled transactions.
In this case the entity may still decide to settle in cash at the settlement date.

If the entity elects to settle in cash, the cash payment is accounted for as
the repurchase of an equity interest, i.e. as a deduction from equity.

if the entity elects to settle by issuing equity instruments, no further

accounting is required (other than a transfer from one component of equity
to another, if necessary).

There is a special rule to amend the above where the entity elects the settlement
alternative with the higher fair value, as at the date of settlement. If this is the
case the entity must recognise an additional expense for the excess value given:

If cash is paid and the fair value of this is greater than the fair value of the
shares that could have been issued in settlement the difference must be
taken to profit.

If shares are issued in settlement and they have a fair value greater than
that of the cash alternative the difference must be taken to profit.

Example: Entity has choice of settlement (indirect measurement)

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants share based compensation to each of its 1,200 employees. X
Limited will pay 200 shares or the cash equivalent to the value of 200 shares to
any employee who satisfies the 3 year service condition.
The fair value of the share at the grant date is Rs. 18.
The fair values of the shares and the employees whose interest is expected to
vest at each reporting date are as follows:
Fair value of equity
Expected shares to be vested
instrument
Date
Year 1
80%
Rs. 17
Year 2
90%
Rs. 16
Year 3
1000 Employees
Rs. 15

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Example (continued): Entity has choice of settlement (indirect measurement)

Treating the grant as cash-settled
31 December Year 1
Year 1 expense re liability
Liability b/f
Year 1 expense (balancing figure)

Rs.
nil
1,088,000

Liability c/f:
(80% u 1,200) employees u 200 shares u Rs. 17 u 1/3

1,088,000

31 December Year 2
Year 2 expense re liability
Liability b/f
Year 2 expense (balancing figure)

Rs.
1,088,000
1,216,000

Liability c/f:
(90% u 1,200) employees u 200 shares u Rs. 16 u 2/3

2,304,000

31 December Year 3
Year 3 expense re liability
Liability b/f
Year 3 expense (balancing figure)

Rs.
2,304,000
696,000

Liability c/f:
1,000 employees u 200 shares u Rs. 15 u 3/3

3,000,000

31 December payment if actually settled in cash

Dr
3,000,000

Liability
Cash

Cr
3,000,000

31 December payment if settled in equity

Dr
3,000,000

Liability
Equity

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Example (continued): Entity has choice of settlement (indirect measurement)

Treating the grant as equity-settled
31 December Year 1
Year 1 expense re liability
Equity balance b/f
Year 1 expense (balancing figure)

Rs.
nil
1,152,000

Equity balance c/f:

(80% u 1,200) employees u 200 shares u Rs. 18 u 1/3

1,152,000

31 December Year 2
Year 2 expense re liability
Equity balance b/f
Year 2 expense (balancing figure)

Rs.
1,152,000
1,440,000

Equity balance c/f:

(90% u 1,200) employees u 200 shares u Rs. 18 u 2/3

2,592,000

31 December Year 3
Year 3 expense re liability
Equity balance b/f
Year 3 expense (balancing figure)

Rs.
2,592,000
1,008,000

Equity balance c/f:

1,000 employees u 200 shares u Rs. 18 u 3/3

3,600,000

31 December payment if actually settled in equity

Equity
Equity (share capital and share premium)

Dr
3,600,000

Cr
3,600,000

31 December payment if settled in cash

Dr
3,600,000

Equity
Retained earnings
Cash

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600,000
3,000,000

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DISCLOSURES
Section overview

Disclosures about nature and extent of share based payment arrangements

Disclosures about fair value measurement

Disclosures about effect on profit or loss for the period and financial position

7.1 Disclosures about nature and extent of share based payment arrangements
Underlying principle
An entity must disclose information that enables users of the financial statements
to understand the nature and extent of share-based payment arrangements that
existed during the period.
To give effect to this principle an entity must disclose at least the following:

a description of each type of share-based payment arrangement that

existed at any time during the period, including the general terms and
conditions of each arrangement, such as:
x

vesting requirements;

the maximum term of options granted; and,

the method of settlement (e.g. whether in cash or equity).

the number and weighted average exercise prices of share options for each
of the following groups of options:
x

outstanding at the beginning of the period;

granted during the period;

forfeited during the period;

exercised during the period;

expired during the period;

outstanding at the end of the period; and

exercisable at the end of the period.

for share options exercised during the period, the weighted average share
price at the date of exercise. If options were exercised on a regular basis
throughout the period, the entity may instead disclose the weighted
average share price during the period.

for share options outstanding at the end of the period, the range of exercise
prices and weighted average remaining contractual life. If the range of
exercise prices is wide, the outstanding options shall be divided into ranges
that are meaningful for assessing the number and timing of additional
shares that may be issued and the cash that may be received upon
exercise of those options.

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7.2 Disclosures about fair value measurement

An entity must disclose information to enable users to understand how the fair
value of the goods or services received, or the fair value of the equity instruments
granted, during the period was determined.

7.3 Disclosures about effect on profit or loss for the period and financial position
Underlying principle
An entity must disclose information that enables users of the financial statements
to understand the effect of share-based payment transactions on the entitys
profit or loss for the period and on its financial position.
To give effect to this principle an entity must disclose at least the following:

the total expense recognised for the period arising from share-based
payment transactions in which the goods or services received did not
qualify for recognition as assets and hence were recognised immediately
as an expense, including separate disclosure of that portion of the total
expense that arises from transactions accounted for as equity-settled
share-based payment transactions;

for liabilities arising from share-based payment transactions:

x

the total carrying amount at the end of the period; and

the total intrinsic value at the end of the period of liabilities for which
the counterpartys right to cash or other assets had vested by the end
of the period (e.g. vested share appreciation rights).

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SOLUTIONS TO PRACTICE QUESTIONS

Solutions

31 December Year 1
Rs.
Expected outcome (at grant date value)
500 85% 100 Rs.15

Equity

637,500
1/3

Year 1 charge

212,500

Accumulated in equity
31 December Year 2

212,500
Rs.

Expected outcome (at grant date value)

500 88% 100 Rs.15

660,000
2/3

Less expense previously recognised

440,000
(212,500)

Year 2 charge

227,500

Accumulated in equity
31 December Year 3

440,000
Rs.

Actual outcome (at grant date value)

44,300 Rs.15
Less expense previously recognised

664,500
(440,000)

Year 3 charge

224,500

Accumulated in equity

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

15

Financial instruments:
Recognition and measurement

Contents
1

GAAP for financial instruments

IAS 39: Recognition and measurement

IAS 39 (IFRS 9) Derecognition of financial

instruments

IAS 39: Other matters

IAS 39: Hedge accounting

IFRIC 16: Hedges of a net investment in a foreign

operation

IFRS 9: Recognition and measurement

IFRS 9: Impairment of financial assets

IFRS 9: Other matters

10 IFRS 9: Hedge accounting

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions on

the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 8

IFRS 9: Financial Instruments

B (a) 30

IAS 39: Financial instruments: recognition and measurement

B (a) 44

IFRIC 16: Hedges of a net investment in a foreign operation

B (a) 47

IFRIC 19: Extinguishing financial liabilities with equity instruments

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GAAP FOR FINANCIAL INSTRUMENTS

Section overview

Background

Definitions

Derivatives

Using derivatives

1.1 Background
The rules on financial instruments are set out in four accounting standards:

IAS 32: Financial instruments: Presentation;

IAS 39: Financial instruments: Recognition and measurement;

IFRS 7: Financial instruments: Disclosure;

IFRS 9: Financial Instruments

IAS 39 and IFRS 9

The IASB inherited IAS 39 from its predecessor body. The IASB has received
many complaints about IAS 39 from interested parties that the requirements in
IAS 39 were difficult to understand, apply and interpret. These interested parties
urged the IASB to develop a new standard for the financial reporting of financial
instruments that is principle-based and less complex.
The IASB entered a project to replace IAS 39. The project progressed as a series
of phases with the results of each phase being published as completed.
The full version of IFRS 9 was completed in July 2014. IFRS 9 will replace IAS 39
but IFRS 9 is not compulsory until 2018 (and then only if the regulatory authorities
in various jurisdictions allow it).
IFRS 9 does allow early adoption and will be adopted before 2018 in some
jurisdictions. In fact, due to the phased production of the new standard the IFRS 9
rules on classification of financial assets are already being applied in some
jurisdictions.
IFRS 9 is not completely different to IAS 39. Rules in several areas have not
changed.
The following table provides a summary of rules that are different.
Area

Comment

Scope

No change.

Recognition

No change.

Measurement on
initial recognition

No change.

Derecognition

No change.

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Area

Comment

Classification of
financial assets

New rules.
Also note that the classification drives subsequent
measurement.

Classification of
financial liabilities

No change

Measurement

No change in the methods but, as mentioned above, the

classification of financial assets drives subsequent
measurement.
This means that some instruments will be measured
differently.

Embedded
derivatives

Embedded derivatives in financial assets no need to

separate as the derivative will cause the host to be
measured at fair value through profit or loss (see later)
Other embedded derivatives no change

Impairment

New rules.

Hedge
accounting

New rules.

1.2 Definitions
A financial instrument is a contract that gives rise to both:

A financial asset in one entity, and

A financial liability or equity instrument in another entity.

A financial asset is any asset that is:

cash;

An equity instrument of another entity;

A contractual right:
x

to receive cash or another financial asset from another entity; or

to exchange financial assets or financial liabilities with another entity

A financial liability is any liability that is a contractual obligation:

To deliver cash or another financial asset to another entity; or

To exchange financial assets or financial liabilities with another entity under

conditions that are potentially unfavourable to the entity.

Financial instruments include:

Cash

Shares

Loans

Debentures

Accounts receivable or accounts payable; and

Financial derivatives and commodity derivatives.

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1.3 Derivatives
A derivative is a financial instrument with all three of the following characteristics:

Its value changes in response to a specified underlying (interest rate,

commodity price, exchange rate etc.); and

It requires no or little initial investment; and

It is settled at a future date

Categories of derivatives
Derivatives can be classified into two broad categories:

Forward arrangements (commit parties to a course of action)

x

forward contracts

futures

swaps

Options (gives the option buyer a choice over whether or not to exercise his
rights under the contract)

Forward contracts
A forward contract is a tailor-made contract to buy or sell a specified amount of a
specified item (commodity or financial item) on a specified date at a specified
price.
A contract like this will require no initial outlay by the company (it has zero fair
value at the date it is entered into). Over the life of the contract its fair value will
depend on the spot exchange rates and the time to the end of the contract.
Example: Forward contracts
A Pakistani company enters into a 6 month forward contract to buy US $100,000
at a rate of Rs. 160 = $1
This means that the Pakistani company will pay Rs. 16,000,000 to buy $100,000
in 6 months time.
This removes uncertainty for the Pakistani company.
A simple valuation of the forward can be made at any time over the life of the
contract by comparing the contracted rate to the spot rate.
Spot rate at date of valuation
Rs. 150 = $1

Rs. 170 = $1

Cost of $100,000 under forward

contract

Rs. 16,000,000

Rs. 16,000,000

Cost of $100,000 on open market

Rs. 15,000,000

Rs. 17,000,000

Difference

Rs. 1,000,000

Rs. 1,000,000

Pakistani company would recognise:

a liability

an
n asset

Note that this is a simplification. In practice the time to the end of the contract
would need to be built into the value. This is beyond the scope of the syllabus.
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Futures
Futures are like forwards but are standardised in terms of amounts, date,
currency, commodity etc. This standardisation means that they can be traded. A
company can enter into a futures contract and then may make a gain or a loss on
the market just like any other traded item.
If a company holds futures they might be an asset or a liability at any particular
date.
Swaps
A swap is an agreement between parties to exchange cash flows related to an
underlying obligation. The most common type of swap is an interest rate swap. In
an interest rate swap, two parties agree to exchange interest payments on the
same notional amount of principal, at regular intervals over an agreed number of
years.
One party might pay interest to the other party at a variable or floating rate, and in
return the other party may pay interest on the same principal at a fixed rate (a
rate that is fixed by the swap agreement).
A swap might be recorded as an asset or liability at any particular date. This
depends on the interaction between the amount that an entity has contracted to
pay out and the amount that it is entitled to receive.
Options
The holder of the option has entered into a contract that gives it the right but not
the obligation to buy (call option) or sell (put option) a specified amount of a
specified commodity at a specified price.
An option differs from a forward arrangement. An option not only offers its
buyer/holder the choice to exercise his rights under the contract, but also the
choice not to enforce the contract terms.
The seller of the option must fulfil the terms of the contract, but only if the option
holder chooses to enforce them.
Holding an option is therefore similar to an insurance policy: it is exercised if the
market price moves adversely. As the option holder has a privileged status
deciding whether or not to enforce the contract terms he is required to pay a
sum of money (a premium) to the option seller. This premium is paid when the
option is arranged, and non-refundable if the holder later decides not to exercise
his rights under the option.
From the point of view of the holder the option will only ever be recorded as an
asset. At initial recognition this would be the amount of the premium.
Subsequently the holder would only exercise the option if it was beneficial to do
so. Therefore it could only ever be an asset.

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1.4 Using derivatives

A company can enter into a transaction involving a derivative for one of two
reasons:

to speculate, and hope to make a profit from favourable movements in rates

or prices; or

to hedge against exposure to a particular risk

Speculation and the use of derivatives

Many derivatives are traded on exchanges, and so are easily available for buying
and selling. Entities can buy or sell derivatives in order to set up speculative
positions, so that a profit will be made from dealing in the derivatives provided
that the market price of the underlying item moves favourably.
For example, forward contracts in cocoa could be purchased by a company that
has no interest in the cocoa itself, but just wants to gamble on future cocoa
prices. The forward contracts would probably be exchange-traded forward
contracts, known as commodity (cocoa) futures.
Speculating in derivatives may expose entities to huge risks, if expectations do
not come true and the price of the underlying item moves the wrong way. In
extreme cases this has led to financial collapse of the company.
Hedging with derivatives
Derivatives can be used to obtain protection against exposure to the risk of an
unfavourable movement in the market price of an item, such as the price of a
commodity, an interest rate or a foreign exchange rate.

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IAS 39: RECOGNITION AND MEASUREMENT

Section overview

Recognition of financial instruments

Initial measurement

Categories of financial asset

Categories of financial liability

Subsequent measurement

Subsequent measurement at fair value

Subsequent measurement at amortised cost

Regular way transactions

2.1 Recognition of financial instruments

A financial asset or a financial liability should be recognised in the statement of
financial position when the reporting entity becomes a party to the contractual
provisions of the instrument.
Comment
This is different from the normal recognition criteria for an asset or a liability.
Usually an asset or liability is recognised when there is a probable inflow or
outflow of economic benefits.
The effect of this is that all financial assets and liabilities, including derivatives,
are recognised in the statement of financial position, even if they have no cost.
Classification on initial recognition
IAS 39 defines four classes of financial asset and two classes of financial liability
into which financial assets and financial liabilities must be allocated to one of
these classes on initial recognition.
The categories of financial assets and liabilities do not affect the initial
measurement of the assets and liabilities. However, they do affect the method of
accounting after initial recognition.

2.2 Initial measurement

A financial instrument should be measured initially at its fair value. This is usually
the fair value of the consideration given or received.
In the case of many derivatives the fair value on initial recognition is often zero. It
may seem odd to recognise a zero amount but this is done so that any gain or
loss that might arise between the date of initial recognition and the reporting date
is recognised in accordance with the rules in IAS 39.
Transaction costs (for example, a dealers fee) might be incurred on initial
recognition of a financial instrument. The accounting treatment of these fees
depends on the subsequent accounting treatment applied to the financial asset or
financial liability in question.
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Transaction costs are expensed immediately in the statement of profit or loss if

the financial asset or financial liability is subsequently measured at fair value with
gains and losses recognised in the statement of profit or loss.
Otherwise the transaction cost is capitalised as part of the carrying amount of the
financial asset or financial liability on initial recognition.
Subsequent measurement

Treatment of transaction cost

Fair value through profit or loss

Written off as an expense in profit and

loss.

Other methods (Amortised cost or fair

value through OCI)

The transaction cost is capitalised and

included in the initial cost of the
financial instrument.

2.3 Categories of financial asset

On initial recognition, financial assets are classified into one of four categories.
This categorisation is very important as it determines the subsequent
measurement of the financial asset.
The four categories are:
(1)

Financial assets at fair value through profit or loss.

This includes financial assets that are held for trading.
Derivatives that are assets must be included in this category unless held in
hedging relationships that qualify for hedge accounting.
An entity can choose to treat other financial instruments as at fair value
through profit or loss, provided that they meet certain criteria.

(2)

Held to maturity investments. These are financial assets with fixed

payments and a fixed maturity that the entity intends to hold until their
maturity. An example is an investment in bonds issued by another entity,
where there is no intention to sell the bonds on the market before their
maturity.
Loan stock, redeemable preference shares and bonds issued by other
entities would fall into this category, provided that the entity plans to hold
the investment to the end of its term (for example, when it is redeemable).

(3)

Loans and receivables. These are assets with fixed payments but are not
quoted in an active market. They include regular bank loans and accounts
receivable (trade receivables). They are not expected to be sold in the near
future.
This category could include loans made to other entities, trade receivables
and investments in bonds and other forms of debt, provided that the other
conditions are met.

(4)

Available-for-sale financial assets. These are any other financial assets

that do not fall into any of the three categories above. In addition, an entity
can designate an asset as available-for-sale when it is first recognised.

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2.4 Categories of financial liability

On initial recognition, financial liabilities are classified into one of two categories.
This categorisation determines the subsequent measurement of the financial
liability.
There are two categories of financial liabilities:
(1)

Financial liabilities at fair value through profit or loss. These include

derivatives that are liabilities unless held in hedging relationships that
qualify for hedge accounting.

(2)

Financial liabilities measured at amortised cost. This category is for all

remaining financial liabilities.

2.5 Subsequent measurement

After initial recognition financial assets (financial liabilities) are measured either
at:

fair value; or

amortised cost.

The measurement methods to be applied to each category of financial asset are

summarised as follows:
Category of financial
asset

Measurement method at subsequent reporting

dates

Financial assets at fair

value through profit or loss

Fair value.
Gain or loss recognised in the statement of proft
or loss

Held to maturity financial

assets

Amortised cost

Loans and receivables

Amortised cost

Available-for-sale financial
assets

Fair value.
Gain or loss recognised in other comprehensive
income and accumulated in a spearate equity
reserve.

The measurement methods to be applied to each category of financial liabilities

are summarised as follows:
Category of financial
asset

Measurement method at subsequent reporting

dates

Liabilities at fair value

through profit or loss

Fair value.
Gain or loss recognised in the statement of proft
or loss

Liabilities measured at
amortised cost

Amortised cost

Valuation at amortised cost is explained later.

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2.6 Subsequent measurement at fair value

Financial assets at fair value through profit or loss
The accounting treatment for financial assets at fair value through profit or loss is
evident in the name of the category.
All financial assets in this category are remeasured to the fair value at each
reporting date with all gains and losses recognised in the statement of profit or
loss. They are said to be marked to market.
Available for sale financial assets
The accounting treatment of an available for sale financial asset (AFS financial
asset) is more complicated. All financial assets in this category are remeasured to
the fair value at each reporting date with all gains and losses recognised in other
comprehensive income and taken to a separate reserve in equity.
When an AFS financial asset is sold the cumulative gain or loss previously
recognised for this asset is reclassified from other comprehensive income to profit
or loss.
Illustration: AFS asset
Recognition of a gain

Dr

AFS asset

Other comprehensive income

Cr
X

The gain recognised in other comprehensive income is accumulated in

reserves as a credit balance.
On sale of the AFS asset
Other comprehensive income
Statement of profit or loss

X
X

The debit recognised in other comprehensive income is set against the

previously recognised credit balance in reserves thus reducing it to zero.
Companies need systems which are able to track gains and losses on individual
AFS financial assets so that when an asset is sold, the appropriate amount can
be reclassified.

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Example: AFS asset

A company purchased a financial asset for Rs. 30,000 plus 1% transaction costs
on 1 April 20X6. It classified this asset as available for sale.
At the end of the financial year (31 December 20X6) the investment was Rs.
40,000.
On 11 January 20X7 the asset was sold for Rs. 50,000.

The following double entries are necessary:

1 April 20X6: Initial recognition

Dr (Rs.)

AFS financial asset

30,300

Cr (Rs.)

Cash

30,300

Being: Initial recognition of an AFS financial asset

(At cost plus transaction cost = Rs. 30,000 + (1% of Rs. 30,000))
31
1 December 20X6: Subsequent measurement

Dr (Rs.)

AFS financial asset (Rs.40,000 - Rs.30,300)

9,700

Cr (Rs.)

Other comprehensive income

9,700

Being: Re-measurement of AFS financial asset to fair value.

1 January 20X7:: Disposal

Dr (Rs.)

Cash

50,000

Cr (Rs.)

AFS financial asset

40,000

Statement of profit or loss

10,000

Being: Recognition of profit on disposal of an AFS financial asset.

Dr (Rs.)
Other comprehensive income
Statement of profit or loss

Cr (Rs.)

9,700
9,700

Being: Reclassification adjustment arising on disposal of an AFS

financial asset.
The statement of profit or loss would show an overall gain of Rs. 19,700 (being
the gain on disposal of Rs. 10,000 plus the reclassification adjustment of Rs.
9,700).

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2.7 Subsequent measurement at amortised cost

Held to maturity investments, loans and receivables and many financial liabilities
are measured at amortised cost after their initial recognition.
Amortised cost is calculated as follows for a financial asset:

amount initially recognised (initial cost of investment); plus

interest income recognised (using the effective rate); less

interest actually received (cash received).

Similarly, the amortised cost of a financial liability is calculated as:

amount initially recognised as a liability (initial cost); plus

interest expense recognised (using the effective rate); less

interest actually paid (cash paid).

Illustration: Amortised cost

Amount at initial recognition

Financial
asset

Financial
liability

Plus: Interest recognised using the

effective rate:
as income

as expense

Less: repayments

(X)

(X)

Amortised cost

Interest expense is measured using the effective rate. This is the rate that
matches the amount loaned (borrowed) with the discounted future cash flows
received (paid).
The effective rate is the discount rate that, when applied to the future interest and
redemption cash flows, gives an amount equal to the amount initially recognised
for the financial asset or financial liability. Thus, it results in a net present value of
zero. It is the IRR of all cash flows associated with lending or borrowing.
The interest recognised is calculated by applying the effective rate to the
outstanding balance on the bond at the beginning of the period. The interest
recognised in profit and loss each year is not necessarily the cash paid.
The outstanding balance at the end of a period is the opening balance plus the
interest charge at the effective rate, minus the actual interest payments in the
period.

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Example: Amortised cost (liability)

A company issues a bond (borrows).
The bond has an issue value of Rs. 1 million and pays a coupon rate of 5%
interest for two years, then 7% interest for two years (this is known as a stepped
bond).
Interest is paid annually on the anniversary of the bond issue.
The bond will be redeemed at par after four years.
The effective rate for this bond is 5.942%
The amortised cost of the liability at the end of each year is calculated by
constructing an amortisation table as follows:

Year
1
2
3
4

Amortised cost
brought
forward
1,000,000

Interest at
5.942%
59,424

1,009,424
1,019,407
1,009,984

59,983
60,577
60,016

(50,000)
(70,000)
(70,000)

240,000

240,000

Cash paid
(50,000)

Amortised cost
carried forward
1,009,424
1,019,407
1,009,984
1,000,000

The bond is initially recorded at cost (Rs. 1,000,000) and by the end of year 1 it
has an amortised cost of Rs. 1,009,424.
The difference is due to the difference in the interest expense recognised in the
statement of profit or loss (Rs. 59,424) and the interest actually paid (Rs.
50,000).
The total interest paid over the four years is Rs. 240,000. However, it is charged
to the profit or loss each year at the effective rate (5.942%) on the outstanding
balance, not as the actual interest paid on the bonds in cash each year.
The investor in the above bond would recognise a financial asset at amortised
cost and recognise interest income in the same amounts as above.

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Practice question

X purchased a loan on 1 January 20X5 and classified it as measured at

amortised cost.
Terms:
Nominal value
Coupon rate
Term to maturity
Purchase price
Effective rate

Rs. 50 million
10%
3 years
Rs. 48 million
11.67%

Required
Calculate the amortised cost of the bond and show the interest income for each
year to maturity.

Practice question

A company issues Rs. 10 million of 6% bonds at a price of Rs. 100.50 for

each Rs. 100 nominal value with issue costs of Rs. 50,000.
The bonds are redeemable after four years for Rs. 10,444,000.
The effective annual interest rate for this financial instrument is 7%.

Required
Calculate the amortised cost of the bond and show the interest expense for
each year to maturity.

2.8 Regular way transactions

In some markets for financial instruments, a contract might be contract entered
into on one date (trade date) is settled at a later date (settlement date) according
to the rules of the market. For example, trades on the Pakistan Stock Exchange
are typically settled 2 days after the date of the trade.
Such transactions are described as regular way transactions.
Definition: Regular way purchase or sale
A purchase or sale of a financial asset under a contract whose terms require
delivery of the asset within the time frame established generally by regulation or
convention in the marketplace concerned.

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Basic rules
The basic rule of initial recognition was explained in paragraph 2.1 above as a
financial asset or a financial liability should be recognised in the statement of
financial position when the reporting entity becomes a party to the contractual
provisions of the instrument.
The date on which an entity becomes a party to the contractual provisions of a
financial asset purchased under a regular way purchase is the trade date.
However, IAS 39 (IFRS 9) contain an exception to this approach by which an
entity can choose to account for a regular way purchase or sale of financial
assets using either trade date accounting or settlement date accounting.
The same method must be applied consistently for all purchases and sales of
financial assets that are classified in the same way.
Trade date accounting and settlement date accounting
The two methods differ in terms of the timing of recognition and derecognition of
assets.
Trade date

Settlement date

Meaning

The trade date is the date that

an entity commits itself to
purchase or sell an asset.

The settlement date is the

date that an asset is delivered
to or by an entity

Purchases

Asset to be received and the

liability to pay for it are
recognised on the trade date

Asset recognised on the date

it is received by an entity.

Sales

Derecogniton of an asset with

recognition of receivable and
gain or loss arising occurs on
the trade date

Derecognition of an asset and

recognition of any gain or loss
on disposal on the day that it
is delivered by the entity.

Settlement date accounting issues

An entity must account for any change in the fair value of the asset between the
trade date and the settlement date in the same way as it accounts for the
acquired asset. In other words any change in value:

is not recognised for assets measured at amortised cost; but

is recognised in profit or loss for assets or other comprehensive income as

appropriate for financial assets measured at fair value.

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Regular way purchase of financial asset

Example: Trade and settlement accounting for the purchase of an investment
An entity bought investment worth Rs. 1,000 on 27 December 2015.
The payment was to be made on 5th January 2016. The company classifies the
investment as FVTPL (held for trading).
The fair value of the asset on relevant dates was as follows:
Date

Fair value

Trade date

27th December 2015

Rs. 1,000

Reporting date

31st December 2015

Rs. 1,005

Settlement date

5th January 2016

Rs. 1,015

The transaction is accounted for as follows using trade date accounting

27 December

Debit

Financial asset
Payable

1,000

31 December

Debit

Financial asset

Credit
1,000
Credit

Statement of profit or loss

5 January

Debit

Payable
Cash

1,000

Credit
1,000

The transaction is accounted for as follows using settlement date

accounting
27 December: No entry
31 December

Debit

Receivable

Statement of profit or loss

5 January

Debit

Financial asset
Receivable

1,015

Credit
5

Statement of profit or loss

Cash

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Regular way sale of financial asset

Example: Trade and settlement accounting for the purchase of an investment
An entity sold an investment with a carrying amount of Rs. 1,015 for Rs. 1,100 on
27 December 2015.
The payment was to be made on 5th January 2016. The company classifies the
investment as FVTPL (held for trading).
The fair value of the asset on relevant dates was as follows:
Date

Fair value

Trade date

27th December 2015

Rs. 1,100

Reporting date

31st December 2015

Rs. 1,105

Settlement date

5th January 2016

Rs. 1,130

The transaction is accounted for as follows using trade date accounting

27 December

Debit

Receivable
Financial asset

1,100

Credit
1,015

Statement of profit or loss

85

31 December: No entry
5 January

Debit

Cash
Receivable

1,100

Credit
1,100

The transaction is accounted for as follows using settlement date

accounting
27 December
Debit
Credit
Financial asset
Statement of profit or loss

85
85

31 December: No entry
5 January

Debit

Cash

1,100

Receivable

Credit
1,100

Note: Under both methods the risks and rewards are transferred on trade
date. Therefore, an entity does not book any gain or loss after trade date.

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IAS 39 (IFRS 9) DERECOGNITION OF FINANCIAL INSTRUMENTS

Section overview

Derecognition of financial assets

Derecognition of financial liabilities

IFRIC 19: Extinguishing financial liabilities with equity instruments

These rules apply to both IAS 39 and IFRS 9.

3.1 Derecognition of a financial asset

Derecognition is the removal of a previously recognised financial asset or
financial liability from an entitys statement of financial position.
Most transactions involving derecognition of a financial asset are straightforward.
However, financial assets may be subject to complicated transactions where
some of the risks and rewards that attach to an asset are retained but some are
passed on. IAS 39 contains complex guidance designed to meet the challenge
posed by complex transactions.
The guidance is structured so that a transaction involving a financial asset is
subject to a series of tests to establish whether the asset should be
derecognised.
These tests can be framed as a series of questions.
1

Have the contractual rights to cash flows of the financial asset expired?
x

If the answer is yes derecognise the financial asset

If the answer is no ask the next question

Has the asset been transferred to another party?

x

If the answer is no the asset is retained

If the answer is yes ask the next question

Have substantially all of the risks and rewards of ownership passed?

x

If the answer is yes derecognise the financial asset

If the answer is no the asset is retained

If the answer is the risks and rewards are neither passed nor
retained (i.e. some are passed but some kept) ask the next
question

Has the asset has been transferred in a way such that risks and rewards of
ownership have neither passed nor been retained but control has been lost.
x

If the answer is yes derecognise the financial asset

If the answer is no the asset is retained

This all sounds very complicated but what it means is that a financial asset is
derecognised if one of three combinations of circumstances occurs:
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the contractual rights to the cash flows from the financial asset expire; or

the financial asset is transferred and substantially all of the risks and
rewards of ownership pass to the transferee; or

the financial asset is transferred, substantially all of the risks and rewards of
ownership are neither transferred nor retained but control of the asset has
been lost.

Most transactions being considered involve the receipt of cash.

Transactions where the asset is derecognised may lead to the recognition

of a profit or loss on disposal.

Transactions where the asset is not derecognised lead to the recognition of

a liability for the cash received.

Example: Derecognition
ABC collects Rs. 10,000 that it is owed by a customer.
1

Have the contractual rights to cash flows of the financial asset expired?
Yes Derecognise the asset
Dr

Cash
Cr

Rs. 10,000
Receivable

Rs. 10,000

Example: Derecognition
ABC sells Rs. 100,000 of its accounts receivables to a factor and receives an 80%
advance immediately. The factor charges a fee of Rs. 8,000 for the service.
The debts are factored without recourse and a balancing payment of Rs. 12,000
will be paid by the factor 30 days after the receivables are factored.

Answer
1

Have the contractual rights to cash flows of the financial asset expired?
No ask the next question

Has the asset been transferred to another party?

Yes (for 80% of it)

Have substantially all of the risks and rewards of ownership passed?

The receivables are factored without recourse so ABC has passed on the
risks and rewards of ownership.
ABC must derecognise the asset transferred.
Dr

Cash
Cr

Rs. 80,000
Receivables

Rs. 80,000

In addition ABC has given part of the receivable to the factor as a fee:
Dr

P&L
Cr

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Example: Derecognition
ABC sells Rs. 100,000 of its accounts receivables to a factor and receives an 80%
advance immediately. The factor charges a fee of Rs. 8,000 for the service.
The debts are factored with recourse and a further advance of 12% will be
received by the seller if the customer pays on time.

Answer
1

Have the contractual rights to cash flows of the financial asset expired?
No ask the next question

Has the asset been transferred to another party?

Yes (for 80% of it)

Have substantially all of the risks and rewards of ownership passed?

The debt is factored with recourse so the bad debt risk stays with ABC. In
addition, ABC has access to future rewards as further sums are receivable
if the customers pay on time.
As ABC has kept the future risks and rewards relating to the Rs. 80,000,
this element of the receivable is not derecognised.
Dr

Cash
Cr

Rs. 80,000
Liability

Rs. 80,000

Being receipt of cash from factor This liability is reduced as the factor
collects the cash.
Dr

Liability
Cr

Rs. X

Receivable

Rs. X

In addition ABC has given part of the receivable to the factor as a fee:
Dr

P&L
Cr

Rs. 8,000
Receivables

Rs. 8,000

Risks and rewards are neither passed nor retained

Deals involving financial assets can be quite complex exposing the parties to
different shares of risks and rewards associated with an asset. This means that it
might not be possible to decide whether the risks and rewards have substantially
passed or not. In such cases the entity that has sold will derecognise the asset
only if control has been lost. This depends on whether the transferee has the
practical ability to sell the asset. If so then the asset is derecognised by the
transferor.
For example, an entity may not sell a financial asset but instead gives a counter
party an option to buy it. In such a case, the passing or retaining of risks and
rewards depends on whether the counter party will exercise the option or not. In
other words the risks and rewards are neither passed nor retained.
Another example involves repo (sale and repurchase transactions).

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Repo transactions
Under a repo transaction, a company sells an asset with a condition that the
same asset will be bought at a later date on fixed price.
Such a transaction is, in substance, a loan arrangement rather than a sale. It is a
method of an entity providing collateral for a loan. The rules in IAS 39 (IFRS 9)
result in the transaction being treated as a financing transaction with the
recognition of a liability as the conditions for derecognition of financial assets are
not fulfilled.
Example: Repo
X Limited sold an investment (Rs. 100,000 15% bond carried at amortised cost of
Rs. 103,000) for Rs. 110,000 and simultaneously entered into a contract to buy
the same investment back in two years with a repurchase rate of 20%
The investment had an effective yield (IRR) of 18%.
This transaction should be reflected in Co. As books as follows:
Debit

Transaction date
Cash
Repo liability

Credit

110,000
110,000

The investment is not derecognised so X Limited recognises income on

the investment at its effective yield.
However, it is the counter party not X Limited that receives the cash so X
Limited shows this as a reduction in the repo liability.
Year 1
Debitt
Credit
Repo liability (15% u Rs.100,000)
Investment

15,000
3,540

Interest income (18% u Rs.103,000)

18,540

Interest expense (20% u Rs.110,000)

22,000

Repo liability

22,000

The movement on the investment and the repo liability is as follows (with
credits being shown in brackets):

Balance b/f

Investment
103,000

Repo
liability

Cash

(110,000)

110,000

Profit or
loss

Year 1:
Income

3,540

Interest expense
Balance b/f

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15,000

(18,540)

(22,000)

22,000

(117,000)

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Chapter 15: Financial instruments: Recognition and measurement

Example continued: Repo

Year 2

Debit

Repo liability
Investment

Credit

15,000
4,177

Interest income Cr

19,177

Interest expense (at the repo rate of 20%)

23,400

Repo liability

23,400

Repayment of repo liability (repurchase of investment)

Debit
Cash
Repo liability

Credit

125,400
125,400
Investment
106,540

Repo
liability
(117,000)

4,177

15,000

(19,177)

Interest expense

(23,400)

23,400

Repurchase of
investment

125,400

Balance b/f

Cash

Profit or
loss

Year 2:
Income

Balance b/f

110,717

(125,400)

3.2 Derecognition of a financial liability

A financial liability (or a part of a financial liability) is derecognised when, and only
when, it is extinguished.
This is when the obligation specified in the contract is discharged or cancelled or
expires.
Modification (restructuring) of a liability
An entity facing liquidity problems might ask a lender to modify the terms of a
loan. This might involve the lender changing the timing of payments
(restructuring) the liability, waiving part of the loan (thus reducing the amount
payable) or a combination of both.
The accounting treatment for a modification depends on whether the terms of the
loan after the modification are substantially different from those of the original
loan.
The terms of a modification are deemed to be substantially different when the
present value of the cash flows of the modified loan discounted at the original
effective rate is at least 10% different from the carrying amount of the original
loan before the modification.

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Modification with substantially different terms

If the new terms are identified as a substantial modification, the original loan is
extinguished and a new financial liability is recognised in its place with any gain
or loss recognised in the statement of profit or loss.
The new liability is recognised at its fair value in accordance with the normal rules
of recognition of financial instruments. This is found by discounting the revised
future payments at the market rate of interest that applies to such cash flows.
Example: Substantial modification of a liability
X Limited had a loan of Rs. 1,000 repayable in 4 years on which it paid interest at
10%.
The carrying amount of the liability was Rs. 1000.
The effective rate of the liability is 10%. (The IRR of any loan carried and
redeemed at par is the same as the coupon rate).
X Limited faced liquidity problems and the lender agreed to restructure the loan.
Under this new arrangement X limited was to make a single payment of Rs.
1,200 at the end of Year 4 instead of the originally scheduled payments.
The market rate at the time of restructuring was 12%.
This would be accounted for as follows:
Step 1: Identify whether the modification is substantial or not
Carrying amount of the original loan
PV of the revised cash flows at the original effective rate
(Rs. 1,200 u 1/1.14)

Rs.
1,000
820

Difference

180

As a percentage of the original carrying amount

(180/1,000 u 100)

18%

Conclusion:
The terms of the original loan have been substantially modified
Step 2: Account for the substantial modification
Extinguishment of original loan
Recognition of new loan (working)

Dr
1,000

Cr
763

Gain on the modification

237

Working: Fair value of new loan on initial recognition

(Rs. 1,200 u 1/1.124) = Rs. 763

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Modification with terms that are not substantially different

A liability is not derecognised when the terms of a modification are not
substantially different from those of the original loan.
Instead, a new effective rate is calculated based on the carrying amount at the
date of the modification (adjusted for any associated modification fee) and the
revised cash flows.
Example: Modification with terms that are not substantially different
X Limited had a liability of Rs. 2,000,000 repayable in 5 years on which it paid
interest at 15%.
The carrying amount of the liability was Rs. 2,000,000.
The effective rate of the liability is 15%.
X Limited faced liquidity problems and the lender agreed to restructure the loan.
Under this new arrangement X limited was to make a single payment of Rs.
3,500,000 at the end of Year 5 instead of the originally scheduled payments.
A fee of Rs. 100,000 was paid for the revision.
This would be accounted for as follows:
Step 1: Identify whether the modification is substantial or not
Carrying amount of the original loan
PV of the revised cash flows at the original effective rate
(Rs. 100,000 + (Rs. 3,500,000 u 1/1.155))
Difference

Rs.
2,000,000
1,840,119
159,881

As a percentage of the original carrying amount

(159,881/2,000,000 u 100)

8%

Conclusion:
The terms of the original loan have not been substantially modified
Step 2: Calculate the new effective yield

Year

Cash flow

Discount
factor at
10%

Present
value at
10%

Discount
factor at
15%

Present
value at
15%

(2,000)

1.000

(2,000)

1,000

(2,000)

100

1.000

100

1,000

100

3,500

0.621

2,173

0.497

1,740

NPV
Using

273

(160)


 
 
 



Interest is recognised at 13% instead of 15% from the date of the modification.

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3.3 IFRIC 19: Extinguishing financial liabilities with equity instruments

Background
The terms of a liability might be renegotiated such that the lender (creditor)
accepts equity instruments as payment instead of cash. (The lender accepts a
debt to equity swap).
IFRIC 19 sets out how an entity that issues equity instruments to extinguish all or
part of a financial liability should account for the transaction.
IFRIC 19 does not address accounting by the creditor.
The following transactions are scoped out of IFRIC 19:

Transactions involving the creditor in its capacity as an existing shareholder

(e.g. a rights issue);

Transactions between businesses under common control both before and

after the transaction. This allows companies within a group to account for
exchange of debt for equity instruments in a corporate reconstruction
without regard to the rules in this interpretation.

Extinguishing a financial liability by issuing equity instruments in

accordance with the original terms of the liability (e.g. convertible
instruments).

Issues addressed
Are an entitys equity instruments issued to extinguish all or part of a financial
liability consideration paid in the context of IAS 39 liability derecognition rules?
How should an entity initially measure the equity instruments issued?
How should the entity account for any difference between the carrying amount of
the liability and the initially measured equity instruments?
Consensus: Are the equity instruments consideration paid
The issue of equity instruments is consideration paid to extinguish all or part of
a financial liability. This leads to the derecognition of the liability.
Consensus: Initial measurement of equity instruments issued
Equity instruments issued must be initially measured at the fair value of those
instruments. If the fair value cannot be reliably measured then the fair value of the
liability extinguished is used instead.
Consensus: Accounting for the difference
The difference between the carrying amount of the liability extinguished and the
consideration paid (fair value of equity instruments issued) must be recognised in
profit or loss. A separate line item or disclosure in the notes is required.
If only a part of the financial liability is extinguished the part of the consideration
allocated to the remaining liability must form part of the assessment as to whether
the remaining liability has been substantially modified.

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Example: Accounting for the difference

Entity X has in issue Rs. 50m 6% loan stock.
It negotiates with the lenders an extinguishment of the debt by the issue of equity
instruments with a fair value of Rs. 48m.
The double entry is as follows:
Debit
Financial liability

Credit

Rs. 50m

Equity

Rs. 48m

Profit on extinguishment

Rs. 2m

Example: IFRIC 19
1 January Year 1
X Limited borrowed Rs. 25,000,000 on the following terms:
Face value

Rs. 25,000,000

Term of loan
Redemption value
Coupon rate
Effective rate (IRR)

10 years
Rs. 30,000,000
12%
13.08150%

31 December Year 5
X Limited has fallen into financial difficulties and renegotiated the terms of the
loan.
The lender has agreed to extinguish 55% of the loan in exchange for an equity
stake in X Limited.
The terms of the agreement were as follows:
Shares to be issued by X Limited to lender

Rs. 17,000,000

Of which:
Consideration for extinguishment of 55% of the loan

Rs. 16,500,000

Shares issued for modification (restructuring fee)

Rs. 500,000

Market rate at the date of arrangement

14.5%

Under the terms of the modification no interest will be paid on the remaining
amount and a sum of Rs. 30,000,000 will be paid at the end of the term. (5 Years
from now)
Required
Show how X Limited must account for the modification to the terms of the loan.

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Example (continued): IFRIC 19

Step 1: Estimate the carrying amount of the liability at the date of the
arrangement
Year

Opening

Interest

Payment

Closing

25,000,000

3,270,375

(3,000,000)

25,270,375

25,270,375

3,305,744

(3,000,000)

25,576,119

25,576,119

3,345,740

(3,000,000)

25,921,860

25,921,860

3,390,968

(3,000,000)

26,312,828

26,312,828

3,442,113

(3,000,000)

26,754,940

Extinguished (55%)

14,715,217

Retained (45%)

12,039,723

Step 2: Accounting for extinguishment of the 55%

Debit
Statement of profit or loss
Financial liability Dr

Credit

1,784,783
14,715,214

Equity

16,500,000

Step 3 Accounting for portion retained (45%)

Step 3a: Identify whether the modification is substantial or not
Carrying amount of the original loan
PV of the revised cash flows at the original effective rate
Rs. 500,000 + (30,000,000 u 1/(1.1308150)5)

Rs.
12,039,723
16,724,206

Difference

4,684,483

As a percentage of the original carrying amount

(4,684,483/12,039,723 u 100)

39%

Conclusion:
The terms of the original loan have been substantially modified
Step 3b: Account for the substantial modification
Debit
Original liability
Statement of profit or loss
Equity
New liability (working)

Credit

12,039,723
3,704,097
500,000
15,243,820

Working: Fair value of new loan on initial recognition

(Rs. 30,000,000 u 1/1.1455) = Rs. 15,243,820

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Chapter 15: Financial instruments: Recognition and measurement

IAS 39: OTHER MATTERS

Section overview

Embedded derivatives

Impairment of financial instruments

4.1 Embedded derivatives

Certain contracts may not meet the definition of a derivative in their entirety but
may have implicit or explicit terms that act in a manner similar to a derivative.
They are said to have a derivative embedded in them.
If a contract contains an embedded derivative it is known as a hybrid contract,
being made up of a host contract and an embedded derivative.
The effect of an embedded derivative is that it causes some of the cash flows
associated with the contract to vary in a similar way to a stand-alone derivative.
The problem is that in the absence of rules requiring separation of embedded
derivatives:

an entity could bury a derivative position in another contract to avoid the

IAS 39 fair value rules; or

two different entities could hold similar derivative positions and therefore
face exactly the same economic exposure, but if the derivative of one
company was embedded in another contract these same economic
exposures would be accounted for differently.

Derivatives might be embedded in financial assets and financial liabilities but

might also be associated with transactions like leases and supply contracts.
Examples: Embedded derivatives
A loan might have interest or principal repayments linked to oil price.
There is an oil derivative embedded in the loan.
Rules
The decision about whether an embedded derivative must be separated, or not,
requires an analysis of the terms and conditions of the hybrid contract.
Separation is required subject to three conditions, all of which must be met.
An embedded derivative must be separated when:

the hybrid is not measured at fair value with changes to P&L; and

a separate instrument with similar terms would be a derivative; and

its economic characteristics and risks are not closely related to those of the
host.

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Commentary on the separation rules

There would be no point in splitting something that is already fair valued into two
components that would be fair valued. Therefore, there is no need to separate an
embedded derivative from an instrument that is measured at fair value through
profit or loss.
However, many contracts cannot be fair valued (e.g. leases, supply contracts,
insurance contracts etc.). These contracts will always satisfy this condition and
therefore, might contain embedded derivatives that would require separation
Secondly a separate instrument with similar terms would be a derivative. There
must be a derivative that can be separated. The contract must include terms
(implied or explicit) that satisfy the definition of a derivative
Lastly separation is only required when the underlying economics of the
derivative are different to those of the host or as IAS 39 puts it, when the
economic characteristics and risks of the embedded derivative are not closely
related to those of the host.
Example: Embedded derivative
A company invests in a convertible debt instrument costing Rs. 250,000.
The fixed interest rate is 7%. At the end of ten years, the instrument can be
converted into ordinary shares, at the option of the company. Otherwise, the
capital of Rs. 250,000 will be repaid.
The investment is classed as available-for-sale.
The fair value of the equity option has been estimated as Rs. 35,000.
Analysis:
The embedded derivative is the option to convert the debt instrument into equity
at the end of ten years. The host contract is the debt instrument. The embedded
derivative must be separated from the host contract because the conditions listed
above are met:
a. The debt instrument is not measured at fair value, with changes in fair
value recognised as profit or loss.
b. A separate instrument with similar terms would be a derivative
c. The debt and equity do not have closely-related characteristics.
There is an embedded derivative.
Since the fair value of the embedded derivative (the equity option) is Rs. 35,000
the transaction is recognised as follows:
Rs.
Available for sale asset

215,000

Derivative (share option)

35,000

Subsequently, the available-for-sale investment and the derivative will

be accounted for in different ways.

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4.2 Impairment of financial instruments

Impairment of most non-current assets is covered by IAS 36, but impairment of
financial instruments is dealt with by IAS 39. The rules for financial assets are
similar to those for non-financial assets.
This is only an issue for financial assets measured at amortised cost and fair
value through OCI. Any impairment losses on those measured at fair value
through profit and loss are automatically recognised through the basic fair value
model.
A financial asset is impaired if its carrying amount exceeds its estimated
recoverable amount. This comparison is made only if there are indications of
impairment at the reporting date. An entity must assess whether this is the case.
Indicators of impairment might include:

financial difficulties of the issuer indicating that interest may not be

received by a holder of bonds of the issuer;

default by the borrower on interest payments;

disappearance of an active market for the investment;

a significant continued decline in value.

If there are indications of impairment of an asset measured at amortised cost an

entity must estimate its recoverable amount. This is the present value of
estimated future cash flows from the asset discounted at the original effective
rate.

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Example: Impairment of financial asset

Company X invests in a bond.
The bond has an issue value of Rs. 1 million and pays a coupon rate of 5%
interest for two years, then 7% interest for two years (this known as a stepped
bond).
Interest is paid annually on the anniversary of the bond issue.
The bond will be redeemed at par after four years.
The effective rate for this bond is 5.942%
At the end of the second year it becomes apparent that the issuer has financial
difficulties and it is estimated that Company X will only receive Rs. 60 for every
Rs. 100 of the future cash flows
At the end of year 2 the amortised cost is:
Year
1
2

Amortised cost
brought forward

Interest at
5.942%

Cash paid

1,000,000
1,009,424

59,424
59,983

(50,000)
(50,000)

Amortised cost
carried forward
1,009,424
1,019,407

The recoverable amount is calculated as follows:

Year
3
4

Discount factor
(@5.942%)
0.9439
0.891

Future cash flows

70,000 @ 60% = 42,000
1,070,000 @ 60% = 642,000

39,644
572,022

Recoverable amount

611,666

Carrying amount

1,019,407

Impairment

407,741

Note that the recoverable amount could have been calculated easily as 60% of
the carrying amount:
60% of 1,019,407 = 611,644 (22 difference due to rounding)
Any impairment loss is charged to profit or loss.

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Chapter 15: Financial instruments: Recognition and measurement

IAS 39: HEDGE ACCOUNTING

Section overview

What is hedging?

Definitions

The principles of hedge accounting

Fair value hedge

Cash flow hedge

Cash flow hedge basis adjustment

Hedges of a net investment in a foreign operation

5.1 What is hedging?

Hedging is the process of entering into a transaction in order to reduce risk.
Companies may use derivatives to establish positions, so that gains or losses
from holding the position in derivatives will offset losses or gains on the related
item that is being hedged.
Example:
A UK company has a liability to pay a US supplier $200,000 in three months
time.
The company is exposed to the risk that the US dollar will increase in value
against the British pound in the next three months, so that the payment in dollars
will become more expensive (in pounds).
A hedge can be created for this exposure to foreign exchange risk by making a
forward contract to buy $200,000 in three months time, at a rate of exchange
that is fixed now by the contract.
This is an example of hedging: the exposure to risk has been removed by the
forward contract.
The logic of accounting for hedging should be that if a position is hedged, then
any gains on the underlying instrument that are reported in profit and loss should
be offset by matching losses on the hedging position in derivatives, which should
also be reported in profit or loss.
Similarly, any losses on the underlying instrument that are reported in profit or
loss should be offset by matching gains on the hedging position in derivatives,
which should also be reported in profit or loss.
However, without special rules to account for hedging, the financial statements
may not reflect the offsetting of the risk and the economic reality of hedging.

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5.2 Definitions
A company can hedge whatever it wants to but, IAS 39 only allows hedge
accounting when certain conditions are satisfied. IAS 39 uses the following
definitions in describing the hedge accounting rules.
Hedged item
Definition
A hedged item is an asset, liability, firm commitment, highly probable forecast
transaction or net investment in a foreign operation that exposes the entity to risk
of changes in fair value or future cash flows and is designated as being hedged.
Hedges of net items cannot qualify for hedge accounting. Suppose a company
whose functional currency was rupees had a 100 asset and an 80 liability. This
company would have a foreign exchange risk exposure on 20. In practice a
company might hedge this 20 position. This cannot qualify for hedge accounting.
Further guidance in IAS 39 limits the risks that can be hedged. A company might
hedge risk components. For example, a company might invest in a foreign
currency, interest bearing bond. The company might hedge the foreign currency
risk and/or the interest rate risk and/or the credit risk of this bond. In each case it
would be allowed to use hedge accounting.
However, this is not the case for non-financial items which must be hedged for
foreign exchange risk or their total risk. For example, a jet fuel manufacturer
might hedge the crude oil cost component of its production costs. This cannot be
hedge accounted under IAS 39.
Hedging instrument
Definition
A hedging instrument is a designated derivative or (for a hedge of the risk of
changes in foreign currency exchange rates only) a designated non-derivative
financial asset or non-derivative financial liability whose fair value or cash flows
are expected to offset changes in the fair value or cash flows of a designated
hedged item.
Hedge accounting is not allowed for hedges where non derivative financial assets
and liabilities are used as hedging instruments except for hedges of foreign
exchange risk.
Hedge accounting is only allowed for hedges involving derivatives external to the
entity. Therefore, if a member of a group takes a derivative position with another
member of the group in order to hedge a risk it may use hedge accounting in its
own financial statements. This hedge accounting must be removed on
consolidation as then the derivative is not external.

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Hedge effectiveness
Definition
Hedge effectiveness is the degree to which changes in the fair value or cash flows
of the hedged item that are attributable to a hedged risk are offset by changes in
the fair value or cash flows of the hedging instrument.
IAS 39 does not specify methods of measuring effectiveness but does require
that it be measured on every reporting date (at least). Whatever method is used
must be documented and in place before hedge accounting is allowed.

5.3 The principles of hedge accounting

Hedge accounting provides special rules that allow the matching of the gain or
loss on the derivatives position with the loss or gain on the hedged item. This
reduces volatility in the statement of financial position and the statement of profit
or loss, and so is very attractive to the preparers of accounts.
The special rules for accounting for hedging can only be used where very
stringent conditions are met:

The derivative must be designated as a hedging instrument.

The hedge must be expected to be highly effective (almost fully offset).

The hedge must be regularly assessed and found to be highly effective.

(Highly effective is where the change in the value of the hedging instrument
(derivative) relative to the change in the item that is being hedged is in the
range 80% - 125%).

Formal documentation must be prepared to describe

x

the hedging instrument;

the hedged item;

the hedged risk;

the method of testing effectiveness; and

the type of hedge.

Hedge accounting models

Where the conditions for using hedge accounting are met, the method of hedge
accounting to be used depends on the type of hedge.
IAS 39 identifies three types of hedging relationship:

fair value hedges

cash flow hedges; and

hedges of a net investment in a foreign entity (accounted for as a cash flow

hedge).

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5.4 Fair value hedge

A fair value hedge is a hedge against the risk of a change in the fair value of an
asset or liability. For example, oil held in inventory could be hedged with an oil
forward contract to hedge the exposure to a risk of a fall in oil sales prices. Or the
risk of a change in the fair value of a fixed rate debt owed by a company could be
hedged using an interest rate swap.
Accounting treatment of fair value hedges
Accounting for a fair value hedge is as follows:

The gain or loss on the hedging instrument (the derivative) is taken to

profit or loss, as normal.

The carrying amount of the hedged item is adjusted by the loss or gain on
the hedged item attributable to the hedged risk with the other side of the
entry recognised in profit or loss.

Example: Fair value hedge

Entity X holds an inventory of 100 barrels of oil at a cost of $70 a barrel.
30th September 20X1: Oil is trading at $100 a barrel. Entity X decides to hedge
the fair value of its oil inventory by entering into a 12 m forward contract to sell
the oil at $100 per barrel.
31st December 20X1: Oil is trading at $90 per barrel.
Required
Assuming that the hedge has been properly documented explain the accounting
treatment for this hedge (ignore time value).

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Answer
Hedging instrument (gain)
The forward contract gives Entity X the right to sell oil at $100 per barrel but it is
only worth $90 per barrel. This represents a gain of $10 per barrel
Dr

Derivative asset (100 barrels @ $10)

Cr

$1,000

P&L

$1,000

Hedged item (loss)

The fair value of oil has fallen by $10 per barrel. The carrying amount of the
inventory is adjusted by this amount.
Dr

P&L

Cr

Inventory

$1,000
$1,000

Note that the hedged item is not fair valued. Its carrying amount is adjusted by
the change in its fair value.
Summary

30th

September 20X1
31st December 20X1:
Fair value change
Derivative
Inventory

Inventory
10,000

Debit/(credit)
Derivative
(asset)

1,000

(1,000)
1,000

1,000

Nil

(1,000)
9,000

P&L

5.5 Cash flow hedge

A cash flow hedge is a hedge against the risk of changes in cash flows relating to
a recognised asset or liability or an anticipated purchase or sale. For example,
floating rate debt issued by a company might be hedged using an interest rate
swap to manage increases in interest rates. Or future US dollar sales of airline
seats by a Pakistani company might be hedged by a US$/Rs. forward contracts
to manage changes in exchange rates. These are hedges relating to future cash
flows from interest payments or foreign exchange receipts.
Accounting treatment of cash flow hedges
Accounting for a cash flow hedge is as follows:

The change in the fair value of the hedging instrument is analysed into
effective and ineffective elements.

The effective portion is recognised in other comprehensive income

(directly in equity).

The ineffective portion is recognised in profit or loss.

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The amount recognised in other comprehensive income is subsequently

released to the profit or loss as a reclassification adjustment in the same
period as the hedged forecast cash flows affect profit or loss.

Example: Cash flow hedge

X SA is a French company
It expects to sell $1,000 of airline seats for cash in six months time.
The current spot rate is 1 = $1.
It sells the future dollar receipts forward to fix the amount to be received in euros
and to provide a hedge against the risk of a fall in the value of the dollar against
the euro.
At inception (30 September 20X1)
At inception, the anticipated future sale is not recorded in the accounts, and the
derivative (the forward contract) has an initial value of zero.
Reporting date (31 December 20X1)
The dollar has weakened with the following results:
a. The derivative is an asset with a fair value of 80.
b. The change in expected cash flows in euros from the forecast seat sales
has fallen by 75 (1,000 to 925).
Effectiveness:
The hedge is highly effective, because the change in the value of the forward
contract (+ 80) closely matches the change in the value of the forecast sales
receipts ( 75).
The hedge is 93.75% effective (75/80). Alternatively, this could be expressed as
106.67% (80/75). It is within the range 80% to 125%.
Accounting:
The gain on the derivative of 80 must be split into effective and ineffective
elements.
The effective gain is the amount of the gain that matches the fall in value in the
hedged item. In this example, this is 75.
The ineffective gain is the difference (80 - 75 = 5).
The effective gain is recognised in other comprehensive income and accumulated
in an equity reserve.
The ineffective element of 5 is reported as a gain in profit or loss for the period.

Derivative
Equity reserve
Profit or loss

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Example (continued): Cash flow hedge.

31 March 20X2 (At settlement)
The forward contract is settled with a gain of 103. This is 23 more than
expected at the last reporting date. The amount must be recognised with the
effective element being taken to OCI and the ineffective element recognised in
P&L.
The airline seats are sold, but the proceeds in euros are 905. This is 20 less
than the 925 estimated at the last reporting date.
The further gain on the derivative must be split into effective and ineffective
elements:
a. Effective = 20 ( 925 905, which is the loss on the euro receipts)
b. Ineffective = 3 (the balance, 23 20).
Dr
Derivative
Equity reserve
Profit or loss

Cr

23
20
3

Accounting on settlement
The income from the sales is 905.
The effective gains on the derivative held in the equity reserve are released to
profit or loss as a reclassification adjustment in other comprehensive income.
The release of the 95 to profit or loss means that the total income from the seat
sales and the effective hedged gains is 1,000. This was the amount of income
that was hedged by the original forward contract.
Summary:

Cash
Previous period
Current period:
Fair value change
Sale of seats
Reclassification
adjustment
Settle forward contract

Debit /(credit)
Derivative
(asset)
OCI

Profit or
loss

80

(75)

(5)

23

(20)

(3)
(905)

95

(95)

(1,008)

905

103

(103)

1,008

The statement of profit or loss includes 1,000 revenue that the company locked
into with the hedging position, plus the gain of 8 (5 + 3) on the ineffective
part of the hedge (= the speculative element of the derivative).

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5.6 Cash flow hedge Basis adjustment

A cash flow hedged transaction might be the future purchase of a non-financial
asset.
Example: Cash flow hedge Basis adjustment
Entity X is based in the UK and has a December year end. Its functional currency
is sterling (GBP)
Entity X forecasts the purchase of a machine from a US supplier and will be paid
for in dollars (USD). The purchase is expected to occur on 1st January 20X3.
It is now 30th September 20X2. The cost of the machine is $15,000. The
exchange rate is $1.5=1 giving a cost to Entity X of 10,000.
Entity X hedges the exchange risk be entering into a forward contract for
$15,000 @ $1.5=1. This is designated as a cash flow hedge and accounted for
accordingly.
1st January 20X3
Entity X buys the machine for $15,000. The exchange rate is $1.47=1 giving a
cost to Entity X of 10,200.
A gain on the forward contract of 200 has been recognised through OCI by this
date. This means that there is a credit balance of 200 in the cash flow hedge
reserve in equity.
This must be released to profit as the hedged transaction impacts the profit and
loss account. The hedged transaction impacts the profit and loss account as the
asset is depreciated.
There are two ways of doing this.
Approach one
Debit /(credit)
Machine

OCI (equity
reserve)

10,200

(200)

1 January 20X3
31 December 20X3:
Depreciation (say 10 years)
Transfer from equity:
reclassification adjustment

(1,020)

Profit or
loss)

1,020
20

Charge for the year

(20)
1,000

Balance carried forward

9,180

(180)

The amounts recognised on the statement of financial position net at 10,000 on

initial recognition (10,200 200). This is because Entity X was able to lock in the
rate of $1.5=1 for the purchase of the machine. The accounting treatment
results in a net expense in the P&L of 1,000 (10,000/10 years).

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Example: Cash flow hedge Basis adjustment

IAS 39 allows a simpler approach.
When a hedged forecast transaction results in the recognition of a non-financial
asset (or liability) an entity is allowed to net off the amount deferred in equity
against the initial amount recognised for the asset.
This is known as a basis adjustment.
Approach two
Debit /(credit)
Equity
Profit or
reserve
Machine
(via OCI) loss (P&L)
1 January 20X3
Basis adjustment
Carrying amount on initial
recognition
31 December 20X3:
Depreciation (say 10 years)

10,200
(200)

(200)
200

10,000

nil

(1,000)

1,000

Charge for the year

1,000

Balance carried forward

9,000

nil

This is only allowed for non-financial assets and liabilities. Approach one must be
used for financial assets and liabilities.

5.7 Hedges of a net investment in a foreign operation

A later chapter explains the accounting treatment, for consolidation purposes, of
an investment in a foreign subsidiary or other foreign operation.
The net assets of the foreign subsidiary are translated at the end of each financial
year, and any foreign exchange differences are recognised in other
comprehensive income (until the foreign subsidiary is disposed of, when the
cumulative profit or loss is then reclassified from equity to profit or loss).
IAS 39 allows hedge accounting for an investment in a foreign subsidiary. An
entity may designate an eligible hedging instrument for a net investment in a
foreign subsidiary, provided that the hedging instrument is equal to or less than
the value of the net assets in the foreign subsidiary.
This is accounted for as a cash flow hedge.

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IFRIC 16: HEDGES OF A NET INVESTMENT IN A FOREIGN OPERATION

Section overview

Introduction

Consensus Location of hedging instrument

Consensus Nature of hedged risk

Consensus Amounts to be reclassified from equity

6.1 Introduction
Scope
IFRIC 16 applies to hedges of foreign currency risk in a net investment in a
foreign operation where an entity wishes to qualify for hedge accounting under
IAS 39
Background
IAS 39 (IFRS 9) allows hedge accounting of hedges of a net investment in a
foreign operation (subject to satisfying the hedge accounting criteria).
Definitions
Foreign operation: an entity that is a subsidiary, associate, joint venture or branch
of a reporting entity, the activities of which are based or conducted in a country or
currency other than those of the reporting entity.
Net investment in a foreign operation: the amount of the reporting entitys
interest in the net assets of that operation.
Therefore (by definition) hedge accounting of the foreign exchange risk of the net
investment in a foreign operation only applies in financial statements where the
interest in the foreign operation is included as the investing companys share of
its net assets. This means for example that hedge accounting in respect of the
exchange risk associated with an investment in a foreign subsidiary is only
allowed in the consolidated financial statements.
Where there is such a designated hedging relationship the effective part of the
gain or loss on the hedging instrument is recognised in other comprehensive
income and accumulated with the foreign exchange differences arising on
translation of the results and financial position of the foreign operation.
Investments in a foreign operation may be held directly or indirectly
IFRIC 16 addresses the following three issues:

Where the hedging instrument should be held within a group.

The nature of the hedged risk and the amount of a hedged item for which a
hedging relationship may be designated?

The amounts that should be reclassified from equity to profit or loss as on

disposal of the foreign operation?

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6.2 Consensus Location of hedging instrument

The hedging instrument may be held by any entity within the group.

6.3 Consensus Nature of hedged risk

Hedge accounting may be applied only to foreign exchange differences arising
between the functional currency of the foreign operation and that of any parent
entity but not to hedges of forex differences between functional currency of a
subsidiary to presentation currency of a parent.
Example:
The following group comprises a parent and 3 100% owned subsidiaries.
The functional currency of each member of the group is shown in brackets.

Further information:
Subsidiary A has external borrowings of $300,000.
Subsidiary C has net assets of $300,000.
Designation of hedged risk
In its consolidated financial statements, the parent designates Subsidiary As
borrowing as a hedge of the /$ exchange risk of its net investment in C.
Accounting
The exchange difference on the retranslation of the net assets of C is recognised
in OCI and accumulated in the currency translation reserve. (IAS 21).
(In effect this is a translation of dollars to pounds and then the pounds into euro).
The exchange gain or loss on the external borrowing is recognised in OCI and
accumulated in the currency translation reserve. (IAS 39/IFRS 9).
(In effect this is a translation of dollars to yen and then the yen into euro).

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Example:
The following group comprises a parent and 3 100% owned subsidiaries.
The functional currency of each member of the group is shown in brackets.

Further information:
Subsidiary A has external borrowings of $300,000.
Subsidiary C has net assets of $300,000.
Designation of hedged risk
In its consolidated financial statements, the parent designates Subsidiary As
borrowing as a hedge of the /$ exchange risk between subsidiary B and C.
Accounting
The exchange difference on the retranslation of the net assets of C is recognised
in OCI and accumulated in the currency translation reserve. (IAS 21).
(In effect this is a translation of dollars to pounds and then the pounds into euro).
The recognition of the exchange gain or loss arising on the external borrowing is
quite complicated.
Dollars to pounds: Any gain or loss recognised in OCI (applying IAS39/IFRS 9
this is the offset of the hedged risk above).
Pounds to yen: Any gain or loss recognised in P&L (applying IAS 21 for individual
company transactions).
Yen to dollars: Any gain or loss recognised in OCI (IAS 21 for translation
differences arising on consolidation).
The hedged item may be an amount of net assets equal to or less than the
carrying amount of the net assets of the foreign operation.
A forex exposure arising from a net investment in a foreign operation may qualify
for hedge accounting only once in consolidated financial statements.

6.4 Consensus Amounts to be reclassified from equity

The following two amounts must be reclassified from the forex translation reserve
to P&L (via OCI) on disposal of a hedged net investment in a foreign operation:

the cumulative translation reserve that has arisen on the consolidation of

the net investment (IAS 21); and

the cumulative effective gain or loss on the hedging instrument (IAS 39)

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IFRS 9: RECOGNITION AND MEASUREMENT

Section overview

Recognition of financial instruments

Classification of financial assets

Other measurement rules

Classification of financial liabilities

7.1 Recognition of financial instruments

The initial recognition rule and the measurement on initial recognition are the
same as those in IAS 39.
A financial asset might be an investment in debt or in equity.

7.2 Classification of financial assets

Classification determines how financial assets are accounted for and in particular,
how they are measured on an ongoing basis.
A company must classify financial assets as subsequently measured at:

amortised cost;

fair value through other comprehensive income; or

fair value through profit or loss

This classification is made on the basis of both:

the business model for managing the financial assets and

the contractual cash flow characteristics of the financial asset.

Financial assets at amortised cost

A financial asset must be measured at amortised cost if both of the following
conditions are met:

the asset is held within a business model whose objective is to hold assets
in order to collect contractual cash flows; and

the contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.

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Financial assets at fair value through other comprehensive income

A financial asset must be measured at fair value through other comprehensive
income if both of the following conditions are met:

the financial asset is held within a business model whose objective is

achieved by both collecting contractual cash flows and selling financial
assets and

the contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.

Financial assets at fair value through profit or loss

A financial asset must be measured at fair value through profit or loss unless it is
measured at amortised cost or at fair value through other comprehensive income.
Reclassification of financial assets after initial recognition is required when an
entity changes its model for managing financial assets. It is not allowed in any
other circumstance.
Example: Classification of financial assets
A company makes a large bond issue to the market.
Three companies (A Limited, B Limited and C Limited) each buy identical Rs.
10,000,000 bonds.
Company

Business model

Classification of bond

A Limited

A Limited holds bonds for the

purpose of collecting contractual
cash flows to maturity
B Limited holds bonds for the
purpose of collecting contractual
cash flows but sells them on the
market when prices are
favourable

A Limited must
measure the bond at
amortised cost

C Limited buys bonds to trade in

them

C Limited must
measure the bond at
fair value through P&L

B Limited

C Limited

B Limited must
measure the bond at
fair value through OCI

7.3 Other measurement rules

Option to designate a financial asset at fair value through profit or loss
Despite the above, a company may, at initial recognition, irrevocably designate a
financial asset as measured at fair value through profit or loss if doing so
eliminates or significantly reduces a measurement or recognition inconsistency
(sometimes referred to as an accounting mismatch) that would otherwise arise
from measuring assets or liabilities or recognising the gains and losses on them
on different bases.

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Equity instruments
Investments in equity are measured at fair value through profit or loss.
However a company can make an irrevocable election at initial recognition to
measure an equity investment at fair value through other comprehensive income
as long as it is not held for trading.
Amortised cost criteria - commentary
The rules try to limit the use of amortised cost to those situations where it best
reflects the substance of the transactions. Therefore it can only be used by a
company whose business model is to make loans and collect future repayments.
A company might sell a loan before its maturity. This does not preclude
classification of loans at amortised cost as long as the companys overall
business model is to hold assets in order to receive contractual cash flows.
On the other hand a company might hold a portfolio of loans in order to profit from
the sale of these assets when market conditions are favourable. In this case the
companys business model is not to hold assets in order to receive contractual
cash flows. The loans in this portfolio must be measured at fair value.
The cash flows received by a company must be solely repayments of the
principal and interest on this principal. An investment in a convertible bond would
not satisfy this criteria as a company might convert it into equity. In that case the
amounts received by the company would not solely be by repayments of principal
or interest.
Overview of classification of financial assets
Method

Which instruments?

Amortised cost

Loans and receivables that satisfy the amortised

cost criteria

Fair value to OCI

Loans and receivables that satisfy the fair value

through OCI criteria
Equity that has been subject to a declaration

Fair value through profit or

loss (FVTPL)

Equity
Derivatives
Loans and receivables that fail the amortised
cost criteria
Loans and receivables that satisfy the amortised
cost criteria but are designated into this category
on initial recognition

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7.4 Classification of financial liabilities

The rules on accounting for financial liabilities are the same as in IAS 39.
At initial recognition, financial liabilities are classified as subsequently measured
at amortised cost with specific exceptions including:

derivatives that are liabilities at the reporting date; and

financial liabilities that might arise when a financial asset is transferred but
this transfer does not satisfy the derecognition criteria.

Reclassification of a financial liability after initial recognition is not allowed.

Irrevocable designation
A company is allowed to designate a financial liability as measured at fair value
through profit or loss. This designation can only be made if:

it eliminates or significantly reduces a measurement or recognition

inconsistency; or

this would allow the company to reflect a documented risk management

strategy.

Any such designation is irrevocable.

If a financial liability is measured at fair value any change due to the companys
own credit risk is recognised in OCI (not P&L)
Reclassification of a financial liability after initial recognition is not allowed.
Summary of accounting of items measured at fair value
Category

Examples

Financial asset at
fair value through
profit or loss

Whole fair value movement to profit or loss

Financial asset at
fair value through
OCI

Whole fair value movement to OCI

Subsequent sale of the asset
Gain or loss on disposal calculated based on the
carrying amount of the asset at the date of disposal.
No reclassification of the amounts previously recognised
in OCI in respect of equity for which an irrevocable
election has been made. (This is different to the IAS 39
requirement on disposal of an AFS equity investment).
Reclassification is still required for debt instruments
measured at fair value through OCI.

Financial liability at
fair value through
profit or loss

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Remaining change in fair value to profit or loss

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Example: Equity investment

An equity investment is purchased for Rs. 30,000 plus 1% transaction costs on 1
January 20X6. It is classified as at fair value through OCI.
At the end of the financial year (31 December) the investment is revalued to its
fair value of Rs. 40,000.
On 11 December 20X7 it is sold for Rs. 50,000.
Required
Explain the accounting treatment for this investment.

Answer
1 January 20X6 The investment is recorded at Rs. 30,300. This is the cost plus
the capitalised transaction costs.
31 December 20X6 The investment is revalued to its fair value of Rs. 40,000.
The gain of Rs. 9,700 is included in other comprehensive income for the year.
11 December 20X7 The journal entry to record the disposal is as follows:
Dr
50,000

Cash
Investment
Statement of profit or loss

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IFRS 9: IMPAIRMENT OF FINANCIAL ASSETS

Section overview

Introduction

Definitions

Simplified approach

General approach

Credit impairment

8.1 Introduction
Impairment of most non-current assets is covered by IAS 36. IAS 36 operates an
incurred loss model. This means that impairment is recognised only when an
event has occurred which has caused a fall in the recoverable amount of an
asset.
Impairment of financial instruments is dealt with by IFRS 9. IFRS 9 contains an
expected loss model. The expected loss model applies to all debt instruments
(loans, receivables etc.) recorded at amortised cost or at fair value through OCI. It
also applies to lease receivables (IAS 17), contract assets (IFRS 15).
The aim of the expected loss model is that financial statements should reflect the
deterioration or improvement in the credit quality of financial instruments held by
an entity. This is achieved by recognising amounts for the expected credit loss
associated with financial assets.
The rules look complex because they have been drafted to provide guidance to
banks and similar financial institutions on the recognition of credit losses on loans
made. However, there is a simplified regime that applies to other financial assets
as specified in the standard (such as trade receivables and lease receivables).
This section explains the simplified regime in the first instance (which in our view
is more likely to be examined). The section then provides an overview of the
more complicated general regime. This is of great importance to lenders, for
example, banks and similar financial institutions.

8.2 Definitions
Credit loss The difference between all contractual cash flows that are due to an
entity in accordance with the contract and all the cash flows that the entity
expects to receive (i.e. all cash shortfalls), discounted at the original effective
interest rate
Lifetime expected credit losses: The expected credit losses that result from all
possible default events over the expected life of a financial instrument.
12-month expected credit losses: The portion of lifetime expected credit losses
that represent the expected credit losses that result from default events on a
financial instrument that are possible within the 12 months after the reporting date

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8.3 Simplified approach

This applies to trade receivables, contract assets and lease receivables. The
approach involves the recognition of lifetime expected losses for the relevant
assets.
The following table summarises when the approach must or may be used.
Financial asset

Simplified approach

Trade receivables or contract assets

(IFRS 15) that do not do not contain a
significant financing component

Must be used

Trade receivables or contract assets

that contain a significant financing
component

May be used if chosen as an

accounting policy to be applied
consistently to all trade receivables or
contract assets.
It may be applied separately to trade
receivables and contract receivables.

Lease receivables

May be used if chosen as an

accounting policy to be applied
consistently.
It may be applied separately to
finance and operating lease
receivables.

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Example:
X Limited has total trade receivables of Rs. 30,000,000.
The trade receivables do not have a significant financing component.
The loss allowance recognised at the end of the previous year was Rs. 500,000.
X Limited has constructed the following provision matrix to calculate expected
lifetime losses of trade receivables.

Current
Default rate

Number of days past due (overdue)

More
than 90
1 to 30
31 to 60
61 to 90

0.3%

1.6%

3.6%

6.6%

10.6%

Required: Calculate the lifetime expected credit loss, show the necessary
double entry to record the loss and state the amounts to be recognised in
the statement of financial position.

Answer
The expected lifetime credit loss is measured as follows:
Gross carrying
amount of trade
receivables

Default rate

Lifetime
expected credit
loss

Rs.

Rs.

Current

15,000,000

0.3

45,000

1 to 30 days

7,500,000

1.6

120,000

31 to 60 days

4,000,000

3.6

144,000

61 to 90 days

2,500,000

6.6

165,000

More than 90

1,000,000

10.6

106,000

30,000,000

580,000

X Limited must recognise a loss provision of Rs. 580,000.

The following double entry would be necessary to increase the opening
loss provision to this amount:
Debit
Statement of profit or loss

Credit

80,000

Loss allowance
80,000
The trade receivables would be presented at an amount net of this
allowance in the statement of financial position (Rs. 30,000,000 - Rs.
580,000 = Rs. 29,420,000).

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8.4 General approach

This approach must be applied to financial assets measured at amortised cost
and financial assets measured at fair value through OCI. The approach also
applies to lease receivables and contract assets unless the entity adopts the
simplified approach described above. (Any impairment losses on financial assets
measured at fair value through profit and loss are automatically recognised in
profit or loss).
The objective of the requirements is to recognise lifetime expected credit losses
for all financial instruments for which there have been significant increases in
credit risk since initial recognition (whether assessed on an individual or collective
basis) considering all reasonable and supportable information.
Overview
For those financial assets to which the general approach applies, a loss
allowance measured as the 12-month expected credit losses is recognised at
initial recognition.
The expected credit loss associated with the financial asset is then reviewed at
each subsequent reporting date. The amount of expected credit loss recognised
as a loss allowance depends on the extent of credit deterioration since initial
recognition.

If there is no significant increase in credit risk the loss allowance for that
asset is remeasured to the 12 month expected credit loss as at that date.

If there is a significant increase in credit risk the loss allowance for that
asset is remeasured to the lifetime expected credit losses as at that date.
This does not mean that the financial asset is impaired. The entity still
hopes to collect amounts due but the possibility of a loss event has
increased.

If there is credit impairment, the financial asset is written down to its

estimated recoverable amount. The entity accepts that not all contractual
cash flows will be collected and the asset is impaired.

Credit impairment (the third bullet above) will be dealt with in a separate section.
The first two bullets simply differ in terms of how the expected loss is measured.
There is no difference between the necessary double entry in each case.
Loss allowance for financial assets carried at amortised cost.
Movement on the loss allowance is recognised in profit or loss.
The loss allowance balance is netted against the financial asset to which it relates
on the face of the statement of financial position.
NB: this is just for presentation only; the loss allowance does not reduce the
carrying amount of the financial asset in the double entry system.

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Example:
1 January 20X1
X Limited has purchased a bond for Rs. 1,000,000.
The bond pays interest at 5% and is to be redeemed at par in 5 years time.
12 month expected credit loss = Rs. 25,000.
31 December 20X1
Interest is collected at its due date.
There is no significant change in credit risk.
12 month expected credit loss = Rs. 30,000.
Required
Show the double entries on initial recognition and at 31 December necessary to
account for the bond and the loss allowance.

Answer
1 January 20X1

Debit

Financial asset at amortised cost

Credit

1,000,000

Cash

1,000,000

Being: Purchase of financial asset at amortised cost

Statement of profit or loss

25,000

Loss allowance

25,000

Being: Recognition of loss allowance on financial asset at amortised cost

31 December 20X1
Financial asset at amortised cost

50,000

Statement of profit or loss

50,000
Being: Accrual of interest income at the effective rate from financial asset
at amortised cost
Cash

50,000

Financial asset at amortised cost

50,000

Being: Receipt of interest income from financial asset at amortised cost

Statement of profit or loss

5,000

Loss allowance

5,000

Being: Recognition of movement on loss allowance.

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Loss allowance for financial assets at fair value through OCI

Movement on the loss allowance is recognised in profit or loss but the loss
allowance balance is not netted against the financial asset to which it relates as
this is carried at fair value. The loss allowance is recognised in other
comprehensive income.
Example:
1 January 20X1
X Limited has purchased a bond for Rs. 1,000,000.
The bond pays interest at 5% and is to be redeemed at par in 5 years time.
12 month expected credit loss = Rs. 25,000.
31 December 20X1
Interest is collected at its due date.
There is no significant change in credit risk.
The fair value of the bond is Rs. 940,000.
12 month expected credit loss = Rs. 30,000.
Required
Show the double entries on initial recognition and at 31 December necessary to
account for the bond and the loss allowance.
Answer
1 January 20X1
Debit
Credit
Financial asset at amortised cost
1,000,000
Cash
1,000,000
Being: Purchase of financial asset at FVOCI
Statement of profit or loss
25,000
Other comprehensive income
25,000
Being: Recognition of loss allowance on financial asset at FVOCI.
31 December 20X1
Financial asset at amortised cost
50,000
Statement of profit or loss
50,000
Being: Accrual of interest income at the effective rate from financial asset at
FVOCI.
Cash
50,000
Financial asset at FVOCI.
Being: Receipt of interest income from financial asset FVOCI.
Other comprehensive income
60,000
Financial asset at FVOCI.
Being: Fair value adjustment (loss) on financial asset at FVOCI.
Statement of profit or loss
5,000
Other comprehensive income

50,000

60,000

5,000

Being: Recognition of movement on loss allowance.

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Answer (continued)
The following table summarises the above double entries. Credit entries are shown
as figures in brackets
Cash

Financial
asset

OCI

P&L

Rs. 000

Rs. 000

Rs. 000

Rs. 000

(1,000)

1,000
(25)

25

1 January 20X1
Purchase of financial asset
Recognition of loss
allowance
31 December 20X1
Interest accrual

50

Interest payment

50

(50)

(50)
1,000

Fair value adjustment

(60)

Movement on loss
allowance

60
(5)

940

30

The balance in OCI for this asset is the fair value adjustment net of the loss
allowance.

8.5 Credit impairment

A financial asset is credit-impaired when one or more events that have a
detrimental impact on the estimated future cash flows of that financial asset have
occurred. Evidence that a financial asset is credit-impaired include (but is not
limited to) observable data about the following events:

significant financial difficulty of the issuer or the borrower;

a breach of contract, such as a default or past due event;
the lender has granted to the borrower a concession for economic or
contractual reasons relating to the borrowers financial difficulty that the
lender would not otherwise have considered:

it is becoming 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 or origination of a financial asset at a deep discount that

reflects the incurred credit losses.
If an entity revises its estimates of receipts it must adjust the gross carrying
amount of the financial asset to reflect actual and revised estimated contractual
cash flows. The financial asset must be remeasured to the present value of
estimated future cash flows from the asset discounted at the original effective
rate.

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Example:
Company X invests in a bond.
The bond has an issue value of Rs. 1 million and pays a coupon rate of 5% interest
for two years, then 7% interest for two years (this known as a stepped bond).
Interest is paid annually on the anniversary of the bond issue.
The bond will be redeemed at par after four years.
The effective rate for this bond is 5.942%
At the end of the second year it becomes apparent that the issuer has financial
difficulties and it is estimated that Company X will only receive 60 paisa in the
rupee of the future cash flows.
At the end of year 2 the amortised cost is:
Amortised cost
brought forward

Interest at
5.942%

Cash paid

1,000,000

59,424

(50,000)

Amortised cost
carried forward
1,009,424

1,009,424

59,983

(50,000)

1,019,407

Year

The recoverable amount is calculated as follows:

Future cash flows

Discount factor
(@5.942%)

Year
3

70,000 @ 60% = 42,000

0.9439

39,644

1,070,000 @ 60% = 642,000

0.891

572,022

Recoverable amount

611,666

Carrying amount

1,019,407

Impairment

407,741

Note that the recoverable amount could have been calculated easily as 60% of
the carrying amount:
60% of 1,019,407 = 611,644 (22 difference due to rounding)
The impairment loss is charged to profit or loss taking into account the
balance on the loss allowance account already recognised for the asset.

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Example:
Suppose in the above example there was a loss allowance of Rs. 100,000
recognised on the asset before the impairment event.
The necessary double entries would be as follows:
Debit
Statement of profit or loss

307,741

Loss allowance

100,000

Financial asset

Credit

407,741

Future revenue recognition

Interest is recognised in the future by applying the effective rate to the new
amortised cost (after the recognition of the impairment loss).

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Chapter 15: Financial instruments: Recognition and measurement

IFRS 9: OTHER MATTERS

Section overview

Embedded derivatives

Derecognition of financial instruments

9.1 Embedded derivatives

The treatment of embedded derivatives depends on whether the hybrid contract
contains a host that is an asset within the scope of IFRS 9.
Hybrid contains a host contract within the scope of IFRS 9
If the host contract is an asset within the scope of IFRS 9 the normal rules of
classification and accounting apply.
The contractual cash flows of the financial asset are assessed in their entirety,
and the asset as a whole is measured at FVTPL if any of its cash flows do not
represent payments of principal and interest.
It may well be the case that the presence of the derivative causes this to happen.
Hybrid contains a host contract outside the scope of IFRS 9
If a hybrid contract contains a host that is not an asset within the scope of IFRS 9,
an embedded derivative must be separated from the host and accounted for as a
derivative subject to the same rules as in IAS 39

9.2 Derecognition of financial instruments

Derecognition is the removal of a previously recognised financial asset or
financial liability from an entitys statement of financial position.
The IAS 39 rules have been incorporated into IFRS 9 with no change.

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10 IFRS 9: HEDGE ACCOUNTING

Section overview

Reasons for change

Summary of changes

10.1 Reasons for change

The hedge accounting rules in IAS 39 have been criticised. Commentators have
pointed out that the accounting treatment is based on rules rather than principles.
This results in the rules being too restrictive resulting in accounting information
that does not adequately reflect risk management practices.
For example, there are instances where hedge accounting cannot be applied to
groups of items, whereas for risk management purposes items are often hedged
on a group basis.
What is the objective of hedge accounting?
An entity uses hedging to manage risks, for example, foreign exchange risk,
interest rate risk or the price of a commodity. It may choose to apply hedge
accounting to show the effect of managing those risks in the financial statements.
IFRS 9 states that the objective of hedge accounting is to represent the effect of
an entitys risk management activities that use financial instruments to manage
exposures arising from particular risks that could affect profit or loss (or OCI).
This statement links the accounting rules to the risk management objective
resulting in a principles based approach.

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10.2 Summary of changes

IAS 39

IFRS 9

Hedge accounting criteria

IAS 39 sets a high hurdle before hedge
accounting is available and for it to continue.
There is a strict quantitative effectiveness test
(80%-125%) which is widely criticised as being
arbitrary and for causing unavailability of hedge
accounting for hedges that are good in
economic terms.

The quantitative hurdle

removed.

Hedging instruments
Non derivative financial instrument can only be
used as hedge of foreign exchange risk.

Non derivative financial

instrument can be
designated as hedging
instruments as long as they
are at FVTPL

Hedged items
IAS 39 allows components (parts) of financial
This distinction has been
items to be hedged, but not components of non- eliminated.
financial items.
Hedges of components of
non-financial items will
For example hedge accounting can be
qualify for hedge
achieved for a hedge of credit risk in bond but
accounting.
not for a hedge of oil price in jet fuel.
Risk managers often hedge a risk component
for non-financial items.
Companies often hedge net positions but IAS
39 does not allow hedge accounting for these
hedges creating an inconsistency between
hedge accounting and risk management
activity.

Hedges of net positions can

qualify for hedge accounting
as long as certain criteria
are met.

For example, a company might hedge a net

foreign exchange position of 20 that is made up
of an asset of 100 and a liability of 80.
Hedge accounting models
Fair value hedge accounting: Fair value
differences to P&L

No change

Basis adjustment allowed when a cash flow

hedge results in the recognition of a nonfinancial asset or liability

Basis adjustment required

when a cash flow hedge or a
fair value hedge results in
the recognition of a nonfinancial asset or liability

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

The amount recognised as income in profit or loss each year is based on the effective
rate of return, but the cash actually received is based on the coupon rate of 10%.
The difference is treated as an adjustment to the carrying value of the investment in the
statement of financial position, which is the amortised cost of the asset.
This is calculated as follows:
Year

Asset value
brought forward

Interest at
11.67%

20X5
20X6

48.00m
48.60m

5.60m
5.65m

20X7

49.25m

5.75m
17m

Cash paid
(5m)
(5m)
(5m)

Asset value
carried forward
48.06m
49.25m
50.00m

15m

Solution

The initial liability is (Rs. 10 million 100.50/100) Rs. 50,000 = Rs. 10,000,000.

Year 1
Year 2
Year 3
Year 4

Liability at
start of year
Rs.
10,000,000
10,100,000
10,207,000
10,321,490

Finance
charge at 7%
Rs.
700,000
707,000
714,490
722,510

Interest paid
Rs.
(600,000)
(600,000)
(600,000)
(600,000)

2,844,000

2,400,000

Liability at
end of year
Rs.
10,100,000
10,207,000
10,321,490
10,444,000

The final interest payment of Rs. 722,510 contains a rounding adjustment of Rs. 6.
Note that the difference between the interest charged and the interest paid is because
the final payment of the redemption proceeds has not been shown. This contains a
redemption premium of Rs. 444,000 which has already been recognised as an expense
by the year end.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

16

Financial instruments:
Presentation and disclosure

Contents
1 IAS 32: Presentation
2 Interpretations
3 IFRS 7: Disclosure

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 7

IFRS 7: Financial instruments: Disclosures

B (a) 25

IAS 32: Financial instruments: Presentation

B (a) 34

IFRIC 2: Members shares in co-operative entities and similar instruments

B (a) 45

IFRIC 17: Distributions of non-cash assets to owners

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IAS 32: PRESENTATION

Section overview

Liability or equity?

Preference shares: debt or equity?

Compound instruments

Transactions in own equity

Offsetting

Distributable profit

1.1 Liability or equity?

Financial instruments issued by a company must be classified as either liabilities
or equity. This classification should be based on the substance of the contract,
rather than the legal form.
A financial liability is any liability where the issuer has a contractual obligation:

To deliver cash or another financial asset to another entity, or

To exchange financial instruments with another entity on potentially

unfavourable terms.

The owner of an equity instrument is entitled to receive a dividend, but the

company does not have a contractual obligation to make the payment. So equity
does not meet the above definition of a financial liability.
An equity instrument is defined as any contract that offers the residual interest in
the assets of the company after deducting all of the liabilities.
Returns on financial instruments
Returns on financial instruments are reported differently, depending on whether
the instrument is a liability or equity. The classification of the financial instrument
determines the treatment of the interest, dividends, gains and losses.

Interest expense, dividend payments, gains and losses relating to a

financial liability are recognised in the statement of profit or loss.

Distributions to equity holders are debited to equity and shown in the

statement of changes in equity.

1.2 Preference shares: debt or equity?

Preference shares are shares that are entitled to a payment of their dividend,
usually a fixed amount each year, before the ordinary shareholders can be paid
any dividend or that rank ahead of ordinary shares for any distribution of net
assets in the event of a winding up of the company.
Preference shares include the following types:

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Redeemable preference shares are those that the entity has an obligation
to buy back (or the right to buy back) at a future date.

Irredeemable (perpetual) preference shares are those that will not be

bought back at any time in the future.

convertible preference shares are those that are convertible at a future date
into another financial instrument, usually into ordinary equity shares of the
entity.

Classification of preference shares

Depending on their characteristics, preference shares issued by a company
might be classified as:

equity; or

a financial liability of the company; or

a compound financial instrument containing elements of both financial

liability and equity.

IAS 32 states (in a guidance note) that the key factor for classifying preference
shares is the extent to which the entity is obliged to make future payments to the
preference shareholders.

Redeemable preference shares.

x

Redemption is mandatory: Since the issuing entity will be required to

redeem the shares, there is an obligation. The shares are a financial
liability.

Redemption at the choice of the holder: Since the issuing entity does
not have an unconditional right to avoid delivering cash or another
financial asset there is an obligation. The shares are a financial
liability.

Redemption at the choice of the issuer: The issuing entity has an

unconditional right to avoid delivering cash or another financial asset
there is no obligation. The shares are equity.

Irredeemable non-cumulative preference shares should be treated as

equity, because the entity has no obligation to the shareholders that the
shareholders have any right to enforce.

1.3 Compound instruments

A compound instrument is a financial instrument, issued by a company that
cannot be classified as simply a liability or as equity, because it contains
elements of both debt and equity. An example of a compound instrument is a
convertible bond. The company issues a bond that can be converted into equity
in the future or redeemed for cash. Initially, it is a liability, but it has a call option
on the companys equity embedded within it.
Typically, a convertible bond pays a rate of interest that is lower than the market
rate for a non-convertible bond (a straight bond) with the same risk profile. This

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is because the terms of the conversion normally allow the bondholder to convert
the bond into shares at a rate that is lower than the market price.
Split accounting for compound instruments
On initial recognition of compound instrument, the credit entry for the financial
instrument must be split into the two component parts, equity and liability.
When convertible bonds are issued they are shown in the statement of financial
position partly as debt finance and partly as equity finance. The question is how
to determine the amount of the issue price that is debt and the amount that is
equity.
The method to use is to calculate the equity element as the residual after
determining the present value of the debt element:

The present value of the interest payments and the redemption value of the
convertible is found using a market interest rate for similar debt finance
which is not convertible (normally a higher interest rate as there is no
conversion element).

Compare this present value to the proceeds of the bond issue to find the
residual equity element.

Any transaction costs incurred by issuing the instrument should be

allocated to each component, the liability and equity, according to the split
in value above.

Comment on the measurement of the debt element

The process starts by deriving a fair value for the liability, on the assumption that
the bond has no conversion rights, and is a straight fixed rate bond that will be
redeemed at par at maturity.
If the company had sold a bond with identical features but with no conversion
rights, how much could it have been sold for? To answer this question, it is
necessary to recognise that the fair value of a bond is simply the present value of
the future cash flows that the bond will generate, discounted at the market rate of
interest, which in the following example is 8%.
Example: Convertible bond
A company issues Rs. 10 million of 6% convertible bonds at par on 1 January
20X1.
The bonds are redeemable at par after four years or can be converted at any time
up to that date into shares with a nominal value of Rs. 2,000,000.
The market rate of interest for similar debt which is not convertible is 8%.

The bonds should be recorded in the statement of financial position at the date of
issue as follows:
Step 1: Measure the liability component first by discounting the interest
payments and the amount that would be paid on redemption (if not converted) at
the prevailing market interest rate of 8%.

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31 December

Cash flow

DF (8%)

Rs.

600,000

3.312

1,987,200

10,000,000

0.735

7,350,000

20X1 to 20X4
Interest: 10,000,000 u 6%
20X4:
Repayment of principle
Value of debt element

9,337,200

Step 2: Compare the value of the debt element to the cash

raised. The difference is the equity element.
Total proceeds

10,000,000

Value of equity element (residual)

662,800

The initial double entry to recognise the bond would be as follows:

Dr
Cash

Cr

10,000,000

Liability

9,337,200

Equity

662,800

The liability component is measured at amortised cost in the usual way at each
subsequent reporting date.
Example (continued): Subsequent measurement of the debt element of the
convertible bond
Amortised
cost at start
of the year

Interest at
effective rate
(8%)

Cash flow
(interest
actually paid
at 6%)

20X1

9,337,200

746,976

(600,000)

9,484,176

20X2

9,484,176

758,734

(600,000)

9,642,910

20X3

9,642,910

771,433

(600,000)

9,814,343

20X4

9,814,343

785,557

(600,000)

10,000,000

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Chapter 16: Financial instruments: Presentation and disclosure

Note that the final interest expense of Rs. 785,557 includes a rounding
adjustment of Rs. 510).
There is no guidance on the subsequent accounting treatment of the equity
element. One approach would be to retain it as a separate component of equity
and then release it to retained earnings when the bond is paid or converted.
Example (continued): Double entry on repayment or conversion of the bond.
At 31 December 20X4 the bond will either be paid or converted. Possible double
entries in each case are as follows:
If the bond is repaid
Dr
Cr
Liability

10,000,000

Cash

10,000,000

and:
Equity component

662,800

Retained earnings

662,800

If the bond is converted:

Dr
Liability

Cr

10,000,000

Share capital

2,000,000

Share premium

8,000,000

and:
Equity component

662,800

Retained earnings

662,800

Practice question

A company issued a convertible bond for Rs. 2,000,000 on 1 January 20X5.

The bond is to be redeemed on 31 December 20X7 (3 years after issue).
The bond holders can take cash or shares with a nominal value of Rs.
1,200,000 on this date.
The bond pays interest at 5% but the market rate of interest for similar risk
bonds without the conversion feature was 9% at the date of issue.
Required
a) Calculate the liability and equity components of the bond on initial
recognition.
b) Construct the necessary journal on initial recognition.
c)

Construct an amortisation table to show how the liability component

would be measured over the life of the bond.

d) Construct the journal to reflect the possible conversion of the bonds to

shares on 31 December 20X7.

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1.4 Transactions in own equity

A company may reacquire its own shares. Such shares are called treasury
shares. . The company might then hold on to the shares until it uses them for a
particular purpose, such as awarding shares to employees in a share grant
scheme. The accounting treatment of treasury shares is that they should be
deducted from equity.
Any gain or loss on transactions involving treasury shares is recognised directly
in equity, and should not be reported in the statement of profit or loss and other
comprehensive income.
IAS 32 requires that the amount of treasury shares held should be disclosed
separately, either:

on the face of the statement of financial position as a deduction from share

capital, or

offset against share capital and disclosed in the notes to the accounts.

1.5 Offsetting
Offsetting an asset and a liability and presenting a net amount on the face of the
statement of financial position can result in a loss of information to the users. IAS
1 prohibits offset unless required or permitted by an IFRS.
The idea is that offset should only be allowed if it reflects the substance of the
transactions or balances.
IAS 32 adds more detail to this guidance in respect of offsetting financial assets
and liabilities.
IAS 32 requires the presentation of financial assets and financial liabilities in a
way that reflects the companys future cash flows from collecting the cash from
the asset and paying the cash on the liability. It limits a companys ability to offset
a financial asset and a financial liability to those instances when the cash flows
will occur at the same time.
The IAS 32 rule is that a financial asset and a financial liability must be offset and
shown net in the statement of financial position when and only when an entity:

Currently has a legal right to set off the amounts; and

Intends either to settle the amounts net, or to realise (sell) the asset and
settle the liability simultaneously.

In order for a legal right of set off to be current it must not be contingent on a
future event. Furthermore it must be legally enforceable in all of the following
circumstances:

The normal course of business;

The event of default;

The event of insolvency or bankruptcy of the entity and all of the

counterparties

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Note: The existence of a legal right to set off a cash balance in one account with
an overdraft in another is insufficient for offsetting to be allowed. The company
must additionally show intent to settle the balances net, and this is likely to be
rare in practice. Consequently, cash balances in the bank and bank overdrafts
are usually reported separately in the statement of financial position, and not
netted off against each other.
Many companies adopting IFRS for the first time find that they have net amounts
in the statement of financial position under their old GAAP that have to be shown
as a separate financial asset and financial liability under IFRS. The net position is
described as being grossed up.

1.6 Distributable profit

Rules are set out in The Companies Ordinance 1984 (Sections 248 to 251).
Dividends are declared, in respect of a period, in a general meeting on the
recommendation of the directors.
A dividend cannot exceed the amount recommended by the directors.
Dividends are payable only out of the distributable profits of the company (but not
profit on the sale of capital assets).
Dividends are paid by individual entities. When a group announces that it is
paying a dividend it is actually the parent company that is making the payment.
Example: Group distributions
P acquired 80% of S on 1 January 20X1 for Rs. 230,000.
The retained profits of S were Rs. 100,000 at that date and are Rs. 300,000 at
the current year end.
P has retained profits of Rs. 400,000 at the current year end.
The consolidated retained profits are as follows:

Rs.

Consolidated retained profits:

All of Ps retained profits
Ps share of the post-acquisition retained profits of S
(80% of (300,000  100,000))

400,000
160,000
560,000

The maximum distribution that can be made by the group (i.e. as a dividend paid
to Ps shareholders) is Rs. 400,000.
The share of post-acquisition retained profits of S are contained in a separate
legal entity and are not available for distribution by the parent.
If S were to pay a dividend, 80% would pass to P and hence become available for
P to pay out to its owners. (The remaining 20% would be owned by the NCI).

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INTERPRETATIONS
Section overview

IFRIC 2: Members shares in cooperative entities and similar instruments

IFRIC 17: Distributions of non-cash assets to owners

2.1 IFRIC 2: Members shares in cooperative entities and similar instruments

Background
IFRIC 2 applies to financial instruments within the scope of IAS 32, including
financial instruments issued to members of co-operative entities that evidence
the members ownership interest in the entity.
Co-operatives (and similar entities) are formed by groups of persons to meet
common economic or social needs. Members interests in a co-operative are
often described as members shares.
Members shares have characteristics of equity. For example they give the
member the rights to vote and to participate in dividend distributions.
Members shares may also give the holder the right to request redemption for
cash or another financial asset but include limits on whether the financial
instruments will be redeemed.
The issue
IAS 32 gives guidance on classification of financial instruments as financial
liabilities or equity. The guidance covers instruments that allow the holder to put
those instruments to the issuer for cash or another financial instrument (puttable
instruments).
IFRIC 2 explains how redemption terms should be evaluated in determining
whether the financial instruments should be classified as liabilities or equity
Consensus
A contractual right of a holder to request redemption does not in itself mean that
the financial instrument must be classified as a financial liability.
An entity must consider all of the terms and conditions of the financial instrument
to determine its classification, including relevant local laws, regulations and the
entitys governing charter in effect at the date of classification.
Members shares that give holders the right to request redemption are classified
as equity when:

the instrument would be classified as equity if there were no such terms

attached; and

the entity has an unconditional right to refuse redemption of the members

shares; or

redemption is unconditionally prohibited by local law, regulation or the

entitys governing charter.

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Example: Equity or liability

X co-operative has a charter which allows redemption of members shares at sole
discretion of the co-operative but redemption has never been refused.
Analysis
X co-operative has the unconditional right to refuse redemption so the members
shares are equity.
The fact that redemption has never been refused is not relevant in deciding the
status of the instruments.
Provisions that prohibit redemption only if conditions (such as liquidity
constraints) are met/not met do not result in members shares being equity.
Example: Equity or liability
X co-operative has a charter which allows redemption of members shares at sole
discretion of the co-operative but also states that redemption is automatic unless
X cannot make payments without violating local regulations regarding liquidity.
Analysis
X co-operative does not have the unconditional right to refuse redemption so the
members shares are liabilities.
Unconditional prohibition may be:

absolute
x

all redemptions are prohibited

members shares are equity

partial
x

redemption prohibited where it causes the number of members

shares or amount of paid-in capital from members shares to fall
below a specified level

Members shares above this level liability

Members shares below this level equity

The limit may change from time to time leading to a transfer between financial
liabilities and equity.

2.2 IFRIC 17: Distributions of non-cash assets to owners

Introduction
IFRIC 17 sets out guidance on how an entity should measure distributions of
assets other than cash when it pays dividends to owners in their capacity as
owners.
Issues addressed:

When should an entity recognise a dividend payable?

How should an entity measure the dividend payable?

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When an entity settles the dividend payable, how should it account for any
difference between the carrying amount of the assets distributed and the
carrying amount of the dividend payable?

A dividend payable should be recognised when it is appropriately authorised and

is no longer at the discretion of the entity
Dividend payable should be measured at the fair value of the net assets to be
distributed
Any difference between the dividend paid and the carrying amount of the net
assets distributed is recognised in profit and loss
Scope
Within scope:

Distributions of non-cash assets (e.g. items of property, plant and

equipment, businesses as defined in IFRS 3, ownership interests in another
entity or disposal groups under IFRS 5).

Distributions that give owners choice of settlement in cash or non-cash

assets.

The IFRIC applies only to distributions in which all owners of the same class of
equity instruments are treated equally.
Outside of the scope

Distributions of non-cash assets that are ultimately controlled by the same

party/parties before and after the distribution, in separate, individual and
consolidated financial statements.

Distributions of part ownership interests in a subsidiary with retention of

control.

IFRIC 17 does not address the accounting for the non-cash distribution by the
shareholders who receive the distribution
Recognition of dividend payable
Dividend payable should be recognised when it is appropriately authorised and is
no longer at the discretion of the entity
This is:

when the declaration is approved by the relevant authority where such

approval is required in the jurisdiction; or

when the dividend is declared if no such approval is required

Measurement of a dividend payable

A liability to distribute non-cash assets to the owners as a dividend must be
measured at the fair value of the assets to be distributed
If the owners have a choice of receiving a non-cash asset or a cash alternative,
the fair value of each and the associated probability of owners selecting each
alternative must be estimated.

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Subsequent measurement:
The carrying amount of the dividend payable must be reviewed at the end of
each reporting period and at settlement with any changes in the amount of the
dividend payable must be recognised in equity.
Accounting for any difference
Any difference between the carrying amount of the assets distributed and the
carrying amount of the dividend payable at settlement must be recognised in
profit and loss
Presentation and disclosure
Any difference between the carrying amounts of the dividend payable and the
assets distributed must be presented as a separate line item in the statement of
profit or loss.
An entity must disclose:

The brought forward and carried forward carrying amount of the dividend
payable.

Any decrease/increase in the carrying amount as a result of the change in

the fair value of the assets to be distributed

When a dividend of non-cash assets is declared after the end of the period but
before the financial statements are authorised for issue the entity must disclose
the:

nature of asset;

carrying amount at period end;

estimated fair value; and

estimation methodology as required by IFRS 7

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IFRS 7: DISCLOSURE
Section overview

Objectives of IFRS 7

Statement of financial position disclosures

Statement of profit or loss disclosures

Risk disclosures

3.1 Objectives of IFRS 7

All companies are exposed to various types of financial risk. Some risks are
obvious from looking at the statement of financial position. For example, a loan
requiring repayment in the next year is reported as a current liability, and users of
the financial statements can assess the risk that the company will be unable to
repay the loan.
However, there are often many other risks that a company faces that are not
apparent from the financial statements. For example if a significant volume of a
companys sales are made overseas, there is exposure to the risk of exchange
rate movements.
Example:
A UK company has an investment of units purchased in a German companys
floating rate silver-linked bond. The bond pays interest on the capital, and part of
the interest payment represents bonus interest linked to movements in the price
of silver.
There are several financial risks that this company faces with respect to this
investment.
It is a floating rate bond. So if market interest rates for bonds decrease, the
interest income from the bonds will fall.
Interest is paid in euros. For a UK company there is a foreign exchange risk
associated with changes in the value of the euro. If the euro falls in value against
the British pound, the value of the income to a UK investor will fall.
A bonus is linked to movements in the price of silver. So there is exposure to
changes in the price of silver.
There is default risk. The German company may default on payments of interest
or on repayment of the principal when the bond reaches its redemption date.
IFRS 7 requires that an entity should disclose information that enables users of
the financial statements to evaluate the significance of financial instruments for
the entitys financial position and financial performance.
There are two main parts to IFRS 7:
A section on the disclosure of the significance of financial instruments for the
entitys financial position and financial performance
A section on disclosures of the nature and extent of risks arising from financial
instruments.

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3.2 Statement of financial position disclosures

The carrying amounts of financial instruments must be shown, either in the
statement of financial position or in a note to the financial statements, for each
class of financial instrument:

Financial assets at fair value through profit or loss

Held-to-maturity investments

Loans and receivables

Available-for-sale financial assets

Financial liabilities at fair value through profit or loss

Financial liabilities measured at amortised cost.

The above categories are replaced by the following if IFRS 9 is being followed:

Financial assets at fair value through profit or loss

Financial assets at amortised cost

Financial liabilities at fair value through profit or loss

Financial liabilities measured at amortised cost.

Other disclosures relating to the statement of financial position are also required.
These include the following:

Collateral. A note should disclose the amount of financial assets that the
entity has pledged as collateral for liabilities or contingent liabilities.

Allowance account for credit losses. When financial assets (such as

trade receivables) are impaired by credit losses and the impairment is
recorded in a separate account (such as an allowance account for
irrecoverable trade receivables), the entity should provide a reconciliation of
changes in the account during the period, for each class of financial assets.

Defaults and breaches. For loans payable, the entity should disclose
details of any defaults during the period in the loan payments, or any other
breaches in the loan conditions.

With some exceptions, for each class of financial asset and financial liability, an
entity must disclose the fair value of the assets or liabilities in a way that permits
the fair value to be compared with the carrying amount for that class. An
important exception is where the carrying amount is a reasonable approximation
of fair value, which should normally be the case for short-term receivables and
payables.

3.3 Statement of profit or loss disclosures

An entity must disclose the following items either in the statement of profit or loss
or in notes to the financial statements:

Net gains or losses on financial assets or financial liabilities at fair value

through profit or loss.

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Net gains or losses on available-for-sale financial assets, showing

separately:
x

the gain or loss recognised in other comprehensive income (and so

directly in equity) during the period, and

the amount removed from equity and reclassified from equity to profit
and loss through other comprehensive income in the period.

Net gains or losses on held-to-maturity investments.

Net gains or losses on loans and receivables.

Net gains or losses on financial liabilities measured at amortised cost.

Total interest income and total interest expense, calculated using the
effective interest method, for financial assets or liabilities that are not at fair
value through profit or loss.

Fee income and expenses arising from financial assets or liabilities that are
not at fair value through profit or loss.

The amount of any impairment loss for each class of financial asset.

Other disclosures
IFRS 7 also requires other disclosures. These include the following:

Information relating to hedge accounting, for cash flow hedges, fair value
hedges and hedges of net investments in foreign operations. The
disclosures should include a description of each type of hedge, a
description of the financial instruments designated as hedging instruments
and their fair values at the reporting date, and the nature of the risks being
hedged.

With some exceptions, for each class of financial asset and financial
liability, an entity must disclose the fair value of the assets or liabilities in a
way that permits the fair value to be compared with the carrying amount for
that class. An important exception is where the carrying amount is a
reasonable approximation of fair value, which should normally be the case
for short-term receivables and payables.

3.4 Risk disclosures

IFRS 7 also requires that an entity should disclose information that enables users
of its financial statements to evaluate the nature and extent of the risks arising
from its financial instruments.
These risks typically include, but are not restricted to:

Credit risk

Liquidity risk, and

Market risk.

For each category of risk, the entity should provide both quantitative and
qualitative information about the risks.

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Qualitative disclosures. For each type of risk, there should be disclosures

of the exposures to risk and how they arise; and the objectives policies and
processes for managing the risk and the methods used to measure the risk.

Quantitative disclosures. For each type of risk, the entity should also
disclose summary quantitative data about its exposures at the end of the
reporting period. This disclosure should be based on information presented
to the entitys senior management, such as the board of directors or chief
executive officer.

Credit risk
Credit risk is the risk that someone who owes money (a trade receivable, a
borrower, a bond issuer, and so on) will not pay. An entity is required to disclose
the following information about credit risk exposures:

A best estimate of the entitys maximum exposure to credit risk at the end
of the reporting period and a description of any collateral held.

For each class of financial assets, a disclosure of assets where payment is

past due or the asset has been impaired.

Liquidity risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to
meet its payment obligations when these are due. IFRS 7 requires disclosure of:

A maturity analysis for financial liabilities, showing when the contractual

liabilities fall due for payment

A description of how the entity manages the liquidity risk that arises from
this maturity profile of payments.

Market risk
Market risk is the risk of losses that might occur from changes in the value of
financial instruments due to changes in:

Exchange rates,

Interest rates, or

Market prices.

An entity should provide a sensitivity analysis for each type of market risk to
which it is exposed at the end of the reporting period. The sensitivity analysis
should show how profit or loss would have been affected by a change in the
market risk variable (interest rate, exchange rate, market price of an item) that
might have been reasonably possible at that date.
Alternatively, an entity can provide sensitivity analysis in a different form, where it
uses a different model for analysis of sensitivity, such as a value at risk (VaR)
model. These models are commonly used by banks.

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SOLUTIONS TO PRACTICE QUESTIONS

Solution
a)

Split of liability and equity on initial recognition

31st December

Cash (R
Rs.)

Discount
factor 9%

Present
value (Rs.))

20X5 - interest
20X6 - interest
20X7 - interest
20X7 - principal

100,000
100,000
100,000
2,000,000

0.9174
0.8417
0.7722
0.7722

91,743
84,168
77,218
1,544,367

Fair value of bond

1,797,496

Value of equity (balance)

202,504

Proceeds from issue of bond

b)

2,000,000

Journal on initial recognition

Cash
Liability

Dr (Rs.)
2,000,000

1,797,496

Equity
c)

d)

202,504

Amortisation table
Liability at
start of year
Rs.
20X5
1,797,496
20X6
20X7

Finance charge
at 9%
Rs.
161,775

Interest
paid
Rs.
(100,000)

Liability at
end of year
Rs.
1,859,271

167,334
173,395

(100,000)
(100,000)

1,926,605
2,000,000

Rs.
2,000,000
202,504

Rs.

1,859,271
1,926,605

Journal on conversion to shares

Bond
Equity - option proceeds
Share capital
Share premium

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

17

IFRS 13: Fair Value Measurement

Contents
1 Introduction to IFRS 13
2 Measurement
3 Valuation techniques
4 Liabilities and an entitys own equity instruments
5 Disclosure

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 9

IFRS 13: Fair value measurement

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INTRODUCTION TO IFRS 13
Section overview

Background

Definition of fair value

The asset or liability

Market participants

1.1 Background
There are many instances where IFRS requires or allows entities to measure or
disclose the fair value of assets, liabilities or their own equity instruments.
Examples include (but are not limited to):
Standard
IASs 16/38

Allows the use of a revaluation model for the measurement of

assets after recognition.
Under this model, the carrying amount of the asset is based on
its fair value at the date of the revaluation.

IAS 40

Allows the use of a fair value model for the measurement of

investment property.
Under this model, the asset is fair valued at each reporting date.

IAS 19

Defined benefit plans are measured as the fair value of the plan
assets net of the present value of the plan obligations.

IAS 39

All financial instruments are measured at their fair value at initial

recognition.
Subsequent measurement of financial assets depends on their
classification but is often at fair value.
Subsequent measurement of financial liabilities is sometimes at
fair value.

IFRS 9

All financial instruments are measured at their fair value at initial

recognition.
Financial assets that meet certain conditions are measured at
amortised cost subsequently. Any financial asset that does not
meet the conditions is measured at fair value.
Subsequent measurement of financial liabilities is sometimes at
fair value.

IFRS 7

If a financial instrument is not measured at fair value that

amount must be disclosed.

IFRS 3

Measuring goodwill requires the measurement of the acquisition

date fair value of consideration paid and the measurement of the
fair value (with some exceptions) of the assets acquired and
liabilities assumed in a transaction in which control is achieved.

IFRS 2

Requires an accounting treatment based on the grant date fair

value of equity settled share based payment transactions.

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Other standards required the use of measures which incorporate fair value.
Standard
IASs 36

Recoverable amount is the lower of value in use and fair value

less costs of disposal.

IFRS 5

An asset held for sale is measured at the lower of its carrying

amount and fair value less costs of disposal.

Some of these standards contained little guidance on the meaning of fair value.
Others did contain guidance but this was developed over many years and in a
piecemeal manner.
Purpose of IFRS 13
The purpose of IFRS 13 is to:

define fair value;

set out a single framework for measuring fair value; and

specify disclosures about fair value measurement.

IFRS 13 does not change what should be fair valued nor when this should occur.
The fair value measurement framework described in this IFRS applies to both
initial and subsequent measurement if fair value is required or permitted by other
IFRSs.
Scope of IFRS 13
IFRS 13 applies to any situation where IFRS requires or permits fair value
measurements or disclosures about fair value measurements (and other
measurements based on fair value such as fair value less costs to sell) with the
following exceptions.
IFRS 13 does not apply to:

share based payment transactions within the scope of IFRS 2; or

measurements such as net realisable value (IAS 2 Inventories) or value in

use (IAS 36 Impairment of Assets) which have some similarities to fair
value but are not fair value.

The IFRS 13 disclosure requirements do not apply to the following:

plan assets measured at fair value (IAS 19: Employee benefits);

retirement benefit plan investments measured at fair value (IAS 26:

Accounting and reporting by retirement benefit plans); and

assets for which recoverable amount is fair value less costs of disposal in
accordance with IAS 36.

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1.2 Definition of fair value

Definition: Fair value
Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement
date (i.e. it is an exit price).
This definition emphasises that fair value is a market-based measurement, not an
entity-specific measurement. In other words, if two entities hold identical assets
these assets (all other things being equal) should have the same fair value and
this is not affected by how each entity uses the asset or how each entity intends
to use the asset in the future.
The definition is phrased in terms of assets and liabilities because they are the
primary focus of accounting measurement. However, the guidance in IFRS 13
also applies to an entitys own equity instruments measured at fair value (e.g.
when an interest in another company is acquired in a share for share exchange).
Note that the fair value is an exit price, i.e. the price at which an asset would be
sold.
Definition: Exit and entry prices
Exit price: The price that would be received to sell an asset or paid to transfer a
liability.
Entry price: The price paid to acquire an asset or received to assume a liability in
an exchange transaction.

1.3 The asset or liability

A fair value measurement is for a particular asset or liability.
Whether the fair value guidance in IFRS 13 applies to a stand-alone asset or
liability or to a group of assets, a group of liabilities or to a group of assets and
liabilities depends on the unit of account for the item being fair valued.
Definition: Unit of account
Unit of account: The level at which an asset or a liability is aggregated or
disaggregated in an IFRS for recognition purposes.
The unit of account for the asset or liability must be determined in accordance
with the IFRS that requires or permits the fair value measurement.
An entity must use the assumptions that market participants would use when
pricing the asset or liability under current market conditions when measuring fair
value. The fair value must take into account all characteristics that a market
participant would consider relevant to the value. These characteristics might
include:

the condition and location of the asset; and

restrictions, if any, on the sale or use of the asset.

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1.4 Market participants

Definition: Market participants
Market participants: Buyers and sellers in the principal (or most advantageous)
market for the asset or liability.
Market participants have all of the following characteristics:

They are independent of each other;

They are knowledgeable, having a reasonable understanding about the

asset or liability and the transaction using all available information,
including information that might be obtained through due diligence efforts
that are usual and customary.

They are able to enter into a transaction for the asset or liability.

They are willing to enter into a transaction for the asset or liability, i.e. they
are motivated but not forced or otherwise compelled to do so.

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MEASUREMENT
Section overview

Measuring fair value

Principal or most advantageous market

Fair value of non-financial assets highest and best use

2.1 Measuring fair value

Fair value measurement assumes that the asset (liability) is exchanged in an
orderly transaction between market participants to sell the asset (transfer the
liability) at the measurement date under current market conditions.
Sometimes it might be possible to use observable market transactions to fair
value an asset or a liability (e.g. a share might be quoted on the Karachi Stock
Exchange). For other assets and liabilities this may not be possible. However, in
each case the objective is the same, being to estimate the price at which an
orderly transaction to sell the asset (or transfer a liability) would take place
between market participants at the measurement date under current market
conditions.
Active market
If an active market exists then it will provide information that can be used for fair
value measurement.

A quoted price in an active market provides the most reliable evidence of

fair value and must be used to measure fair value whenever available.

It would be unusual to find an active market for the sale of non- financial
assets so some other sort of valuation technique would usually be used to
determine their fair value.

Definition: Active market

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.
If there is no such active market (e.g. for the sale of an unquoted business or
surplus machinery) then a valuation technique would be necessary.

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2.2 Principal or most advantageous market

Fair value measurement is based on a possible transaction to sell the asset or
transfer the liability in the principal market for the asset or liability.
If there is no principal market fair vale measurement is based on the price
available in the most advantageous market for the asset or liability.
Definitions: Most advantageous market and principal market
Most advantageous market: The market that maximises the amount that would be
received to sell the asset or minimises the amount that would be paid to transfer
the liability, after taking into account transaction costs and transport costs.
Principal market: The market with the greatest volume and level of activity for the
asset or liability.

Identifying principle market (or most advantageous market)

It is not necessary to for an entity to make an exhaustive search to identify the
principal market (or failing that, the most advantageous market). However, it
should take into account all information that is reasonably available.
Unless there is evidence to the contrary, principal market (or failing that, the most
advantageous market) is the one in which an entity normally enters into
transactions sell the asset or to transfer the liability being fair valued.
If there is a principal market for the asset or liability, the fair value measurement
must use the price in that market even if a price in a different market is potentially
more advantageous at the measurement date.
The price in a principle market might either be directly observable or estimated
using a valuation technique.
Transaction costs
The price in the principal (or most advantageous) market used to measure the
fair value of the asset (liability) is not adjusted for transaction costs. Note that:

fair value is not net realisable value or fair value less costs of disposal;
and

using the price at which an asset can be sold for as the basis for fair
valuation does not mean that the entity intends to sell it

Transport costs
If location is a characteristic of the asset the price in the principal (or most
advantageous) market is adjusted for the costs that would be incurred to
transport the asset from its current location to that market.

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Example: Fair valuation

An entity holds an asset which could be sold in one of two markets.
Information about these markets and the costs that would be incurred if a sale
were to be made is as follows:
Market A
Market B
Rs.

Rs.

Sale price

260

250

Transport cost

(20)

(20)

240

230

Transaction cost

(30)

(10)

Net amount received

210

220

(a)

What fair value would be used to measure the asset if Market A were the
principal market?

(b)

What fair value would be used to measure the asset if no principal market
could be identified?

Answer
(a)

If Market A is the principal market for the asset the fair value of the asset
would be measured using the price that would be received in that market,
after taking into account transport costs (Rs. 240).

(b)

If neither market is the principal market for the asset, the fair value of the
asset would be measured using the price in the most advantageous
market.
The most advantageous market is the market that maximises the amount
that would be received to sell the asset, after taking into account
transaction costs and transport costs (i.e. the net amount that would be
received in the respective markets). This is Market B where the net amount
that would be received for the asset would be Rs. 220.
The fair value of the asset is measured using the price in that market (Rs.
250), less transport costs (Rs. 20), resulting in a fair value measurement of
Rs. 230.
Transaction costs are taken into account when determining which market
is the most advantageous market but the price used to measure the fair
value of the asset is not adjusted for those costs (although it is adjusted for
transport costs).

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Example: Fair valuation

An entity owns an item of industrial equipment (asset x) for which it wishes to
ascertain a fair value in accordance with IFRS 13.
Information about the markets in which the asset could be sold and the costs
that would be incurred if a sale were to be made is as follows:
Market A

Market B

Rs.

Rs.

Sale price

500

505

Transport cost

(20)

(30)

480

475

Volume of sales of asset x (units)

1,000

29,000

(a)

Which is the most advantageous market?

(b)

What is the fair value of the asset in accordance with IFRS 13?

Answer
a)

Market A is the most advantageous market as it provides the highest return

after transaction costs.

b)

The fair value of the asset in accordance with IFRS 13 is $505. This is the
price available in the principal market before transaction costs. (The
principal market is the one with the highest level of activity).

Different entities might have access to different markets. This might result in
different entities reporting similar assets at different fair values.

2.3 Fair value of non-financial assets highest and best use

Fair value measurement of a non-financial asset must value the asset at its
highest and best use.
Highest and best use is a valuation concept based on the idea that market
participants would seek to maximise the value of an asset.
Definition: Highest and best use
Highest and best use: The use of a non-financial asset by market participants that
would maximise the value of the asset or the group of assets and liabilities (e.g. a
business) within which the asset would be used.
This must take into account use of the asset that is:

physically possible;

legally permissible; and

financially feasible.

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The current use of land is presumed to be its highest and best use unless market
or other factors suggest a different use.
Example: Highest and best use
X Limited acquired a plot of land developed for industrial use as a factory. A
factory with similar facilities in Karachi and access has recently been sold for Rs.
50 million.
The plot is located on the outskirts of Clifton in Karachi.
Similar sites nearby have recently been developed for residential use as sites for
high-rise apartment buildings.
X Limited determines that the land could be developed as a site for residential
use at a cost of Rs. 10 million (to cover demolition of the factory and legal costs
associated with the change of use). The plot of land would then be worth Rs. 62
million.
The highest and best use of the land would be determined by comparing the
following:
Rs. million
Value of the land as currently developed

50

Value of the land as a vacant site for residential use

(Rs. 62 million Rs. 10 million)

52

Conclusion:
The fair value of the land is Rs. 52 million.

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VALUATION TECHNIQUES
Section overview

Valuation techniques

Inputs to valuation techniques

Fair value hierarchy

Bid/offer prices

3.1 Valuation techniques

The objective of using a valuation technique is to estimate the price at which an
orderly transaction to sell the asset (or to transfer the liability) would take place
between market participants at the measurement date under current market
conditions.
IFRS 13 requires that one of three valuation techniques must be used:

market approach uses prices and other relevant information from market
transactions involving identical or similar assets and liabilities;

cost approach the amount required to replace the service capacity of an

asset (also known as the current replacement cost);

income approach converts future amounts (cash flows, profits) to a single

current (discounted) amount.

An entity must use a valuation technique that is appropriate in the circumstances

and for which sufficient data is available to measure fair value, maximising the
use of relevant observable inputs and minimising the use of unobservable inputs.

3.2 Inputs to valuation techniques

An entity must use valuation techniques that are appropriate in the circumstances
and for which sufficient information is available to measure fair value.
A valuation technique should be used to maximise the use of relevant observable
inputs and minimise the use of unobservable inputs.
Definition: Inputs
Inputs: The assumptions that market participants would use when pricing the asset
or liability, including assumptions about risk, such as the following:
(a)

the risk inherent in a particular valuation technique used to measure fair

value (such as a pricing model); and

(b)

the risk inherent in the inputs to the valuation technique.

Quoted price in an active market provides the most reliable evidence of fair value
and must be used to measure fair value whenever available.

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3.3 Fair value hierarchy

IFRS 13 establishes a fair value hierarchy to categorise inputs to valuation
techniques into three levels.
Definition

Examples

Level 1

Quoted prices in active

markets for identical
assets or liabilities that the
entity can access at the
measurement date

Share price quoted on the London

Stock Exchange

Level 2

Inputs other than quoted

prices included within
Level 1 that are
observable for the asset or
liability, either directly or
indirectly.

Quoted price of a similar asset to the

one being valued.
Quoted interest rate.

Level 3

Unobservable inputs for

the asset or liability.

Cash flow projections.

3.4 Bid /Offer prices

For some assets (liabilities) markets quote prices that differ depending on
whether the asset is being sold to or bought from the market.

The price at which an asset can be sold to the market is called the bid price
(it is the amount the market bids for the asset).

The price at which an asset can be bought from the market is called the ask
or offer price (it is the amount the market asks for the asset or offers to sell
it for).

The price within the bid-ask spread that is most representative of fair value in the
circumstances must be used to measure fair value.
Previously, bid price had to be used for financial assets and ask price for financial
liabilities but this is no longer the case.

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LIABILITIES AND AN ENTITYS OWN EQUITY INSTRUMENTS

Section overview

General principles

Liabilities and equity instruments held by other parties as assets

Liabilities and equity instruments not held by other parties as assets

Financial assets and financial liabilities managed on a net basis

4.1 General principles

Fair value measurement assumes the transfer of an item to a market participant
at the measurement date.
The fair valuation of a liability assumes that it not be settled with the counterparty
at the measurement date but would remain outstanding. In other words, the
market participant to whom the liability could be transferred would be required to
fulfil the obligation.
The fair valuation of an entitys own equity instrument assumes that market
participant to whom the instrument could be transferred would take on the rights
and responsibilities associated with the instrument.
The same guidance that applies to the fair value of assets also applies to the fair
value of liabilities and an entitys own equity instruments including that:

an entity must maximise the use of relevant observable inputs and

minimise the use of unobservable inputs; and

quoted price in an active market must be used to measure fair value

whenever available.

In the absence of an active market there might be an observable market for items
held by other parties as assets.

4.2 Liabilities and equity instruments held by other parties as assets

If a quoted price for the transfer of an identical or a similar liability or entitys own
equity instrument is not available it may be possible to measure fair value from
the point of view of a party that holds the identical item as an asset at the
measurement date.
If this is the case fair value is measured as follows:

using the quoted price in an active market (if available) for the identical item
held by another party as an asset; or failing that

using other observable inputs (e.g. quoted price in a market that is not
active for the identical item held by another party as an asset); or failing
that

another valuation technique (e.g. using quoted prices for similar liabilities or
equity instruments held by other parties as assets (market approach).

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Adjustments to quoted price

There might be factors that are specific to the asset held by the third party that
are not applicable to the fair value of the liability or entitys own equity.
The quoted price of such items is adjusted for such factors. For example, a
quoted price might relate to a similar (but not identical) liability or equity
instrument held by another party as an asset.
However, the price of the asset must not reflect the effect of a restriction
preventing the sale of that asset.

4.3 Liabilities and equity instruments not held by other parties as assets
In this case fair value is measured from the perspective of a market participant
that owes the liability or has issued the claim on equity.
For example, when applying a present value technique an entity might take into
account the future cash outflows that a market participant would expect to incur
in fulfilling the obligation (including the compensation that a market participant
would require for taking on the obligation).

4.4 Financial assets and financial liabilities managed on a net basis

An entity might manage a group of financial assets and financial liabilities on the
basis of its net exposure to either market risks or credit risk.
In this case the entity is allowed to measure the fair value net position (i.e. a net
asset or a net liability as appropriate).
This is an exception to the general rules in IFRS 13 which would otherwise apply
separately to the asset and the liability. It applies only to financial assets and
financial liabilities within the scope of IAS 39: Financial instruments: Recognition
and Measurement or IFRS 9: Financial instruments.
The exception is only allowed if the entity does all the following:

It manages the group of financial assets and financial liabilities on the basis
of the entitys net exposure to a particular risk (market risk or credit risk of a
particular counterparty) in accordance with its documented risk
management or investment strategy;

It provides information on that basis about the group of financial assets and
financial liabilities to the entitys key management personnel; and

It measures those financial assets and financial liabilities at fair value in the
statement of financial position at the end of each reporting period.

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DISCLOSURE
Section overview

Recurring and non-recurring fair value measurement

Overall disclosure objective

Disclosures

5.1 Recurring and non-recurring fair value measurement

The fair value measurement of assets and liabilities might be recurring or nonrecurring.

Recurring fair value measurements are those that are required or permitted
in the statement of financial position at the end of each reporting period
(e.g. the fair value of investment property when the IAS 40 fair value model
is used);

Non-recurring fair value measurements are those that are required or

permitted in the statement of financial position in particular circumstances
(e.g. when an entity measures an asset held for sale at fair value less costs
to sell in accordance with IFRS 5).

Disclosures are necessary in respect of each of the above.

5.2 Overall disclosure objective

Information must be disclosed to help users assess both of the following:

the valuation techniques and inputs used to measure the fair value assets
and liabilities on a recurring or non-recurring basis;

the effect on profit or loss or other comprehensive income for the period of
recurring fair value measurements using significant unobservable inputs
(Level 3).

All of the following must be considered to meet the above objectives:

the level of detail necessary to satisfy the disclosure requirements;

how much emphasis to place on each of the various requirements;

how much aggregation or disaggregation to undertake; and

the need for additional information.

Classes of assets and liabilities

Classes of assets and liabilities must be identified for the purpose of fulfilling the
minimum disclosure requirements of IFRS 15.
Appropriate classes are identified on the basis of the following:

the nature, characteristics and risks of the asset or liability; and

the level of the fair value hierarchy within which the fair value measurement
is categorised.

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5.3 Disclosures
The following information must be disclosed as a minimum for each class of
assets and liabilities measured at fair value in the statement of financial position
after initial recognition.
For recurring and non-recurring fair value measurements
The fair value measurement at the end of the reporting period and the reasons
for the measurement for non-recurring fair value measurements
The level of the fair value hierarchy within which the fair value measurements are
categorised in their entirety (Level 1, 2 or 3).
For fair value measurements categorised within Level 2 and Level 3 of the fair
value hierarchy:

a description of the valuation technique(s) and the inputs used in the fair
value measurement for;

the reason for any change in valuation technique;

Quantitative information about the significant unobservable inputs used in the fair
value measurement for fair value measurements categorised within Level 3 of the
fair value hierarchy.
A description of the valuation processes used for fair value measurements
categorised within Level 3 of the fair value hierarchy.
The reason why a non-financial asset is being used in a manner that differs from
its highest and best use when this is the case.
For recurring fair value measurements
The amounts of any transfers between Level 1 and Level 2 of the fair value
hierarchy, the reasons for those transfers and the entitys policy for determining
when transfers between levels are deemed to have occurred.
For fair value measurements categorised within Level 3 of the fair value
hierarchy:

a reconciliation of opening balances to closing balances, disclosing

separately changes during the period attributable to the following:
x

total gains or losses recognised in profit or loss (and the line items in
which they are recognised);

unrealised amounts included in the above;

total gains or losses recognised in other comprehensive income(and

the line item in which they are recognised);

purchases, sales, issues and settlements;

details of transfers into or out of Level 3 of the fair value hierarchy;

for recurring fair value measurements categorised within Level 3 of the fair
value hierarchy:

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a narrative description of the sensitivity of the fair value measurement

to changes in unobservable inputs;

the fact that a change to one or more of the unobservable inputs

would change fair value significantly (if that is the case) and the effect
of those changes.

Other
If financial assets and financial liabilities are managed on a net basis and the fair
value of the net position is measured that fact must be disclosed.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

18

IAS 12: Income taxes

Contents
1 Accounting for taxation
2 Deferred tax: Introduction
3 Recognition of deferred tax: basic approach
4 Recognition and measurement rules
5 Deferred tax: business combinations
6 Presentation and disclosure

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 16

IAS 12: Income Taxes

B (a) 53

SIC 25: Income taxes changes in the tax status of an enterprise or its
shareholders

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ACCOUNTING FOR TAXATION

Section overview

Taxation of profits

Over-estimate or under-estimate of tax from the previous year

Taxation in the statement of financial position

1.1 Taxation of profits

Companies pay tax on their profits. The tax charge is based on their accounting
profit as adjusted according to the tax law of Pakistan.
Definitions
Accounting profit is profit or loss for a period before deducting tax expense.
Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance
with the rules established by the taxation authorities, upon which income taxes are
payable (recoverable).
Current tax is the amount of income taxes payable (recoverable) in respect of the
taxable profit (tax loss) for a period.
Tax computation
A series of adjustments is made against a companys accounting profit to arrive
at its taxable profit. These adjustments involve:

Adding back inadmissible deductions (accounting expenses which are not

allowed as a deduction against taxable profit).

Deducting admissible deductions which include:

x

expenses that are allowable as a deduction against taxable profit but

which have not been recognised in the financial statements; and

income recognised in the financial statements but which is exempted

from company income tax.

The tax rate is applied to the taxable profit to calculate how much a company
owes in tax for the period. IFRS describes this as current tax.
An exam question might require you to perform a basic taxation computation
from information given in the question.
Illustration: Tax computation format

Accounting profit before tax

Add back: Inadmissible deductions

Rs.
X
X

Less: Admissible deductions

(X)

Taxable profit

Tax rate

x%

Tax payable (current tax)

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Example: Taxation computation

X Limited had an accounting profit of Rs. 789,000 for the year ended 31 December
2016.
The accounting profit was after depreciation of Rs. 70,000 and included a profit on
disposal (capital gain) of Rs. 97,000.
The company had incurred borrowing costs of Rs. 70,000 in the year of which Rs.
10,000 had been capitalised in accordance with IAS 23.
The company holds some assets under finance leases. During the year finance
charge in respect of the leases was Rs. 15,000 and rentals paid were Rs. 80,000.
At 1 January 2016 the tax written down value of machinery was Rs. 120,000 and
for buildings was Rs. 600,000.
Tax regime
All borrowing costs are deductible for tax purposes.
Capital gains are not taxable.
Fines are not tax deductible.
Finance lease rentals are deductible in full for tax purposes.
Accounting depreciation is not allowable for tax purposes.
Tax depreciation is claimable at 10% per annum for buildings and 15% per
annum for machinery applied to tax written down value at the start of the year.
Tax is paid at 30%
The tax computation is as follows:
Rs.
Accounting profit

789,000

Add back inadmissible deductions:

Accounting depreciation

70,000

Fine paid

125,000

Finance charge on finance lease

15,000
210,000

Less: Admissible deductions

Lease payments

80,000

Capital gain

97,000

Borrowing cost capitalised

10,000
(187,000)

Assessable profit

812,000

Less: Capital allowances

(15% u 120,000 + 10% u 600,000)

(78,000)

Taxable profit

734,000

Income tax (30% of taxable profit)

220,200

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Chapter 18: IAS 12: Income taxes

Tax base
The above example referred to the tax written down value of the machinery and
buildings. This is the tax authoritys view of the carrying amount of the asset
measured at cost less capital allowances calculated according to the tax
legislation.
IFRS uses the term tax base to refer to an asset or liability measured according
to the tax rules.
Definition
The tax base of an asset or liability is the amount attributed to that asset or liability
for tax purposes.
The tax base of an asset is the amount that the tax authorities will allow as a
deduction in the future.
Measurement
Current tax liabilities (assets) for the current and prior periods must be measured
at the amount expected to be paid to (recovered from) the taxation authorities,
using the tax rates (and tax laws) that have been enacted or substantively
enacted by the end of the reporting period.

1.2 Over-estimate or under-estimate of tax from the previous year

Current tax for current and prior periods must be recognised as a liability until
paid. If the amount already paid exceeds the amount due the excess must be
recognised as an asset.
When the financial statements are prepared, the tax charge on the profits for the
year is likely to be an estimate. The figure for tax on profits in the statement of
comprehensive income is therefore not the amount of tax that will eventually be
payable, because it is only an estimate. The actual tax charge, agreed with the
tax authorities some time later, is likely to be different.
In these circumstances, the tax charge for the year is adjusted for any underestimate or over-estimate of tax in the previous year.

an under-estimate of tax on the previous years profits is added to the tax

charge for the current year.

an over-estimate of tax on the previous years profits is deducted from the

tax charge for the current year.

Example: Over-e
estimate or under-e
estimate of tax
Rs.
Profit from operations

Rs.
460,000

Interest

(60,000)

Profit before tax

400,000

Tax:
Adjustment for under-estimate of tax in the
previous year
Tax on current year profits

100,000

Tax charge for the year

(103,000)

Profit after tax

Emile Woolf International

3,000

297,000

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Advanced accounting and financial reporting

1.3 Taxation in the statement of financial position

The taxation charge for the year is the liability that the company expects to pay.
The timing of tax payments on profits varies from one country to another,
depending on the tax rules in each country. The actual amount of tax payable,
and reported in the statement of financial position as a current liability (taxation
payable), is calculated as follows:
Illustration: Taxation in the statement of financial position

Tax payable at the beginning of the year

Tax charge for the year

Rs.
X
X

Tax payments made during the year

X
(X)

Tax payable at the end of the year

Example: Taxation in the financial statements

Fresh Company has a financial year ending on 31 December.
At 31 December 2015 it had a liability for income tax of Rs. 77,000.
The tax on profits for the year to 31 December 2016 was Rs. 114,000.
The tax charge for the year to 31 December 2015 was over-estimated by Rs.
6,000.
During the year to 31 December 2016, the company made payments of Rs.
123,000 in income tax.
This would result in the following accounting treatment:
Tax charge in the statement of comprehensive income
Tax on current year profits
Adjustment for over-estimate of tax in the previous year
Taxation charge for the year

(6,000)
108,000

Tax liability in the statement of financial position

Tax payable at the beginning of the year
Tax charge for the year

Rs.
114,000

Rs.
77,000
108,000
185,000

Tax payments made during the year

Tax payable at the end of the year

Emile Woolf International

498

(123,000)
62,000

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Chapter 18: IAS 12: Income taxes

DEFERRED TAX: INTRODUCTION

Section overview

Deferred taxation Underlying problem

Identifying deferred tax balances

IAS 12 approach to the problem

2.1 Deferred taxation - Underlying problem

As explained in the last section, in most jurisdictions the rules for the recognition
and measurement of certain assets, liabilities, income and expenses for tax
purposes differ from the equivalent rules under IFRSs. This results in different
figures in the financial statements and in the tax computations/tax working
papers.
It is convenient to envisage two separate sets of accounts:

one set constructed following IFRS rules; and,

a second set following the tax rules (tax computations).

This results in a breakdown in the tax rate percentage relationship between the
profit before tax figure and the taxation figure. In other words the tax charge is
not the tax rate applied to the profit before tax.
Example: Deferred taxation - Underlying problem
X Limited made accounting profit before tax of Rs. 50,000 in each of the years,
20X1, 20X2 and 20X3 and pays tax at 30%.
X Limited bought an item of plant on 1 January 20X1 for Rs. 9,000. This asset is to
be depreciated on a straight line basis over 3 years.
Accounting depreciation is not allowed as a taxable deduction in the jurisdiction in
which the company operates. Instead tax allowable depreciation is available as
shown in the following tax computations.
20X1

20X2

20X3

Rs.

Rs.

Rs.

Accounting profit (after

depreciation)

50,000

50,000

50,000

Add back depreciation

3,000

3,000

3,000

(4,500)

(2,500)

(2,000)

(1,500)

500

1,000

Taxable profit

48,500

50,500

51,000

Tax @ 30%

14,550

15,150

15,300

Deduct capital allowances

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Example continued: Deferred taxation - Underlying problem

In the absence of the recognition of deferred tax this would be reported as follows:
X Limited: Statement of comprehensive income for the years ending:
20X1
1
Rs.

20X2
2
Rs.

20X3
3
Rs.

Total
Rs.

50,000

50,000

50,000

150,000

Profit before tax

Income tax @ 30% (as
above)

(14,550)

Profit after tax

35,450

(15,150) (15,300)
34,850

34,700

(45,000)
105,000

Looking at the total column, the profit before tax is linked to the taxation
figure through the tax rate (150,000 u 30% = 45,000).
This is not the case in each separate year.
This is because the current tax charge is not found by multiplying the
accounting profit before tax by the tax rate. Rather, it is found by
multiplying an adjusted version of this figure by the tax rate
The item of plant is written off in the calculation of both accounting profit
and taxable profit but by different amounts in different periods. The
differences are temporary in nature as over the three year period, the
same expense is recognised for the item of plant under both the
accounting rules and the tax rules.
Transactions recognised in the financial statements in one period may have their
tax effect deferred to (or more rarely, accelerated from) another. Thus the tax is
not matched with the underlying transaction that has given rise to it.
In the above example the tax consequences of an expense (depreciation in this
case) are recognised in different periods to when the expense is recognised.
Accounting for deferred tax is based on the principle that the tax consequence of
an item should be recognised in the same period as the item is recognised. It
tries to match tax expenses and credits to the period in which the underlying
transactions to which they relate are recognised.
In order to do this, the taxation effect that arises due to the differences between
the figures recognised under IFRS and the tax rules is recognised in the financial
statements.
The double entry to achieve this is between a deferred tax balance in the
statement of financial position (which might be an asset or a liability) and the tax
charge in the statement of comprehensive income.
The result of this is that the overall tax expense recognised in the statement of
comprehensive income is made up of the current tax and deferred tax numbers.
Definition: Tax expense
Tax expense (tax income) is the aggregate amount included in the determination of
profit or loss for the period in respect of current tax and deferred tax.

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Chapter 18: IAS 12: Income taxes

2.2 Identifying deferred tax balances

The differences between the two sets of rules will result in different numbers in
the financial statements and in the tax computations.
Two perspectives
These differences can be viewed from:

a statement of comprehensive income (income and expenses) perspective:

x

the differences arising in the period are identified by comparing

income and expenses recognised under IFRS to the equivalent
figures that are taxable or allowable under tax legislation;

the approach identifies the deferred tax expense or credit recognised

in the statement of comprehensive income for the period (with the
other side of the entry recognised as a liability or asset);or

a statement of financial position (assets and liabilities) perspective:

x

the differences are identified on a cumulative basis by comparing the

carrying amount of assets and liabilities under IFRS to the carrying
amount of the same assets and liabilities according to the tax rules;

the approach identifies the deferred tax liability (or asset) that should
be recognised (with the movement on this amount recognised as a
credit or expense in the statement of comprehensive income).

IAS 12 uses the statement of financial position perspective but both will be
explained here for greater understanding.

Example continued: Two perspectives

The following table identifies the differences between the accounting treatment
and the taxation treatment of the item of plant from both perspectives.
Assets
Income
Carrying
and
and
amount
Tax base liabilities
expenses
Cost at 01/01/X1

9,000

9,000

Charge for the year

(3,000)

(4,500)

Cost at 31/12/X1

6,000

4,500

Charge for the year

(3,000)

(2,500)

Cost at 31/12/X2

3,000

2,000

Charge for the year

(3,000)

(2,000)

Cost at 31/12/X3

Emile Woolf International

501

(1,500)
1,500
500
1,000
1,000


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Advanced accounting and financial reporting

Statement of comprehensive income perspective

Example continued: Statement of comprehensive income perspective
20X1:
Rs. 3,000 is disallowed but Rs. 4,500 is allowed instead.
taxable expense is Rs. 1,500 greater than the accounting expense.
taxable profit is Rs. 1,500 less than accounting profit.
current tax is reduced by 30% of Rs. 1,500 (Rs. 450).
deferred tax expense of Rs. 450 must be recognised to restore the
balance (Dr: Tax expense / Cr: Deferred taxation liability).
20X2:
Rs. 3,000 is disallowed but Rs. 2,500 is allowed instead.
taxable expense is Rs. 500 less than the accounting expense.
taxable profit is Rs. 500 more than accounting profit.
current tax is increased by 30% of Rs. 500 (Rs. 150).
deferred tax credit of Rs. 150 must be recognised to restore the balance
(Dr: Deferred taxation liability / Cr: Tax expense).
20X3
3:
Rs. 3,000 is disallowed but Rs. 2,000 is allowed instead.
taxable expense is Rs. 1,000 less than the accounting expense.
taxable profit is Rs. 1,000 more than accounting profit.
current tax is increased by 30% of Rs. 1,000 (Rs. 300).
deferred tax credit of Rs. 300 must be recognised to restore the balance
(Dr: Deferred taxation liability / Cr: Tax expense).
The statement of comprehensive income would now be as follows:
20X1

20X2

20X3

Rs.

Rs.

Rs.

Profit before tax

50,000

Income tax @ 30% W1

14,550

15,150

15,300

450

(150)

(300)

(15,000)

(15,000)

(15,000)

35,000

35,000

35,000

20X1

20X2

20X3

Deferred tax liability:

Rs.

Rs.

Rs.

Balance b/f

nil

450

300

Movement in the year

450

(150)

(300)

Balance b/f

450

300

nil

Deferred tax
Profit after tax
Statement of financial position

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50,000

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Chapter 18: IAS 12: Income taxes

Statement of financial position perspective

Example continued: Statement of financial position perspective
This approach compares the carrying amount of assets and liabilities in the
financial statements to their tax base to identify the cumulative differences to that
point in time.
These differences are called temporary differences.
An asset in the financial statements compared to the taxmans view requires the
recognition of a deferred tax liability which is measured by applying the tax rate to
the temporary difference.
Carrying
Temporary
Tax @
amount
30%
Tax base difference
At 31/12/X1

6,000

4,500

1,500

450

At 31/12/X2

3,000

2,000

1,000

300

At 31/12/X3

nil

nil

nil

nil

By the end of 20X1

The asset in the financial statements is Rs. 1,500 more than the tax base.
A deferred tax liability of Rs. 450 must be recognised.
Debit
450

Tax expense
Deferred tax liability

Credit
450

By the end of 20X2

The asset in the financial statements is Rs. 1,000 more than the tax base.
A deferred tax liability of Rs. 300 must be recognised but there was Rs. 450
at the start of the year so the liability must be reduced.
Debit
150

Deferred tax liability

Tax expense

Credit
150

By the end of 20X3

The asset in the financial statements is the same as the tax base (nil).
A deferred tax liability of nil must be recognised but there was Rs. 300 at
the start of the year so the liability must be reduced.
Debit
300

Deferred tax liability

Tax expense

Credit
300

These amounts are the same as on the previous page and would have the
same impact on the financial statements.

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Advanced accounting and financial reporting

The recognition of deferred taxation has restored the relationship between profit
before tax and the tax charge through the tax rate in each year (30% of Rs.
50,000 = Rs. 15,000).
Terminology
When a difference comes into existence or grows it is said to originate. When the
difference reduces in size it is said to reverse.
Thus, in the above example a difference of Rs. 1,500 originated in 20X1. This
difference then reversed in 20X2 and 20X3.

2.3 IAS 12 approach to the problem

IAS 12: Income taxes, advocates a statement of financial position approach.
Business must identify a deferred tax liability (or perhaps asset) at each reporting
date.
It must do this by identifying the differences between the carrying amount of
assets and liabilities in the financial statements to the tax base (tax authoritys
view of those same items). These differences are known as temporary
differences (this will be explained in more detail in the next section).
Once the temporary differences have been identified the deferred tax balance is
calculated by applying the appropriate tax rate to the difference.

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Chapter 18: IAS 12: Income taxes

RECOGNITION OF DEFERRED TAX: BASIC APPROACH

Section overview

Identifying the temporary difference

Taxable and deductible temporary differences

Sources of temporary differences

Accounting for deferred tax

Deferred tax relating to revaluations and other items recognised outside profit or
loss

SIC 25: Changes in tax status of an entity or its shareholders

3.1 Identifying the temporary difference

Accounting for deferred tax is based on the identification of the temporary
differences.
Definition: Temporary difference
Temporary differences are differences between the carrying amount of an asset or
liability in the statement of financial position and its tax base.
Temporary differences may be either:
(a) taxable temporary differences, which are temporary differences that will result
in taxable amounts in determining taxable profit (tax loss) of future periods
when the carrying amount of the asset or liability is recovered or settled; or
(b) deductible temporary differences, which are temporary differences that will
result in amounts that are deductible in determining taxable profit (tax loss) of
future periods when the carrying amount of the asset or liability is recovered
or settled.
The tax base of an asset is the amount that will be deductible for tax purposes
against any taxable economic benefit that will flow to an entity when it recovers
the carrying amount of the asset.
Definition: Tax base
The tax base of an asset or liability is the amount attributed to that asset or liability
for tax purposes.

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Advanced accounting and financial reporting

3.2 Taxable and deductible temporary differences

Temporary differences may be either taxable temporary differences or deductible
temporary differences.
Taxable temporary differences
A taxable temporary difference is caused by a debit in the carrying amount of an
asset or liability in the financial statements compared to the tax base of that item.
Taxable temporary differences lead to the recognition of deferred tax liabilities.
Example: Taxable temporary differences
Each of the following is a taxable temporary difference leading to the recognition of
a deferred tax liability.
Carrying
amount
Non-current asset

1,000

Tax base
800

Temporary
difference

Deferred
tax liability
(30%)

200

60

Inventory

650

600

50

15

Receivable

800

500

300

90

Receivable (note 1)

500

nil

500

150

(1,000)

(1,200)

200

60

Payable (note 2)

Note 1::
This implies that an item accounted for using the accruals basis in the
financial statements is being taxed on a cash bases.
If an item is taxed on cash basis the tax base would be zero as no
receivable would be recognised under the tax rules.
Note 2:
The credit balance in the financial statements is Rs. 1,000 and the tax base
is a credit of Rs. 1,200. Therefore, the financial statements show a debit
balance of 200 compared to the tax base. This leads to a deferred tax
liability.
IAS 12 rationalises the approach as follows (using the non-current assets
figures to illustrate)
Inherent in the recognition of an asset is that the carrying amount (Rs.
1,000) will be recovered in the form of economic benefits that will flow to
the entity in future periods.
When the carrying amount exceeds the tax base (as it does in this case at
Rs. 800) the amount of taxable economic benefit will exceed the amount
that will be allowed as a deduction for tax purposes.
This difference is a taxable temporary difference and the obligation to pay
the resulting income tax in the future periods is a liability that exists at the
reporting date.
The company will only be able to deduct Rs. 800 in the tax computations
against the recovery of Rs. 1,000.
The Rs. 200 that is not covered will be taxed and that tax should be
recognised for now.

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Chapter 18: IAS 12: Income taxes

Definition: Deferred tax liability

Deferred tax liabilities are the amounts of income taxes payable in future periods
in respect of taxable temporary differences.
Deductible temporary differences
A deductible temporary difference is caused by a credit in the carrying amount of
an asset or liability in the financial statements compared to the tax base of that
item.
Deductible temporary differences lead to the recognition of deferred tax assets.
Example: Deductible temporary differences
Each of the following is a deductible temporary difference leading to the
recognition of a deferred tax asset.
Deferred
Carrying
Temporary tax asset
amount Tax base difference
(30%)
Non-current asset (note 1)
1,000
1,200
(200)
60
Receivable
Payable

800

900

(100)

30

(1,200)

(1,000)

(200)

60

Note 1:
There is a debit balance for the non-current asset of Rs. 1,000 and its tax
base is a debit of Rs. 1,200. Therefore, the financial statements show a
credit balance of 200 compared to the tax base. This leads to a deferred tax
asset.

Definition: Deferred tax asset

Deferred tax assets are the amounts of income taxes recoverable in future periods
in respect of:
(a)

deductible temporary differences;

(b)

the carry forward of unused tax losses; and

(c)

the carry forward of unused tax credits.

3.3 Sources of temporary differences

Circumstances under which temporary differences arise include;

Situations when income or expense is included in accounting profit in one

period but included in the taxable profit in a different period. Examples
include:
x

items which are taxed on a cash basis but which will be accounted for
on an accruals basis.

situations where the accounting depreciation does not equal capital

allowances.

Revaluation of assets where the tax authorities do not amend the tax base
when the asset is revalued.

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Examples leading to the recognition of deferred tax liabilities

Interest may be received in arrears, leading to a receivable in the statement of
financial position. However, this interest may not be taxable until the cash is
received.
Example: Recognition of deferred tax liabilities
A Limited recognises interest receivable of Rs. 600,000 in its financial statements.
No cash has yet been received and interest is taxed on a cash basis. The interest
receivable has a tax base of nil.
Carrying
Temporary
Tax base
amount
difference
Rs.
Rs.
Rs.
Interest receivable

600,000

Deferred tax liability @ 30%

600,000
180,000

Development costs may be capitalised and amortised (in accordance with IAS
38) but tax relief may be given for the development costs as they are paid.
Example: Recognition of deferred tax liabilities
In the year ended 30 June 2016, B Limited incurred development costs of Rs.
320,000.
These were capitalised in accordance with IAS 38, with an amortisation charge of
Rs. 15,000 in 2016.
Development costs are an allowable expense for tax purposes in the period in
which they are paid. The relevant tax rate is 30%.
Carrying
Temporary
amount
difference
Tax base
Rs.
Rs.
Rs.
Development costs
305,000
305,000

Deferred tax liability @ 30%

91,500

Accounting depreciation is not deductible for tax purposes in most tax regimes.
Instead the governments allow a deduction on statutory grounds.
Example: Recognition of deferred tax liabilities
C Limited has non-current assets at 31 December 2016 with a cost of Rs.
5,000,000.
Accumulated depreciation for accounting purposes is Rs. 2,250,000 to give a
carrying amount of Rs. 2,750,000
Tax deductible depreciation of Rs. 3,000,000 has been deducted to date.
The fixed assets have a tax base of Rs. 2,000,000.
Carrying
Temporary
amount
Tax base
difference
Rs.
Rs.
Rs.
Non-current asset
2,750,000
2,000,000
750,000
Deferred tax liability @ 30%

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225,000

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Chapter 18: IAS 12: Income taxes

Examples leading to the recognition of deferred tax assets

Warranty costs may be recognised as a liability (in accordance with IAS 37) but
tax relief may be given only when the cash is spent in the future.
Example: Recognition of deferred tax assets
D Limited recognises a liability of Rs. 100,000 for accrued product warranty costs.
For tax purposes, the product warranty costs will not be deductible until the entity
pays any warranty claims. (Therefore the tax base is nil).
The company is very profitable and does not expect this to change. (This means
that they expect to pay tax in the future so should be able to recover the deferred
tax asset).

Warranty provision

Carrying
amount

Tax base

Temporary
difference

Rs.

Rs.

Rs.

100,000

100,000

Deferred tax asset @ 30%

30,000
This time the financial statements contain a liability when compared to the tax
authoritys view of the situation. Therefore deferred tax is an asset.
It is possible to have a temporary difference even if there is no asset or liability. In
such cases there is a zero value for the asset (or liability). For example, research
costs may be expensed as incurred (in accordance with IAS 38) but tax relief
may be given for the costs at a later date.
Example: Recognition of deferred tax assets
In the year ended 31 December 2016, E Limited incurred research costs of Rs.
500,000.
These were expensed accordance with IAS 38.
Research costs are not permitted as a taxable deduction until a later period.
The relevant tax rate is 30%.
Carrying
Temporary
amount
difference
Tax base
Research costs
Deferred tax asset @ 30%

Rs.

Rs.

Rs.

nil

500,000

500,000
150,000

As a general rule when

Income approach
x

Accounting income > Taxable income = Deferred tax liability

Taxable income > Accounting income = Deferred tax asset

Balance sheet approach

x
In case of assets: Carrying amount > Tax base = Deferred tax liability
(and vice versa)
x

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In case of liabilities: Carrying amount > Tax base = Deferred tax asset
(and vice versa)

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Advanced accounting and financial reporting

3.4 Accounting for deferred tax

Accounting for deferred taxation involves the recognition of a liability (or an asset)
in the statement of financial position at each year end. The business must then
account for the movement on the liability (or asset).
The other side of the entry that changes the balance on the deferred taxation
liability (asset) is recognised in the statement of profit or loss except to the extent
that it arises in other comprehensive income or directly in equity.
Approach
The calculation of the balance to be recognised in the statement of financial
position is quite straightforward.

Step 1: Identify the temporary differences (this should always involve a

columnar working as in the example below);

Step 2: Multiply the temporary differences by the appropriate tax rate.

Step 3: Compare this figure to the opening figure and complete the double
entry.

Example: Accounting for deferred tax

X Limited has non-current assets with a carrying value of Rs. 200,000 and a tax
base of Rs. 140,000.
It has recognised a receivable of Rs. 10,000. This relates to income which is taxed
on a cash basis.
It has also accrued for an expense in the amount of Rs. 20,000. Tax relief is only
given on this expense when it is paid.
At the start of the year X Limited had a deferred tax liability of Rs. 12,000.
Required
Show the movement on the deferred tax account and construct the journal to
record this movement.
In order to answer a question like this you need to complete the following
proforma:
Rs.
Deferred taxation balance at the start of the year

12,000

Transfer to the income statement (as a balancing figure)

Deferred taxation balance at the end of the year (working)

In order to complete this you need a working to identify the temporary

differences.

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Chapter 18: IAS 12: Income taxes

Example continued: Accounting for deferred tax

The temporary differences are identified and the required deferred tax balance
calculated as follows:
Working:
Carrying
Temporary
DT balance at
amount
30%
Tax base differences
Rs.

Rs.

Rs.

Rs.

Non-current assets

200,000

140,000

60,000

Accrued income

10,000

10,000

18,000
(liability)
3,000
(liability)

Accrued expense

(20,000)

(20,000)

(6,000)
asset

50,000

15,000

The answer can then be completed by filling in the missing figures and
constructing the journal as follows:
Rs.
Deferred taxation balance at the start of the year

12,000

Statement of profit or loss (as a balancing figure)

3,000

Deferred taxation balance at the end of the year (working above)

15,000

Journal:

Debit

Credit

Income statement (tax expense)

3,000

Deferred tax liability

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3.5 Deferred tax relating to revaluations and other items recognised outside
profit or loss
A change in the carrying amount of an asset or liability might be due to a
transaction recognised outside the statement of profit or loss.
For example, IAS 16: Property, plant and equipment, allows for the revaluation of
assets. The revaluation of an asset without a corresponding change to its tax
base (which is usually the case) will change the temporary difference in respect
of that asset. An increase in the carrying amount of an asset due to an upward
revaluation is recognised outside profit or loss. In Pakistan it is credited directly to
an account outside equity called revalution surplus in accordance with the
Companies Ordinance 1984. (Elsewhere is credited to other comprehensive
income in accordance with IAS 16).
In these cases, the other side of the entry that changes the balance on the
deferred taxation liability (asset) is also recognised outside the statement of profit
or loss and in the same location as the transaction that gave rise to the change in
the temporary difference.
Example continued: Accounting for deferred tax
The following information relates to the movement on the carrying amount of an
item of plant together with temporary differences in a reporting period.
Carrying
amount

Tax base

Temporary
differences

DT balance at
30%

At 1 January

Rs.
100,000

Rs.
80,000

Rs.
20,000

Rs.
6,000

Depreciation

(10,000)

(15,000)

5,000

1,500

90,000

65,000

35,000

35,000

10,500

125,000

65,000

60,000

18,000

Revaluation

The movement on the deferred tax liability is as follows:

Rs.
Deferred taxation balance at the start of the year
Statement of profit or loss (usually as a balancing figure)

6,000
1,500

Revaluation surplus

10,500

Deferred taxation balance at the end of the year (working above)

18,000

Journal:

Credit

Debit

Statement of profit or loss (tax expense)

Revaluation surplus
Deferred tax liability

1,500
10,500
12,000

Note: The balance on the revaluation surplus account is a credit balance

stated net of taxation at Rs. 24,500 (Rs. 35,000 Rs. 10,500).

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Items recognised outside profit or loss

IFRS requires or permits various items to be recognised in other comprehensive
income. Examples of such items include:

a change in carrying amount arising from the revaluation of property, plant

and equipment (IAS 16) though this is not the case in Pakistan;

a change in carrying amount arising from the revaluation of intangible

assets (IAS 38: Intangible assets) though this is not the case in Pakistan;

remeasurements of defined benefit plans (IAS 19: Employee benefits);

exchange differences arising on the translation of the financial statements

of a foreign operation (IAS 21: The effects of changes in foreign exchange
rates);

IFRS requires or permits various items to be recognised directly in equity.

Examples of such items include:

adjustment to the opening balance of retained earnings resulting from

either a change in accounting policy that is applied retrospectively or the
correction of an error (see IAS 8: Accounting policies, changes in
accounting estimates and errors); and

amounts arising on initial recognition of the equity component of a

compound financial instrument (IAS 32: Financial Instruments:
Presentation).

Deferred tax and convertible bonds

IAS 32: Financial instruments: Presentation requires that on initial recognition of
a compound instrument, for example a convertible bond, the credit entry must be
split into the two component parts, equity and liability.
In many jurisdictions the tax base of the convertible bond would be the amount
borrowed. Therefore, split accounting results in the origination of a taxable
temporary difference (being the difference between the carrying amount of the
liability and its tax base).
An entity must recognise the resultant deferred tax liability. The temporary
difference arises on initial recognition because the equity portion of the bond is
recognised in equity. Therefore, the other side of the double entry to establish the
deferred tax liability is also recognised in equity (where it is netted off against the
equity component.
Over the life of the bond its carrying value is adjusted to the amount borrowed.
Therefore, the taxable temporary difference and the resultant deferred tax liability
falls over the bonds life. These changes in the deferred taxation liability are due
differences in the annual effective rate used to value the initial liability and the
cash interest. Therefore, the movement in deferred tax is recognised in the
statement of profit or loss.
The following example is a continuation of the example seen in paragraph 1.3 in
Chapter 16: Financial Instruments: Presentation and disclosure.

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Example: Deferred taxation and convertible bonds

A company issues Rs. 10 million of 6% convertible bonds at par on 1 January
20X1.
The bonds are redeemable at par after four years.
The market rate of interest for similar debt which is not convertible is 8%.
The bonds was recorded in the statement of financial position at the date of issue
as follows:
Dr
10,000,000

Cash

Cr

Liability

9,337,200

Equity

662,800

Subsequent measurement of the liability would be as follows:

End of:

Amortised
cost at start
of the year

Interest at
effective rate
(8%)

Cash flow
(interest
actually paid
at 6%)

Amortised
cost at year
end

20X1

9,337,200

746,976

(600,000)

9,484,176

20X2

9,484,176

758,734

(600,000)

9,642,910

20X3

9,642,910

771,433

(600,000)

9,814,343

20X4

9,814,343

785,557

(600,000)

10,000,000

The deferred tax liability at initial recognition and at each subsequent year end is
as calculated as follows:
Deferred
tax liability
Carrying
Temporary
difference
amount
Tax base
(30%)
Rs.

Rs.

Rs.

9,337,200

10,000,000

(662,800)

(198,840)

20X1

9,484,176

10,000,000

(515,824)

(154,747)

20X2

9,642,910

10,000,000

(357,090)

(107,127)

20X3

9,814,343

10,000,000

(185,657)

(55,697)

20X4

10,000,000

10,000,000

Initial
recognition
End of:

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Example (continued): Deferred taxation and convertible bonds

The double entries to record the deferred taxation at initial recognition and at
each year end are as follows:
Initial recognition
Dr
Equity

Cr

198,840

Deferred tax liability

198,840

Note: The complete double entry to record the convertible bond and
deferred tax on initial recognition is as follows
Dr
Cash

Cr

10,000,000

Liability

9,337,200

Deferred tax liability

198,840

Equity (662,800 198,840)

463,960

Year 1
Dr
Deferred tax liability (198,840  154,747)
Statement of profit and loss

Cr

44,093
44,093

Year 2
Dr
Deferred tax liability (154,747  107,127)
Statement of profit and loss

Cr

47,620
47,620

Year 3
Dr
Deferred tax liability (107,127  55,697)
Statement of profit and loss

Cr

51,429
51,429

Year 4
Dr
Deferred tax liability (55,697  0)
Statement of profit and loss

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3.6 SIC 25: Changes in tax status of an entity or its shareholders

Issue
A change in the tax status of an entity or its shareholders may increase or
decrease tax assets and liabilities.
How should the tax consequences of such change be accounted for?
Consensus
The current and deferred tax consequences of a change in tax status must be
included in the statement of profit or loss for the period unless they relate to
transactions recognised in other comprehensive income or directly in equity.
In those cases the tax consequences should be recognised in other
comprehensive income or directly in equity.

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RECOGNITION AND MEASUREMENT RULES

Section overview

Recognition of deferred tax liabilities

Recognition of deferred tax assets

A recognition issue non-taxable items

Measurement of deferred tax balances

4.1 Recognition of deferred tax liabilities

A deferred tax liability must be recognised for all taxable temporary differences,
except to the extent that the deferred tax liability arises from:

the initial recognition of goodwill; or

the initial recognition of an asset or liability in a transaction which:

x

is not a business combination; and

at the time of the transaction, affects neither accounting profit nor

taxable profit (tax loss).

There is further guidance on the recognition of deferred tax liabilities in respect of

taxable temporary differences arising in a business combination.
Comment on the exceptions: Goodwill
Goodwill usually exists only in group accounts. Groups are not taxed as such: it
is the members of a group that are the taxable entities, i.e. the parent and each
subsidiary are taxed separately. Goodwill in group accounts is not an asset
recognised by the tax authorities so has a tax base of nil. This means that
goodwill is a temporary difference but does not lead to the recognition of a
deferred tax liability because of the exception.
Example: Goodwill
In the year ended 31 December 2016, A Limited acquired 80% of another
company and recognised goodwill of Rs. 100,000 in respect of this acquisition.
The relevant tax rate is 30%.
Carrying
Temporary
Tax base
amount
difference
Goodwill
Deferred tax (due to the exception)

Rs.

Rs.

Rs.

100,000

nil

100,000
nil

The exception refers to the initial recognition of goodwill. However, there is

no deferred tax in respect of this difference at any time in the future even
if the carrying amount (and hence the temporary difference) changes..

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In some jurisdictions goodwill can arise in individual company financial

statements. Furthermore, the goodwill might be tax deductible in those
jurisdictions. In such cases goodwill is just the same as any other asset and its
tax consequences would be recognised in the same way.
Example: Goodwill
In the year ended 31 December 2016, B Limited acquired a partnership and
recognised good will of Rs. 100,000 in respect of this acquisition.
The relevant tax rate is 30%.
Carrying
Temporary
amount
difference
Tax base
Goodwill

Rs.

Rs.

Rs.

100,000

100,000

nil

Deferred tax on initial recognition

nil

In the future, both the carrying amount and the tax base of the goodwill
might change leading to deferred tax consequences.
Comment on the exceptions: Initial recognition of other items
A temporary difference may arise on initial recognition of an asset or liability, for
example if part or all of the cost of an asset will not be deductible for tax
purposes. This exception relates to the initial recognition of an asset or liability in
a transaction that is not a business combination. In other words, the exception
does not apply if the initial recognition is due to a business combination. There is
guidance on deferred tax arising in business combinations
If the transaction is not a business combination and affects either accounting
profit or taxable profit the exception does not apply and deferred tax is
recognised on initial recognition.
Example: Loan
In the year ended 31 December 2016, C Limited lent Rs. 100,000 to another
company and incurred costs of Rs. 5,000 in arranging the loan. The loan is
recognised at Rs. 105,000 in the accounts.
Under the tax rules in C Limiteds jurisdiction the cost of arranging the loan is
deductible in the period in which the loan is made.
The relevant tax rate is 30%.
Carrying
amount
Loan
Deferred tax on initial recognition

Rs.

Tax base
Rs.

105,000

100,000

Temporary
difference
Rs.
5,000
1,500

The exception does not apply as the transaction affects the taxable
profits on initial recognition. Hence a deferred taxation liability is
booked.

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If the transaction is not a business combination, and affects neither accounting

profit nor taxable profit, deferred tax would normally be recognised but the
exception prohibits it.
Example: Initial recognition
In the year ended 31 December 2016, D Limited acquired a non-current asset at a
cost of Rs. 100,000. The asset is to be depreciated on a straight line basis over its
useful life of 5 years.
The asset falls outside the tax system. Depreciation is not allowable for tax
purposes and there is no tax deductible equivalent. Any gain on disposal is not
taxable and any loss on disposal not taxable.
The relevant tax rate is 30%.
Initial recognition:

Non-current asset

Carrying
amount

Tax base

Temporary
difference

Rs.
100,000

Rs.
Nil

Rs.
100,000

Deferred tax on initial recognition (due to the exception)

Subsequent measurement (1 year later)
Carrying
amount
Rs.
80,000

Non-current asset

nil

Tax base

Temporary
difference

Rs.
Nil

Rs.
80,000

Deferred tax on initial recognition (due to the exception

this still results from the initial recognition)

nil

4.2 Recognition of deferred tax assets

IAS 12 brings a different standard to the recognition of deferred tax assets than it
does to deferred tax liabilities:

liabilities are always be recognised in full (subject to certain exemptions);

but

assets may not be recognised in full (or in some cases at all).

IAS 12 rule
A deferred tax asset must 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, unless the deferred tax asset
arises from the initial recognition of an asset or liability in a transaction that:

is not a business combination; and

at the time of the transaction, affects neither accounting profit nor taxable
profit (tax loss).

There is further guidance on the recognition of deferred tax asset in respect of

deductible temporary differences arising in a business combination

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A deferred tax asset must only be recognised to the extent that it is probable that
taxable profit will be available against which the deductible temporary difference
can be used.
Implication
In order to meet this requirement an entity must make an assessment of the
probability that profits will be available in the future against which the deferred tax
asset might be utilised.
IAS 12 says that this will be the case when there are sufficient taxable temporary
differences relating to the same taxation authority and the same taxable entity
which are expected to reverse:

in the same period as the expected reversal of the deductible temporary

difference; or

in periods into which a tax loss arising from the deferred tax asset can be
carried back or forward.
If this is not the case (i.e. there are insufficient taxable temporary differences
relating to the same taxation authority and the same taxable entity) a deferred tax
asset is recognised only to the extent that such profits exist or tax planning
opportunities are available that will create taxable profit in appropriate periods.
Tax planning opportunities are actions that could be taken in order to create or
increase taxable income in a particular period.
Deferred tax assets for unused tax losses
The availability of unused tax losses and unused tax credits that can be carried
forward to reduce future taxable profits will result in the recognition of a deferred
tax asset according to the same criteria as above. In other words, a deferred tax
asset will be recognised to the extent that it is probable that future taxable profit
will be available against which the unused tax losses and unused tax credits can
be utilised.
Example: Unused tax losses
X Limited pays tax at 30%
In the year ended 31 December 2016, X Limited had incurred a taxable loss of Rs
200,000.
This was the first such loss suffered by the company. It fully expects to return to
profit next year. In fact its forecasts show an expected profit of Rs. 300,000 next
year.
The company had a single taxable temporary difference as follows:.
Analysis
The loss is fully recoverable against future taxable profits.
Conclusion
X Limited should recognise a deferred tax asset of Rs. 60,000 (30%u Rs.
200,000).
However, the existence of unused tax losses is strong evidence that future
taxable profit may not be available. An entity with a history of recent losses may
only recognise a deferred tax asset in respect of unused tax losses or tax credits
to the extent that:

there are sufficient taxable temporary differences; or

there is convincing other evidence that sufficient taxable profit will be

available against which they can be used.

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In such circumstances, IAS 12 requires disclosure of the amount of the deferred

tax asset and the nature of the evidence supporting its recognition.
Example: Unused tax losses
X Limited pays tax at 30%
By the 31 December 2016 year-end, X Limited had unused taxable loss of Rs
200,000.
These losses had been building up over several recent years.
The company forecasts a profit of Rs. 300,000 next year. There is no convincing
evidence that this will be the case.
The company had a single taxable temporary difference as follows:.

Non-current asset

Carrying
amount

Tax base

Temporary
difference

Rs.
1,500,000

Rs.
1,380,000

Rs.
120,000

Analysis
The loss is not fully recoverable against future taxable profits.
Conclusion
X Limited should recognise a deferred tax asset to the extent of the
taxable temporary differences. This is an amount of Rs. 36,000 (30%u
Rs. 120,000).
Review at the end of each period
IAS 12 requires that the carrying amount of a deferred tax asset must be
reviewed at the end of each reporting period to check if it is still probable that
sufficient taxable profit is expected to be available to allow the benefit of its use.
If this is not the case the carrying amount of the deferred tax asset must be
reduced to the amount that it is expected will be used in the future. Any such
reduction might be reversed in the future if circumstances change again.
IAS 12 also requires that unrecognised deferred tax assets should be reassessed
at the end of each reporting period. A previously unrecognised deferred tax asset
will be recognised to the extent that it has become probable that future taxable
profit will allow the deferred tax asset to be recovered.

4.3 A recognition issue non-taxable items

The definition of temporary difference is repeated here for convenience:
Definition: Temporary difference
Temporary differences are differences between the carrying amount of an asset or
liability in the statement of financial position and its tax base.
Deferred tax should be recognised only in respect of those items where expense
or income is recognised in both accounting profit and taxable profit but in different
periods.
Unfortunately, applying the definition of temporary difference given above would
result in the inclusion of items where the difference might not be temporary but
permanent in nature.

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Example: Permanent difference.

E Limited has recognised Rs. 100,000 income as a receivable in its accounting
profit for the year.
This income is not taxable.
Applying the definition of temporary difference would lead to the following:
Carrying
amount
Receivable

Rs.

Tax base
Rs.

100,000

nil

Temporary
difference
Rs.
100,000

However, this is not a temporary difference. It is not a transaction

recognised in accounting profits in one period and taxable profits in
another.
It is never recognised in taxable profits.
Items not taxable or tax allowable should not result in the recognition of deferred
tax balances. In order to achieve this effect, IAS 12 includes the following rules:

the tax base of an asset is the amount that will be deductible for tax
purposes against any taxable economic benefits that will flow to an entity
when it recovers the carrying amount of the asset. If those economic
benefits will not be taxable, the tax base of the asset is equal to its carrying
amount.

the tax base of a liability is its carrying amount, less any amount that will be
deductible for tax purposes in respect of that liability in future periods. In the
case of revenue which is received in advance, the tax base of the resulting
liability is its carrying amount, less any amount of the revenue that will not
be taxable in future periods.

Returning to the above example:

Example: Permanent difference.
E Limited has recognised Rs. 100,000 income as a receivable in its accounting
profit for the year.
This income is not taxable.
Applying the definition of temporary difference would lead to the following:
Carrying
amount
Rs.

Tax base
Rs.

Temporary
difference
Rs.

Receivable
100,000
100,000
nil
The item is not taxable so its tax base is set to be the same as its
carrying amount.
This results in a nil temporary difference and prevents the recognition of
deferred tax on this asset.
This sounds rather complicated but just remember that it is a mechanism to
exclude non-taxable items from the consideration of deferred tax (even though
the definition might have included them).
Remember this: there is no deferred tax to recognise on items that are not
taxed or for which no tax relief is given.

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Closing comment
Accounting for deferred taxation restores the relationship that should exist
between the profit before tax in the financial statements, the tax rate and the tax
charge. In earlier examples we saw that after accounting for deferred tax the tax
expense (current and deferred tax) was equal to the tax rate u the accounting
profit before tax.
This will not be the case if there are permanent differences.

4.4 Measurement of deferred tax balances

Discounting
Deferred tax assets and liabilities must not be discounted.
Tax rates
Deferred tax assets and liabilities 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, based on tax rates (and tax laws) that have been enacted or
substantively enacted by the end of the reporting period.
Manner of settlement
Deferred tax balances must be measured in a way that reflects the tax
consequences that would follow from the manner in which the entity expects to
recover or settle the carrying amount of its assets and liabilities.
For example, the tax rate that applies might depend on whether an asset is used
to generate profits or is sold. The tax rate used would depend on how the asset is
expected to be recovered in the future.
In addition to this general guidance, IAS 12 also provides specific guidance as
follows:

Deferred tax balances arising from the revaluation of a non-depreciable

asset (IAS 16) must be measured to reflect the tax consequences of
recovering its carrying amount through sale.

There is a rebuttable presumption that the carrying amount of an

investment property will be recovered through sale when it is measured
using the IAS 40 fair value model.

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DEFERRED TAX: BUSINESS COMBINATIONS

Section overview

Introduction
Revaluation of assets/liabilities in the fair value exercise

Unremitted earnings of group companies

Unrealised profit adjustments

Change in recoverability of parents deferred tax asset due to an acquisition

5.1 Introduction
Additional deferred tax items need to be considered in preparing group accounts,
because new sources of temporary differences arise:

revaluation of assets/liabilities in the fair value exercise;

unremitted earnings of group companies;

unrealised profit adjustments.

5.2 Revaluation of assets/liabilities in the fair value exercise

When a parent company makes an acquisition, it must perform a fair value
exercise on the assets and liabilities of the entity it has acquired. This will result
in a change in the carrying value of some of the assets and liabilities. However,
the tax base will not be affected, as this is based on the original cost.
Temporary differences arise for all the revalued assets and liabilities
Double entry
The deferred tax is recognised automatically during the consolidation process.
There is no need to make a specific double entry.
Example: Fair value exercise and deferred tax
P Ltd acquires a 100% subsidiary on 31 December 20X6.for Rs. 600,000.
The subsidiarys deferred taxation position at the date of acquisition was as
follows:
Book value

Tax base

Temporary
differences

Rs. 000

Rs. 000

Rs. 000

Property, plant and equipment

180

150

30

Accounts receivable

210

210

Inventory

124

124

(120)

(120)

Pension liability
Accounts payable
Temporary differences

30

Deferred tax at 30%

P Ltd carries out a fair value exercise.

The deferred tax balance must be recomputed to take account of the fair
value differences as follows:

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Fair value

Tax base

Temporary
differences

Rs. 000

Rs. 000

Rs. 000

Property, plant and equipment

270

150

120

Accounts receivable

210

210

Inventory

174

124

50

Pension liability

(30)

(30)

(120)

(120)

Accounts payable
Fair value of net assets

504

Temporary differences

140

Deferred tax at 30%

42

The deferred tax balance of Rs. 9,000 must be increased to Rs. 42,000
in the consolidation workings.
Goodwill is calculated as follows:
Rs. 000
Cost of investment

600

Fair value of net assets acquired (as in the

statement of financial position)

504

Deferred tax arising on fair value exercise

(42)
(462)

Goodwill on acquisition

138

5.3 Unremitted earnings of group companies

When a company acquires a subsidiary or associate, it acquires a right to receive
dividends out of its accumulated profits. A temporary difference arises on the
profits of the subsidiary or associate that have not been distributed to the parent
as at the date of consolidation. For clarity, this is the parents share of the
subsidiarys post acquisition retained profit.
IAS 12 requires that a deferred tax liability be recognised for these undistributed
earnings, because they will attract tax when the dividends are paid to the parent
in the future.
However, deferred taxation is not recognised on such amounts when:

the parent is able to control the timing of the reversal of the temporary
difference (i.e. the timing of when the dividend is paid); and

it is probable that the temporary difference will not reverse in the future (i.e.
there is no intention to instigate the payment of a dividend).

In practice, it is unusual to see companies recognising deferred tax liability for

undistributed profits of a subsidiary because of the above rule.
The situation for investments in associates is different because the parent is
unlikely to control the timing of the reversal of the temporary difference.
Recognition of deferred tax liability for undistributed profits of associates is quite
common.

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5.4 Unrealised profit adjustments

Where inter-company trading takes place between group companies and the
inventory is still held by the group at the year end, an adjustment is made in the
group accounts because the profit has not been realised outside of the group.
However, tax is charged on the profits of the individual companies, not on the
group as a whole. The profit on intra-group sales will therefore be subjected to
tax, and this will create a temporary difference.
The issue to resolve is whose tax rate should be used when providing for the
deferred tax on this temporary difference the sellers or the buyers? IAS 12
requires that deferred tax be provided at the buyers rate of tax.

5.5 Change in recoverability of parents deferred tax asset due to an acquisition

A parent company may have a deferred tax asset that it has not recognised as it
does not believe it probable that taxable profits will be available against which the
asset can be used.
The probability of realising a pre-acquisition deferred tax asset of the acquirer
could change as a result of a business combination.
For example, the acquirer may be able to utilise the benefit of its unused tax
losses against the future taxable profit of the acquiree.
In such cases, the parent company should recognise the change in the deferred
tax asset in the period of the business combination. This does not affect the
goodwill calculation.

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PRESENTATION AND DISCLOSURE

Section overview

Presentation
Disclosure

6.1 Presentation
IAS 12: Income taxes contains rules on when current tax liabilities may be offset
against current tax assets
Offset of current tax liabilities and assets
A company must offset current tax assets and current tax liabilities if, and only if,
it:

has a legally enforceable right to set off the recognised amounts; and

intends either to settle on a net basis, or to realise the asset and settle the
liability simultaneously.

These are the same rules as apply to assets and liabilities in general as
described in IAS 1.
In the context of taxation balances whether a current tax liability and asset may
be offset is usually specified in tax law, thus satisfying the first criterion.
In most cases, where offset is legally available the asset would then be settled on
a net basis (i.e. the company would pay the net amount).
Offset of deferred tax liabilities and assets
A company must offset deferred tax assets and deferred tax liabilities if, and only
if:

the entity has a legally enforceable right to set off current tax assets against
current tax liabilities; and

the deferred tax assets and the deferred tax liabilities relate to income
taxes levied by the same taxation authority on either:
x

the same taxable entity; or

different taxable entities which intend either to settle current tax

liabilities and assets on a net basis, or to realise the assets and settle
the liabilities simultaneously, in each future period in which significant
amounts of deferred tax liabilities or assets are expected to be settled
or recovered.

The existence of deferred tax liability is strong evidence that a deferred tax asset
from the same tax authority will be recoverable.
Example: Offset of deferred tax liabilities and assets
The following deferred tax positions relate to the same entity:
Deferred tax liability
Deferred tax asset

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12,000
(8,000)

Situation 2
5,000
(8,000)

4,000

(3,000)

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In situation 1, the financial statements will report the net position as a liability of
4,000. The existence of the liability indicates that the company will be able to
recover the asset, so the asset can be set off against the liability.
In situation 2, setting off the asset against the liability leaves a deferred tax asset
of 3,000. This asset may only be recognised if the entity believes it is probable that
it will be recovered in the foreseeable future.

6.2 Disclosure
Components of tax expense (income)
The major components of tax expense (income) must be disclosed separately.
Components of tax expense (income) may include:

current tax expense (income);

any adjustments recognised in the period for current tax of prior periods;

the amount of deferred tax expense (income) relating to the origination and
reversal of temporary differences;

the amount of deferred tax expense (income) relating to changes in tax

rates or the imposition of new taxes;

the amount of the benefit arising from a previously unrecognised tax loss,
tax credit or temporary difference of a prior period that is used to reduce
current tax expense;

deferred tax expense arising from the write-down, or reversal of a previous

write-down, of a deferred tax asset;

the amount of tax expense (income) relating to those changes in

accounting policies and errors that are included in profit or loss in
accordance with IAS 8, because they cannot be accounted for
retrospectively.

Illustration: Note to the statement of comprehensive income

Taxation expense
Current tax
Adjustment for over estimate of tax in prior year

Rs.
129,000
(5,000)

Deferred taxation
Arising during the period

20,000

Due to change in tax rate

(5,000)
15,000
139,000

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Example: Change in rate

31 December 2015
Profits were taxed at 30%.
A Limited recognised a deferred tax liability of Rs. 30,000 (it had temporary
differences of Rs. 100,000).
31 December 2016
The tax rate changed to 25% during the year.
At the year- end A Limited carried out the following deferred tax calculation:
Carrying
Temporary
amount
Tax base
difference
Rs.
Non-current assets

1,000,000

Rs..

Rs.

820,000

180,000

Deferred tax at 25%

45,000

The movement on the deferred tax liability would be shown as follows:

Rs.
Deferred taxation b/f

30,000

Statement of comprehensive income: Rate change (5/30 u

30,000)

(5,000)

Deferred taxation b/f restated

25,000

Statement of comprehensive income (balancing figure due

to the origination of temporary differences in the period)

20,000

Deferred taxation balance at the end of the year (working)

45,000

Journal:
Income statement (tax expense)

Debit

Income statement (tax expense)

20,000

Deferred tax liability

Credit
5,000
15,000

Tax reconciliation
The following must also be disclosed:

an explanation of the relationship between tax expense (income) and

accounting profit in either or both of the following forms:
x

a numerical reconciliation between tax expense (income) and the

product of accounting profit multiplied by the applicable tax rate(s),
disclosing also the basis on which the applicable tax rate(s) is (are)
computed; or

a numerical reconciliation between the average effective tax rate and

the applicable tax rate, disclosing also the basis on which the
applicable tax rate is computed;

an explanation of changes in the applicable tax rate(s) compared to the

previous accounting period;

A major theme in this chapter is that the different rules followed to calculate
accounting profit and taxable profit lead to distortion of the relationship that exists

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between profit before tax in the financial statements, the tax rate and the current
tax expense for the period. Accounting for deferred tax corrects this distortion so
that after accounting for deferred tax the tax expense (current and deferred tax)
was equal to the tax rate u the accounting profit before tax.
This is not the case if there are permanent differences. The above reconciliations
show the effect of permanent differences.
Instances of when permanent differences may arise:

Exempt Income e.g. capital gains

Non-Allowable expense e.g. penalties

Income taxable at lower or higher rates e.g. dividend income

Include example of Dividend

Example: Tax reconciliations
B Limited had an accounting profit before tax of Rs. 500,000.
This contained income of Rs. 20,000 which is not taxable.
Accounting depreciation in the year was Rs. 100,000 and tax allowable
depreciation was Rs. 150,000. This means that a temporary difference of Rs.
50,000 originated in the year.
B Limiteds taxation computation is as follows:
Rs.
Accounting profit
500,000
Add back inadmissible deductions
Depreciation
100,000
Deduct admissible deduction
Income not taxed
(20,000)
Assessable profit
580,000
Tax allowable depreciation
(150,000)
Taxable profit
430,000
Tax at 30%

129,000

Tax expense
Current tax

129,000

Deferred taxation (30% u Rs. 50,000)

Tax expense

15,000
144,000

Tax reconciliation (in absolute numbers)

Accounting profit
Applicable tax rate

500,000
30%

Accounting profit u the applicable tax rate

Tax effect of untaxed income (30% of Rs. 20,000)
Tax expense

150,000
(6,000)
144,000

Tax reconciliation (in percentages)

Applicable tax rate
Tax effect of untaxed income (6,000/500,000)
Effective tax rate (144,000/500,000)

30.0%
(1.2%)
28.8%

Note: this difference arises only when there are permanent differences

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Other disclosures
The following must also be disclosed separately:

the aggregate current and deferred tax relating to items recognised directly
in equity;

the amount of income tax relating to each component of other

comprehensive income;

details (amount and expiry date, if any) of deductible temporary differences,

unused tax losses, and unused tax credits for which no deferred tax asset
is recognised;

the aggregate amount of temporary differences associated with

investments in subsidiaries, branches and associates and interests in joint
arrangements, for which deferred tax liabilities have not been recognised;

in respect of each type of temporary difference, and in respect of each type

of unused tax losses and unused tax credits:

the amount of the deferred tax assets and liabilities recognised in the
statement of financial position for each period presented;

the amount of the deferred tax income or expense recognised in profit

or loss if not apparent from the changes in the amounts recognised in
the statement of financial position;

in respect of discontinued operations, the tax expense relating to:

x

the gain or loss on discontinuance; and IAS 12

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;

the amount of income tax consequences of dividends to shareholders

proposed or declared before the financial statements were authorised for
issue, but are not recognised as a liability in the financial statements;

the amount of any change recognised for an acquirers pre-acquisition

deferred tax asset caused by a business combination; and

the reason for the recognition of a deferred tax benefits acquired in a

business combination recognised at the acquisition date but not recognised
at the acquisition date.

the amount of a deferred tax asset and the nature of the evidence
supporting its recognition, when:
x

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; and

the entity has suffered a loss in either the current or preceding period
in the tax jurisdiction to which the deferred tax asset relates.

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Practice questions
XYZ Limited had an accounting profit before tax of Rs. 90,000 for the year
ended 31st December 2016. The tax rate is 30%.
The following balances and information are relevant as at 31st December
2016.
Non--current assets
Property
Plant and machinery
Assets held under finance lease

Rs.
63,000

Rs.

100,000

90,000

1
2

80,000

Trade receivables

73,000

Interest receivable
Payables

1,000

Receivables:

Fine

10,000

Finance lease obligation

85,867

3,300

Interest payable

Note 1:: The property cost the company Rs. 70,000 at the start of the year. It
is being depreciated on a 10% straight line basis for accounting purposes.
The companys tax advisers have said that the company can claim Rs.
42,000 accelerated depreciation as a taxable expense in this years tax
computation.
Note 2: The balances in respect of plant and machinery are after providing
for accounting depreciation of Rs. 12,000 and tax allowable depreciation of
Rs. 10,000 respectively.
Note 3:: The asset held under the finance lease was acquired during the
period.
The tax code does not distinguish between finance leases and operating
leases. Rental expense for leases is tax deductible. The annual rental for
the asset is Rs. 28,800 and was paid on 31st December 2017.
Note 4: The receivables figure is shown net of an allowance for doubtful
balances of Rs. 7,000. This is the first year that such an allowance has been
recognised. A deduction for debts is only allowed for tax purposes when the
debtor enters liquidation.
Note 5: Interest income is taxed and interest expense is allowable on a cash
basis. There were no opening balances on interest receivable and interest
payable.
a.

Prepare a tax computation and calculate the current tax expense.

b.

Calculate the deferred tax liability required as at 31 December 2016

6.

c.

Show the movement on the deferred tax account for the year ended 31
December 2016 given that the opening balance was Rs. 3,600 Cr.
Prepare a note showing the components of the tax expense for the period.

d.
e.

Prepare a reconciliation between the tax expense and the product of the
accounting profit multiplied by the applicable rate.

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SOLUTIONS TO PRACTICE QUESTIONS

Solution: Tax computation for the year ended 31 December 2016
Rs.
Accounting profit
Add back inadmissible expenses
Depreciation on property
Depreciation of plant and machinery
Depreciation of asset held under finance lease
Finance charge re finance lease
Increase in provision for doubtful debts
Interest payable accrual
Fine
Less admissible deductions
Interest income
Tax allowable depreciation on property
Tax allowable depreciation on plant and
machinery
Lease rentals

7,000
12,000
20,000
14,667
7,000
3,300
10,000

1a
a
Rs.
90,000

73,967

1,000
42,000
10,000
28,800

Tax 30%

(81,800)
82,167
24,650

Solution: Deferred tax liability as 31 December 2016

Property
Plant and machinery
Assets held under finance lease
Finance lease obligation
Trade receivables
Interest receivable
Fine
Interest payable

Carrying
value
Rs.
63,000
100,000
80,000
(85,867)
(5,867)
73,000
1,000
(10,000)
(3,300)

1b
Tax base
Rs.
28,000
90,000
nil
nil
nil
80,000
nil
(10,000)
nil

Deferred tax @ 30%

Temporary
differences
46,000
(16,167)

Deferred tax liabilities

Deferred tax assets

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Temporary
difference
Rs.
35,000
10,000
80,000
(85,867)
(5,867)
(7,000)
1,000

(3,300)
29,833
8,950
Deferred
tax @ 30%
13,800
(4,850)
8,950

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Solution: Movement on the deferred tax account for the year ended 31 December
2016..
Rs.
Deferred tax as at 1st January 2016
3,600
Statement of comprehensive income (balancing figure)
5,350
Deferred tax as at 31st December 2016

8,950

Solution: Components of tax expense for the year ended 31 December 2016.

Current tax expense (see part a)

Deferred tax (see part c)

Rs.
24,650
5,350

Tax expense

30,000

Solutions: Tax reconciliation for the year ended 31 December 2016.

Accounting profit
Tax at the applicable rate (30%)

27,000

Tax effects of expenses that are not deductible in determining

taxable profit
Fines
Tax expense

1d

1e
Rs.
90,000

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

19

Business combinations
and consolidation
Contents
1 The nature of a group and consolidated accounts
2 IFRS 10: Consolidated financial statements
3 Proposed amendments
4 IFRS 3: Business combinations
5 Consolidation technique
6 Accounting for goodwill

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A1

Presentation of financial statements (IAS 1)

A3

IFRS 10: Consolidated financial statements

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 4

IFRS 3: Business combinations

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THE NATURE OF A GROUP AND CONSOLIDATED ACCOUNTS

Section overview

International accounting standards and group accounts

Location of accounting rules

The nature and purpose of consolidated financial statements

1.1 International accounting standards and group accounts

The following standards relate to accounting for investments:

IFRS 10 Consolidated financial statements

IAS 27 Separate financial statements

IAS 28 Investments in associates and joint ventures

IFRS 11 Joint Arrangements

IFRS 3 Business combinations

IAS 1 and group accounts

IAS 1 requires that financial statements distinguish between:

profit or loss for the period;

other comprehensive income, which consists of gains or losses that are not
reported in profit or loss such as gains on asset revaluations;

transactions between the entity and its owners in their capacity as owners,
which are called equity transactions and reported in the statement of
changes in equity.

This applies to consolidated accounts (group accounts).

1.2 Location of accounting rules

IFRS 3 defines a business combination as a transaction or other event in which
an acquirer obtains control of one or more businesses.
IFRS 10 explains that a business under the control of another is a subsidiary and
the controlling entity is the parent.
IFRS 10 defines consolidated financial statements as the financial statements of
a group in which the assets, liabilities, equity, income, expenses and cash flows
of the parent and its subsidiaries are presented as those of a single economic
entity. This means that groups must present their financial statements in the form
of consolidated accounts.
Guidance on the process of consolidation is set out in two standards, IFRS 3
Business Combinations and IFRS 10 Consolidated Financial Statements.
IFRS 3 is largely about the initial accounting for a new investment, setting out the
rules on the calculation of goodwill.

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IFRS 10 covers the on-going rules related to consolidation. It is IFRS 10 that

requires:

that the financial statements of P and S be prepared using uniform

accounting policies;

the consolidated assets, liabilities, income and expenses are those of the
parent and its subsidiaries added on a line by line basis;

the elimination of unrealised profit on intra group transactions; and

the cancellation of intra group balances.

Changes of ownership
IFRS 3 explains how to account for further investments in a subsidiary after
control has been achieved. These are called step acquisitions.
IFRS 10 explains how to account for disposals.

1.3 The nature and purpose of consolidated financial statements

A subsidiary is usually acquired through the purchase of a controlling interest in
its equity. The parent makes a long-term investment in the subsidiary. In the
statement of financial position of the parent, there is a non-current asset:
Investment in subsidiary, at cost
Sometimes, a parent company has no assets at all except shares in the
subsidiaries in the group. A parent whose main assets (or only assets) are
shares in subsidiaries is sometimes called a holding company.
When a large part of the assets of a parent company consists of investments in
subsidiaries, it is difficult for the users of the financial statements of the parent to
understand anything about its financial position or financial performance. To find
out meaningful information about their investment, users of the parents financial
statements need to know about the financial position and performance of the
operating subsidiaries.
The purpose of consolidated accounts is to provide financial statements that
have meaning and relevance to users.
When a parent acquires a subsidiary, both the parent and the subsidiary remain
legally separate entities. However, in practice they operate as if they were one
organisation. Consolidated financial statements reflect the reality (or substance)
of the situation: the group is a single economic unit.
Consolidated financial statements are the financial statements of a group in
which the assets, liabilities, equity, income, expenses and cash flows of the
parent and its subsidiaries are presented as those of a single economic entity.

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IFRS 10: CONSOLIDATED FINANCIAL STATEMENTS

Section overview

Introduction to IFRS 10

Situations where control exists

The requirement to prepare consolidated accounts

2.1 Introduction to IFRS 10

IFRS 10 establishes principles for the presentation of consolidated financial
statements when an entity controls one or more other entities
Definitions: Group, parent and subsidiary
Group: A parent and its subsidiaries
Parent: An entity that controls one or more entities.
Subsidiary: An entity that is controlled by another entity.
A group consists of a parent entity and one or more entities that it has control
over. These are called subsidiaries.
The entity that ultimately controls all the entities in the group is called the parent.
Some parent companies have no assets at all except shares in the subsidiaries
of the group. A parent whose main assets (or only assets) are shares in
subsidiaries is sometimes called a holding company.
Control
An entity is a subsidiary of another entity if it is controlled by that other entity.
IFRS 10 contains a principles based definition of control.
Definition: Control
An investor controls an investee when:
a. it is exposed, or has rights, to variable returns from its involvement with the
investee; and
b. it has the ability to affect those returns through its power over the investee.
In other words an investor controls an investee, if and only if, it has all the
following:

power over the investee;

exposure, or rights, to variable returns from its involvement with the

investee; and

ability to use its power over the investee to affect the amount of its returns

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2.2 Situations where control exists

The above definition of control is quite complicated.
In practice, the vast majority of cases involve a company achieving control of
another through buying a controlling interest in its shares.
Furthermore, in the vast majority of cases obtaining a controlling interest means
buying shares which give the holder more than 50% of the voting rights in the
other company.
Illustration: Wholly owned subsidiary
A owns 100% of Bs voting share capital.
A
100%
B

This 100% holding is described as a controlling

interest and gives A complete control of B.
B would be described as a wholly owned
subsidiary.

A company does not have to own all of the shares in another company in order to
control it.
Illustration: Partly owned subsidiary
A owns 80% of Bs voting share capital.
A
80%
B

This 80% holding is described as a controlling

interest and gives A complete control of B.
B would be described as a partly owned
subsidiary.
Other parties own the remaining 20% of the
shares. They have an ownership interest in B but
do not have control.
This is described as a non-controlling interest.
Non-controlling interest (NCI) is defined by IFRS
10 as: the equity in a subsidiary not attributable
to a parent.

Control is assumed to exist when the parent owns directly, or indirectly through
other subsidiaries, more than half of the voting power of the entity, unless in
exceptional circumstances it can be clearly demonstrated that such control does
not exist.

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Illustration:
A
60%
B
70%

A owns a controlling interest in B.

B owns a controlling interest in C.
Therefore, A controls C indirectly through its
ownership of B.
C is described as being a sub-subsidiary of A.

In certain circumstances, a company might control another company even if it

owns shares which give it less than half of the voting rights. Such a company is
said to have de facto control over the other company. (De facto is a Latin phrase
which translates as of fact. It is used to mean in reality or to refer to a position
held in fact if not by legal right).
Illustration: Wholly owned subsidiary
A owns 45% of Bs voting share capital.
The other shares are held by a large number of unrelated investors none of whom
individually own more than 1% of B.
A
45%
B

This 45% holding probably gives A complete

control of B.
It would be unlikely that a sufficient number of
the other shareholders would vote together to
stop A directing the company as it wishes.

A company might control another company even if it owns shares which give it
less than half of the voting rights because it has an agreement with other
shareholders which allow it to exercise control.
Illustration: Wholly owned subsidiary
A owns 45% of Bs voting share capital.
A further 10% is held by As bank who have agreed to use their vote as directed by
A.
A
45%

This 45% holding together with its power to use

the votes attached to the banks shares gives A
complete control of B.

It was stated above but is worth emphasising that in the vast majority of cases
control is achieved through the purchase of shares that give the holder more than
50% of the voting rights in a company.

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Two or more investors collectively control an investee when they must act
together to direct the relevant activities. If this is the case, no investor can direct
the activities without the co-operation of the others so no investor individually
controls the investee and it is not a subsidiary. Each investor must account for its
interest in accordance with the relevant IFRSs, such as IFRS 11 Joint
Arrangements, IAS 28 Investments in Associates and Joint Ventures or IFRS 9
Financial Instruments.
Power
An investor has power over an investee when it has existing rights that give it the
current ability to direct the relevant activities (the activities that significantly affect
the investees returns). This power does not necessarily have to be exercised. As
long as the rights exist, all other things being equal, the investee is a subsidiary.
Power arises from rights.

Assessing power is often straightforward for example when power arises

through holding more than 50% of voting rights; or

Assessing power might be more complex, for example:

x

when power results from one or more contractual arrangements; or

when power is due to a dominant but not majority shareholding.

Only substantive rights are taken into account. Substantive rights are rights that
an investor has the practical ability to exercise. Usually such rights must be
currently exercisable so that the entity is in a position to direct the relevant
activities of the other entity. However sometimes rights might be substantive,
even though they are not currently exercisable.
Example: Substantive rights
S Ltd. is an investee company.
Policies over the relevant activities can be changed only at special or scheduled
shareholders meetings. This includes the approval of material sales of assets as
well as the making or disposing of significant investments.
S Ltd. holds annual shareholder meetings at which decisions to direct the
relevant activities are made. The next scheduled shareholders meeting is in eight
months.
Shareholders that individually or collectively hold at least 5% of the voting rights
can call a special meeting to change the existing policies over the relevant
activities with 30 days notice.
X Ltd holds a majority of the voting rights in S Ltd. Are these rights substantive?

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Answer
The rights are substantive and S Ltd is a subsidiary of X Ltd.
X Ltd is able to make decisions about the direction of the relevant activities when
they need to be made. The fact that it takes 30 days before it can exercise its
voting rights does not stop it from having the current ability to direct the relevant
activities.

Example: Substantive rights

B Ltd is an investee company (with the same fact pattern as for S Ltd above).
A Ltd holds an option, which if exercised, would give it ownership of shares with
more than 50% of the voting rights of B Ltd. This option is exercisable in 25 days
and is deeply in the money.
Is B Ltd a subsidiary of A Ltd?

Answer
The option contract is a substantive right that gives A Ltd the current ability to
direct the relevant activities of B Ltd.
A Ltd has rights that are essentially equivalent to those of a majority shareholder
in that it can make decisions about the direction of the relevant activities when
they need to be made.
The fact that it takes 30 days before it can exercise its votes does not stop it from
having the current ability to direct the relevant activities.
B Ltd is a subsidiary of A Ltd.

2.3 The requirement to prepare consolidated accounts

Definition
Consolidated financial statements: The financial statements of a group in which
the assets, liabilities, equity, income, expenses and cash flows of the parent and
its subsidiaries are presented as those of a single economic entity
All parents?
An entity that is a parent must present consolidated financial statements.
There is an exception to this rule. A parent need not present consolidated
financial statements if (and only if) it meets all of the following conditions:

The parent itself (X) is a wholly-owned subsidiary, with its own parent (Y).

Alternatively, the parent (X) is a partially-owned subsidiary, with its own

parent (Y), and the other owners of X are prepared to allow it to avoid
preparing consolidated financial statements.

The parents debt or equity instruments are not traded in a public market.

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The parent does not file its financial statements with a securities
commission for the purpose of issuing financial instruments in a public
market.

The parents own parent, or the ultimate parent company (for example, the
parent of the parents parent), does produce consolidated financial
statements for public use that comply with International Financial Reporting
Standards.

All subsidiaries?
Consolidated financial statements should include all the subsidiaries of the parent
from the date at which control is achieved to the date upon which control is lost.
A question might explain that a parent does not wish to consolidate a subsidiary
but it would usually have to do so. The following might be given as spurious
justification for failing to consolidate a particular subsidiary:

The subsidiarys activities are dissimilar from those of the parent, so that
the consolidated financial statements might not present the groups
financial performance and position fairly.

Obtaining the information needed would be expensive and time-consuming

and might delay the preparation of the consolidated financial statements.

The subsidiary operates under severe long term restrictions, so that the
parent is unable to manage it properly. For example, a subsidiary might be
located in a country badly disrupted by a war or a revolution. However, note
that if the parent loses control then the investee is no longer a subsidiary
and should not be consolidated.

Sometimes a group is acquired and the new parent intends to sell one of the new
subsidiaries. In this case the subsidiary is accounted for as discontinued
operation according to the rules in IFRS 5. This means that all of its assets and
all of its liabilities are included as separate lines on the face of the statement of
financial position and the group share of its profit (or loss) is shown as a separate
line on the face of the statement of profit or loss.
Investment entities exemption
Under normal rules a parent must consolidate all controlled entities.
However, an investment entity might take shares in another entity in order to
make gains through dividends or capital appreciation, not to become involved in
business of that entity. Furthermore, an investment entity might hold shares in a
diverse range of businesses in very different sectors.
These rules apply to an entity whose business activity is primarily investing
activity for example, venture capitalists, unit trusts and mutual funds. Some
investments of such entities may result in control.
An investment entity must not consolidate the entities that it controls but it must
measure them at fair value through profit or loss in accordance with IFRS 9
Financial Instruments.
An entity is an investment entity only if it meets all of the following criteria:

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Its only substantive activities are investing in multiple investments for

capital appreciation, investment income (dividends or interest), or both.

It has made an explicit commitment to its investors that its purpose of

investment is to earn capital appreciation, investment income (dividends or
interest), or both.

Ownership in the entity is represented by units of investments, such as

shares or partnership interests, to which proportionate shares of net assets
are attributed.

The funds of its investors are pooled so that they can benefit from
professional investment management.

It has investors that are unrelated to the parent (if any), and in aggregate
hold a significant ownership interest in the entity.

Substantially all of the investments of the entity are managed, and their
performance is evaluated, on a fair value basis.

It provides financial information about its investment activities to its

investors.

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PROPOSED AMENDMENTS
Section overview

ED/2014/2: Investment entities: Applying the consolidation exemption

ED/2014/4: Measuring quoted investments in subsidiaries, joint ventures and
associates at fair value

3.1 ED/2014/2: Investment entities: Applying the consolidation exemption

Exemption from presenting consolidated financial statements
IFRS 10 provides an exemption from presenting consolidated financial
statements for a parent entity that meets specified criteria. One criterion is that its
ultimate or any intermediate parent produces consolidated financial statements
that are available for public use and comply with IFRS.
The ED proposes to amend IFRS 10 to confirm that the exemption from
preparing consolidated financial statements is also available to a parent entity
that is a subsidiary of an investment entity, even when the investment entity
measures its subsidiaries at fair value in accordance with paragraph 31 of IFRS
10.
Example: Proposed clarification on exemption from presenting consolidated
financial statements
A owns 100% of B
B owns 100% of C
B is exempt from preparing group accounts (in which it consolidates C) if its
ultimate parent produces consolidated financial statements that are available for
public use and comply with IFRS (subject to meeting other criteria).
If A were an investment entity it cannot consolidate B but must measure it at fair
value through profit or loss.
The ED proposes that in this case B would still not need to consolidate C.
Investment entities
IFRS 10 requires an investment entity to measure its investments in subsidiaries
at fair value. However, IFRS 10 requires an investment entity to consolidate a
subsidiary that provides services that relate to the investment entitys investment
activities.
When a subsidiary of an investment entity itself meets the definition of an
investment entity and, additionally, provides services that relate to the parents
investment activities, it is unclear as to whether the investment entity parent
should measure that investment entity subsidiary at fair value or consolidate it.
The ED proposes to amend IFRS 10 to say that the requirement for an
investment entity to consolidate a subsidiary, instead of measuring it at fair value,
applies only to those subsidiaries that act as an extension of the operations of the
investment entity parent, and do not themselves qualify as investment entities.

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The ED proposes to limit the need for an investment entity to consolidate

subsidiaries that provide services to those who are not themselves investment
entities and whose main purpose is to provide services to the parent.
Example: Investment entities
Situation 1
A owns 100% of B
A is an investment entity
A is not allowed to consolidate B but must measure its interest at fair value
through profit or loss.

Situation 2
A owns 100% of B
A is an investment entity
B provides services to A that relate to As investment activities.
A must consolidate B.

Situation 3
A owns 100% of B
Both A and B are investment entities
B provides services to A that relate to As investment activities.
The proposal is that A must not consolidate B but must measure its interest at
fair value through profit or loss.
Consolidation of investment entities
IFRS 10 states that a non-investment entity parent of an investment entity cannot
retain the fair value measurement applied by the investment entity to its interests
in subsidiaries. That non-investment entity parent must instead consolidate all
subsidiaries in the group.
Example: Consolidation of investment entities
A owns 100% of B
B owns 100% of C
B is an investment entity
B must not consolidate C but must measure it at fair value through profit or loss.

A is not allowed to retain this treatment in its consolidated financial statements.

It must consolidate B and C in the usual way.
IAS 28 does not contain an equivalent explicit statement related to the application
of the equity method by a non-investment entity investor for its investments in
joint ventures or associates that are investment entities. The ED proposes to
include such a statement.

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Example: Consolidation of investment entities

A owns 40% of B
B owns 100% of C
B is an investment entity
B must not consolidate C but must measure it at fair value through profit or loss.

Proposal: A is not allowed to retain this treatment in its consolidated financial

statements. It must equity account for B and C in the usual way.

3.2 ED/2014/4: Measuring quoted investments in subsidiaries, joint ventures

and associates at fair value
The proposals in the ED clarify that the fair value measurement of quoted
investments in subsidiaries, joint ventures and associates should be the product
of the quoted price (P) multiplied by the quantity of financial instruments held (Q),
or P Q, without adjustments. For example, an entity might argue that the
product should be adjusted to take account of the size of the holding but this
would not be allowed.

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IFRS 3: BUSINESS COMBINATIONS

Section overview

Introduction to IFRS 3
Acquisition method

Goodwill

Cost (consideration transferred)

Acquisition date amounts of assets acquired and liabilities assumed

4.1 Introduction to IFRS 3

Definitions
A business combination is a transaction or other event in which an acquirer
obtains control of one or more businesses.
A business is an integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing a return in the form of
dividends, lower costs or other economic benefits directly to investors or other
owners, members or participants.
Objective of IFRS 3
The objective of IFRS 3 is to improve the relevance, reliability and comparability
of information reported about business combinations and their effects.
It establishes principles and requirements for:

the recognition and measurement of identifiable assets acquired, liabilities

assumed and non-controlling interest in the acquiree;

the recognition and measurement of goodwill (or a gain from a bargain

purchase); and

disclosures that enable users to evaluate the nature and financial effects of
a business combination.

Transactions under common control are not within the scope of IFRS 3.This
means that transfers of ownership of a subsidiary within a group (for example in
group reconstructions) are not subject to the rules in this standard. Companies
engaging in such transactions must develop accounting policies in accordance
with the guidance given in IAS 8.

4.2 Acquisition method

All business combinations are accounted for by the acquisition method which
involves:

identifying the acquirer;

determining the acquisition date;

recognising and measuring the identifiable assets acquired, the liabilities

assumed and any non-controlling interest in the acquiree; and

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recognising and measuring goodwill or a gain from a bargain purchase

Identifying the acquirer

It might be difficult to identify an acquirer:

The acquirer is usually the combining entity whose relative size is

significantly greater than that of the other(s).

In a business combination affected by transferring cash (other assets) or by

incurring liabilities the acquirer is usually the entity that makes the transfer
or incurs the liabilities.

In a business combinations affected by exchange of equity interests the

acquirer is usually the entity that issues equity (however, in a reverse
acquisition the issuing entity is the acquiree).

Also note that the acquirer is usually the entity:

whose owners have the largest portion of the voting rights in the combined
entity;

whose owners have the ability to determine the composition of the

governing body of the combined entity;

whose (former) management dominates the management of the combined

entity;

that pays a premium over the pre-combination fair value of the equity
interests of the others

Determining the acquisition date

Acquisition date is the date on which the acquirer effectively obtains control of the
acquiree.
This generally the closing date (date of transfer of consideration and when net
assets are acquired) but might be before or after this date depending on
circumstances.

4.3 Goodwill
IFRS 3 is largely about the calculation of goodwill.
Definition: Goodwill
Goodwill: An asset representing the future economic benefits arising from other
assets acquired in a business combination that are not individually identified and
separately recognised.

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IFRS 3 sets out the calculation of goodwill as follows:

Illustration: Goodwill
N.B. All balances are as at the date of acquisition.

Consideration transferred (cost of the business combination)

Rs.
X

Non-controlling interest

X
X

The net of the acquisition date amounts of identifiable

assets acquired and liabilities assumed (measured in
accordance with IFRS 3)

Goodwill recognised

The non-controlling interest may be stated as either:

a proportionate share of the identifiable assets acquired and liabilities

assumed; or

at fair value as at the date of acquisition

Issues to address:
IFRS 3 gives guidance on:

cost of a business combination;

recognition and measurement of identifiable assets and liabilities assumed;

and

accounting for goodwill.

4.4 Cost (consideration transferred)

IFRS 3 states that the purchase consideration for an acquisition (business
combination) is the sum of:

the fair values, at the acquisition date, of the assets transferred by the
acquirer, such as cash

the liabilities incurred by the acquirer to the former owners of the acquiree

equity instruments issued by the acquirer in exchange for control of the

acquiree.

The purchase consideration may include some deferred consideration.

When the acquirer issues shares as part of the purchase consideration and the
shares are quoted equity instruments, they are normally valued at their market
price at the acquisition date for the purpose of measuring the
consideration/acquisition cost.
If the consideration includes assets or liabilities of the acquirer carried at amounts
that differ from their fair values at the acquisition date, these are revalued with
gains and losses taken to P&L.

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Consideration includes any asset or liability resulting from a contingent

consideration arrangement:

recognised at acquisition-date fair value; and

classified as a liability or equity on the basis of guidance in IAS 32 or other

applicable IFRSs.

A right to the return of previously transferred consideration is classified as an

asset if specified conditions are met.
Costs of acquisition: transaction costs
Transaction costs incurred in making an acquisition, such as the cost of the fees
of advisers and lawyers, must not be included in the cost of the acquisition.
These costs must be treated as an expense as incurred and written off to profit or
loss.
The amount of transaction costs associated with an acquisition and written off
during the period to profit or loss must be disclosed in a note to the financial
statements.
However, if an entity borrows money to finance an acquisition, the costs
associated with arranging the borrowing are treated in accordance with the rules
of IAS 39. These costs are deducted from the value of the debt and amortised
over the term of the debt using the effective rate of interest (i.e. the amortised
cost method).
Example: Cost of acquisition
Company P acquired 80% of the shares of Company S when the fair value of the
net assets of S was Rs. 800,000.
The purchase price was Rs. 300,000 in cash plus 10,000 new shares in Company
P.
The new shares were to be issued 1 month after the date of acquisition.
The market value of Ps shares at the date of acquisition was Rs.40 each. One
month later the market value had increased to Rs.45.
The costs of making the acquisition were Rs. 80,000.
The cost of the investment in the shares of S = Rs. 300,000 + (10,000 Rs.40 =
Rs. 700,000. The share price at the date of acquisition is used not that at the
date of issue.
The costs of making the acquisition should be written off to profit or loss.
The parent companys share of the net assets of S at the acquisition date was Rs.
640,000 (80% Rs. 800,000). Purchased goodwill attributable to owners of the
parent company is therefore Rs. 60,000 (Rs. 700,000 - Rs. 640,000).
Deferred consideration
Sometimes all or part of the cost of an acquisition is deferred and does not
become payable until a later date.
The amount of any deferred consideration (the amount not payable immediately)
is discounted to its present value at the acquisition date.

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Contingent consideration
Sometimes the final cost of the combination is contingent on (depends on) a
future event. For example, an acquirer could agree to pay an additional amount if
the acquired subsidiarys profits exceed a certain level within three years of the
acquisition.
In a situation such as this, the contingent payment should be included in the cost
of the combination (discounted to present value if the payment will occur more
than 12 months in the future).
Under the rules of IFRS 3, contingent consideration must be recognised at fair
value at acquisition, even if it is not probable that the consideration will actually
have to be paid.
Example: Contingent consideration
Company X purchased 100% of the issued capital of Company S on 1 January
Year 4.
The purchase agreement required Company X to pay Rs. 300,000 in cash
immediately and an additional sum of Rs. 100,000 on 31 December Year 6 if the
earnings of Company S increase at an annual rate of 25% per year in each of the
three years following the acquisition.
How should the contingent payment be recognised in calculating the goodwill
arising at the date of acquisition?

Answer
The contingent consideration should be included in the cost of investment (the
purchase consideration) whether or not it is probable that it will have to be paid.
The contingent consideration of Rs. 100,000 should be measured at fair value.
If it is fairly certain that the contingent consideration will have to be paid, an
appropriate measure of fair value might be the present value of the future
payment, discounted at an appropriate cost of capital. The purchase
consideration is therefore Rs. 300,000 plus the present value of the contingent
(deferred) consideration.
If there is still contingent consideration at the end of an accounting period, it
might be necessary to re-measure it.
If the contingent consideration will be payable in cash, it should be re-measured
to fair value at the end of the reporting period. Any gain or loss on remeasurement should be taken to profit or loss.
If the contingent consideration will take the form of debt, the amount of the debt is
re-measured at fair value at the end of the reporting period and the change in
value is recognised in profit or loss in the period.
If the contingent consideration will take the form of equity, it is not re-measured at
the end of the reporting period. The eventual settlement of the payment will be
accounted for as an equity transaction (i.e. a transaction between the entity and
owners of the group in their capacity as owners).

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A reason for re-measuring the contingent consideration is that the amount

payable might depend on the performance of the subsidiary after its acquisition.
If the profits are higher than expected, the contingent consideration might be remeasured to a higher value, increasing the liability (the contingent payment) and
reducing the reported profit for the period.
Similarly if the profits are lower than expected, the contingent consideration might
be re-measured to a lower value, reducing the liability (the contingent payment)
and increasing the reported profit for the period.
(Note: Under the previous accounting rules, before the introduction of IFRS 3,
any increase in the value of contingent consideration was charged to goodwill.)
Share options given to the previous owners
When an entity acquires a subsidiary that was previously managed by its owners,
the previous owners might be given share options in the entity as an incentive to
stay on and work for the subsidiary after it has been acquired. IFRS 3 states that
the award of share options in these circumstances is not a part of the purchase
consideration. The options are post-acquisition employment expenses and
should be accounted for as share-based payments in accordance with IFRS 2.

4.5 Acquisition date amounts of assets acquired and liabilities assumed

Core principle
An acquirer of a business must recognise assets acquired and liabilities assumed
at their acquisition date fair values and disclose information that enables users to
evaluate the nature and financial effects of the acquisition.
To support this IFRS 3 sets out:

a recognition principle;

classification guidance; with

a measurement principle.

There are specified exceptions to each of these.

Any asset acquired or liability assumed is subsequently measured in accordance
with applicable IFRS. There are also exceptions to this rule.
Recognition principle
An acquirer must recognise (separately from goodwill), identifiable assets
acquired, liabilities assumed and any non-controlling interest in the acquiree as of
the acquisition date.
To qualify for recognition identifiable assets acquired and liabilities assumed
must meet the definitions of assets and liabilities set out in The Conceptual
Framework as at the acquisition date.
This might result in recognition of assets and liabilities not previously recognised
by the acquiree.
When a company acquires a subsidiary, it may identify intangible assets of the
acquired subsidiary, which are not included in the subsidiarys statement of

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financial position. If these assets are separately identifiable and can be measured
reliably, they should be included in the consolidated statement of financial
position as intangible assets, and accounted for as such.
This can result in the recognition of assets and liabilities not previously
recognised by the acquiree.
Illustration: Identifiable asset on acquisition
If a company bought 100% of the Coca-Cola Corporation they would be buying a lot
of assets but part (perhaps the largest part) of the purchase consideration would
be to buy the Coca Cola brand.
Coca Cola does not recognise its own brand in its own financial statements
because companies are not allowed to recognised internally generated brands.
However, as far as the company buying the Coca-Cola Corporation is concerned the
brand is a purchased asset. It would be recognised in the consolidated financial
statements and would be taken into account in the goodwill calculation.
Contingent liabilities
Many acquired businesses will contain contingent liabilities such as contingent
liabilities for the settlement of legal disputes or for warranty liabilities. IFRS 3
states that contingent liabilities should be recognised at acquisition even if it is
not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation.
The contingent liabilities should be measured at fair value at the acquisition date.
(Contingent assets are not recognised).
Restructuring costs
An acquirer should not recognise a liability for the cost of restructuring a
subsidiary or for any other costs expected to be incurred as a result of the
acquisition (including future losses).
This is because a plan to restructure a subsidiary after an acquisition cannot be a
liability at the acquisition date. For there to be a liability (and for a provision to be
recognised) there must have been a past obligating event. This can only be the
case if the subsidiary was already committed to the restructuring before the
acquisition.
This means that the acquirer cannot recognise a provision for restructuring or
reorganisation at acquisition and then release it to profit and loss in order to
smooth profits or reduce losses after the acquisition.
Measurement principle
Identifiable assets acquired and the liabilities assumed are measured at their
acquisition date fair values.
Definition: Fair value
Fair value: The price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement
date.

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The net assets of a newly acquired business are subject to a fair valuation
exercise.
The table below shows how different types of asset and liability should be valued.
Item

Fair value

Marketable
investments

Current market value

Non-marketable
investments

Estimated values that take into consideration features

such as:
(a) price earnings ratios
(b) dividend yield
(c) expected growth rates of comparable investments

Trade and other

receivables

Present values of the amounts to be received. This is

normally the same as the book value. Discounting is not
usually required because amounts are expected to be
received within a few months.

Inventories:
finished goods

Selling price less the sum of:

(a) the costs of disposal, and
(b) a reasonable profit allowance for the selling effort of
the acquirer based on profit for similar finished
goods.

Inventories: work
in progress

Selling price of finished goods less the sum of:

(a) costs to complete,
(b) costs of disposal, and
(c) a reasonable profit for the completing and selling
effort based on profit for similar finished goods.

Inventories: raw
materials

Current replacement costs

Land and buildings

Market value

Plant and
equipment

Normally market value. Use depreciated replacement

cost if market value cannot be used (e.g., because of the
specialised nature of the plant and equipment or because
the items are rarely sold, except as part of a continuing
business).

Intangible assets

As discussed above

Trade and other

payables; longterm debt and
other liabilities.

Present values of amounts to be disbursed in meeting the

liability determined at appropriate current interest rates.
For current liabilities this is normally the same as book
value.

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Exceptions
Note that this table only shows the exceptions to the above principles and
guidance.
Topic

Recognition
principle

Measurement at
acquisition

Measurement at
later dates

Contingent
liability

Defined by IAS
37 and not
recognised.
Contingent
liability due to a
present obligation
is recognised

Fair value

At the higher of
the original
amount and the
amount that
would be reported
under IAS 37.

Income taxes

IAS 12 applies

IAS 12 applies

IAS 12 applies

Employee
benefits

IAS 19 applies

IAS 19 applies

IAS 19 applies

Indemnification
assets

This is a right to
be compensated
by the seller if a
defined
contingency
occurs
Recognition of
the asset mirrors
the recognition of
the liability

Measurement of
the asset mirrors
the recognition of
the liability

Measurement of
the asset mirrors
the recognition of
the liability

Reacquired rights

n/a

Recognised as an
intangible asset
and measured on
the basis of the
remaining
contractual term
of the related
contract
regardless of
whether market
participants would
consider potential
contractual
renewals in
determining its
fair value

The asset
recognised is
amortised over
the over the
remaining
contractual period
of the contract in
which the right
was granted.

Share based
payments

IFRS 2 applies

Assets held for

sale

IFRS 5 applies

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Deferred tax
Deferred income tax assets and liabilities are recognised and measured in
accordance with IAS 12 Income Taxes, rather than at their acquisition-date fair
values.
Measurement period
Initial accounting for goodwill may be determined on a provisional basis and must
be finalised by the end of a measurement period.
This ends as soon as the acquirer receives the information it was seeking about
facts and circumstances that existed at the acquisition date but must not exceed
one year from the acquisition date.
During the measurement period new information obtained about facts and
circumstances that existed at the acquisition date might lead to the adjustment of
provisional amounts or recognition of additional assets or liabilities with a
corresponding change to goodwill.
Any adjustment restates the figures as if the accounting for the business
combination had been completed at the acquisition date.
Classification guidance
Identifiable assets acquired and liabilities assumed must be classified
(designated) as necessary at the acquisition date so as to allow subsequent
application of appropriate IFRS.
The classification is based on relevant circumstances as at the acquisition date
with two exceptions:

classification of a lease contract in accordance with IAS 17 Leases; and

classification of a contract as an insurance contract in accordance with

IFRS 4 Insurance Contracts.

Classification in these cases is based on circumstances at the inception of the

contract or date of a later modification that would change the classification.

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CONSOLIDATION TECHNIQUE
Section overview

The basic approach

Practice questions

5.1 The basic approach

Suggested step by step approach to the preparation of consolidated statements of
financial position
To prepare a consolidated statement of financial position as at the acquisition
date, the following steps should be taken.
Step 1: Establish the group share (parent company share) in the subsidiary and
the percentage owned by non-controlling interests.
Step 2: Perform double entry to record any individual company adjustments that
might be necessary. Mark these in the face of the question. The information can
be lifted into workings later so that the marker can understand what you have
done.
Step 3: Set out a pro-forma (skeleton) statement of financial position and fill in
the easy numbers (for example those assets and liabilities that are a straight
cross cast and the share capital)
Step 4: Calculate the net assets of the subsidiary at the acquisition date and at
the end of the reporting period taking into account information about the fair value
of assets at the acquisition date and the existence of any assets not recognised
by the subsidiary that might need to be capitalised for consolidation purposes.
Step 5: Calculate the goodwill
Illustration: Goodwill

Consideration transferred (cost of the business combination)

Non-controlling interest

Rs.
X
X
X

The net of the acquisition date amounts of identifiable

assets acquired and liabilities assumed (measured in
accordance with IFRS 3)

Goodwill recognised

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Step 6: Calculate the non-controlling interest.

Illustration: Consolidated retained earnings
Rs.
NCI at the date of acquisition

NCIs share of the post-acquisition retained earnings of S

NCIs share of each other post-acquisition reserves of S (if any)

NCI at the date of consolidation

Step 7: Calculate consolidated retained earnings.

Possible complications
You should be familiar with the following of possible complications that you may
need to take into account when answering questions:

Before consolidation
x

Measuring the cost of acquisition

Identifying assets not recognised by the subsidiary which need to be

included for consolidation purposes

Performing the fair value exercise

Construct a net assets summary of each subsidiary showing net assets at the
date of acquisition and at the reporting date.

During consolidation
x

Mid-year acquisition consolidation must be from the date of

acquisition so you may need to construct a net assets total for a
subsidiary at a point during the previous year.

Elimination of inter-company balances

Elimination of unrealised profit.

After consolidation
x

Impairment testing goodwill

Accounting for a gain on a bargain purchase.

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5.2 Practice questions

Practice question

P acquired 70% of S on 1 January 20X1 for Rs.450,000

The retained earnings of S were Rs. 50,000 at that date.
It is Ps policy to recognise non-controlling interest at the date of acquisition
as a proportionate share of net assets.
The statements of financial position P and S as at 31 December 20X1 were
as follows:
Assets:

P (Rs.)

S(Rs.)

Investment in S, at cost

450,000

Other assets

500,000

350,000

950,000

350,000

Share capital

100,000

100,000

Retained earnings

650,000

100,000

750,000

200,000

200,000

150,000

950,000

350,000

Equity

Current liabilities

Required
Prepare a consolidated statement of financial position as at 31
December 20X1.

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Practice question

P acquired 70% of S on 1 January 20X1 for Rs.450,000

The retained earnings of S were Rs. 50,000 at that date.
It is Ps policy to recognise non-controlling interest at the date of acquisition
at fair value.
The fair value of the non-controlling interest at the date of acquisition was
Rs. 75,000.
The statements of financial position P and S as at 31 December 20X1 were
as follows:
Assets:

P (Rs.)

S(Rs.)

Investment in S, at cost

450,000

Other assets

500,000

350,000

950,000

350,000

Share capital

100,000

100,000

Retained earnings

650,000

100,000

750,000

200,000

200,000

150,000

950,000

350,000

Equity

Current liabilities

Required
Prepare a consolidated statement of financial position as at 31
December 20X1.

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Practice question

P bought 80% of S 2 years ago.

At the date of acquisition Ss retained earnings stood at Rs. 600,000. The
fair value of its net assets was not materially different from the book value
except for the fact that it had a brand which was not recognised in Ss
accounts. This had a fair value of 100,000 at this date and an estimated
useful life of 20 years.
The statements of financial position P and S as at 31 December 20X1 were
as follows:
P (Rs.)
PP and E

1,800,000

Investment in S

1,000,000

Other assets

Share capital
Retained earnings
Liabilities

S(Rs.)
1,000,000

400,000

300,000

3,200,000

1,300,000

100,000

100,000

2,900,000

1,000,000

200,000

200,000

3,200,000

1,300,000

Required
Prepare a consolidated statement of financial position as at 31
December 20X1.

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Practice question

P bought 80% of S 2 years ago.

At the date of acquisition Ss retained earnings stood at Rs. 600,000 and
the fair value of its net assets were Rs. 1,000,000. This was Rs. 300,000
above the book value of the net assets at this date.
The revaluation was due to an asset that had a remaining useful economic
life of 10 years as at the date of acquisition.
The statements of financial position P and S as at 31 December 20X1
were as follows:
P

Rs.

Rs.

PP and E

1,800,000

Investment in S

1,000,000

Other assets

Share capital
Retained earnings
Liabilities

1,000,000

400,000

300,000

3,200,000

1,300,000

100,000

100,000

2,900,000

1,000,000

200,000

200,000

3,200,000

1,300,000

Required
Prepare a consolidated statement of financial position as at 31
December 20X1.

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Practice question

P acquired 70% of S on 1 January 20X1 for Rs.1,000,000

The retained earnings of S were Rs. 50,000 at that date.
Also, at the date of acquisition S held an item of plant with a carrying
amount of 250,000 less than its fair value. This asset had a remaining
useful life of 10 years as from that date.
It is Ps policy to recognise non-controlling interest at the date of acquisition
as a proportionate share of net assets.
The statements of financial position of P and S as at 31 December 20X1
were as follows:
P (Rs.)

S(Rs.)

Assets:
Investment in S, at cost

1,000,000

Other non-current assets

400,000

200,000

Current assets

500,000

350,000

1,900,000

550,000

100,000

100,000

1,600,000

300,000

1,700,000

400,000

200,000

150,000

1,900,000

550,000

Equity
Share capital
Retained earnings

Current liabilities

Required
Prepare a consolidated statement of financial position as at 31
December 20X1.

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Advanced accounting and financial reporting

ACCOUNTING FOR GOODWILL

Section overview

Accounting for goodwill

Impairment testing of goodwill

6.1 Accounting for goodwill

Positive goodwill - Excess of cost of combination over share of net assets
After initial recognition goodwill is measured at cost less any accumulated
impairment losses.

Goodwill acquired in a business combination is not amortised.

It is tested for impairment annually or more frequently if events or changes

in circumstances indicate that it might be impaired, in accordance with IAS
36, Impairment of Assets.

Gain from a bargain purchase (Negative goodwill)

A bargain purchase is a business combination in which the calculation of goodwill
leads to a negative figure.
When this happens the acquirer must reassess whether it has correctly identified
all of the assets acquired and all of the liabilities assumed and must recognise
any additional assets or liabilities that are identified in that review.
The acquirer must then review the procedures used to measure the amounts this
IFRS requires to be recognised at the acquisition date for all of the following:

the identifiable assets acquired and liabilities assumed;

the non-controlling interest in the acquiree (if any); and

the consideration transferred.

Any amount remaining after applying the above requirements is recognised as a

gain in profit or loss on the acquisition date.
This means that in most cases when a bargain purchase occurs, the negative
goodwill should be added to the consolidated profit for the group for the year.

6.2 Impairment testing of goodwill

Purchased goodwill is not amortised, but must be tested for impairment on an
annual basis. It cannot be tested for impairment directly. It is allocated to one or
more cash generating unit (IAS 36) and then the carrying amount of the cash
generating unit is compared to its recoverable amount.
The following discussion and examples assume that the subsidiary in question is
a cash generating unit (CGU).

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Chapter 19: Business combinations and consolidation

Partial goodwill method (NCI at acquisition measured as a proportionate share of

subsidiarys net assets
Recoverable amount of the CGU is based on the cash flows that its assets are
expected to generate (either through use or sale of the unit). These cash flows
will be a function of all of the assets of the unit including the NCIs share of the
goodwill but this latter figure has not been recognised.
The carrying amount of the CGU is made up of:

the total net assets of the unit (parents interest and NCIs); and

the parents interest in goodwill.

Any comparison of carrying amount to recoverable amount should compare like

to like but the cash flows from the NCIs goodwill contribute to the recoverable
amount but this goodwill is not in the carrying amount. IAS 36 requires a working
that grosses up the carrying amount of the CGUs assets by the NCI share of
goodwill. Note that this is only in a working; it is not part of the double entry.
This notionally adjusted carrying amount is then compared with the recoverable
amount of the unit to determine whether the cash-generating unit is impaired.
Any impairment is charged against the goodwill in the first instance with any
balance writing down other assets in the unit.
Only that part of any impairment loss attributable to the parent is recognised by
the entity as a goodwill impairment loss.
Example: Impairment of goodwill
X Ltd paid Rs. 1,600 for an 80% interest in Y Ltd on 01/01/X1.
On this date Y had identifiable net assets with a fair value of Rs. 1,500.
Goodwill on acquisition:

Rs.

Cost of acquisition
Share of
Rs.1,500)

net

1,600
assets

(80%

Goodwill

(1,200)
400

The following amounts are recognised in the consolidated financial

statements at the date of acquisition:
Rs.
Goodwill

400

Asset

1,500

NCI (20% u 1,500)

300

This cash-generating unit includes goodwill within its carrying amount, so it

must be tested for impairment annually (or more frequently if there is an
indication that it may be impaired).

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31/12/X1 Impairment test

X Ltd estimates that the recoverable amount of Y Ltd is Rs. 1,400.
The net assets of Y Ltd (after fair value adjustments) were still Rs. 1,520.
Carrying amount of Y Ltd::

Goodwill

As at 01/01/X1

Asset

Total

400

1,500

1,900

100

100

500

1,500

2,000

Notional grossing up of goodwill

400 u 20/80

Recoverable amount

(1,520)

Impairment loss

480

The whole loss (480) is covered by the goodwill of 500 but only 80% of this
is in the financial statements. Therefore only 80% of the loss is recognised

Allocation of impairment loss

Goodwill (notional)

Allocation of impairment loss

Notional
write off

X Ltd
share

X Ltd write
off

480

80%

384

Goodwill

Asset

Total

1,500

1,900

As at 31/12/X1

400

Impairment loss

(384)
16

(384)
1,500

1,516

Full goodwill method (NCI at acquisition measured at fair value

This is more straightforward.
If there is a NCI in a cash-generating unit to which goodwill has been allocated,
the carrying amount of that unit is made up of:

both the parents interest and the NCI in the net assets of the unit; and

both the parents interest in goodwill and the NCIs interest in goodwill.

When non-controlling interests are valued by the fair value method, any
impairment in the total goodwill after acquisition should be shared between the
parent company shareholders and the NCI.
It is tempting to allocate the write off of goodwill between the parent and NCI in
proportion to the goodwill attributable to each. However, para C6, Appendix C to

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Chapter 19: Business combinations and consolidation

IAS 36 says that the impairment should be allocated between the parent and the
NCI on the same basis as that on which profit or loss is allocated.
Example: Impairment of goodwill
S has 10 million shares of Rs.1 each in issue. H acquired 80% of these shares at
a price of Rs.11.6 million when the net assets of S were Rs.10 million. Prior to
the acquisition, the shares of S had been trading in the stock market at Rs.1.20
per share.
Suppose that subsequently goodwill is impaired in value by Rs.1.5 million, so that
it is now valued at just Rs. 2,500,000.
The impairment in the goodwill must be attributed to the parent company and
the NCI in the according to the proportions used to allocate profit or loss (80:20).
Goodwill

Purchase consideration
Non-controlling interest
(2m shares @ Rs.1.2)

Total
Rs.000

Parent
Rs.000

11,600

11,600

2,400

NCI
Rs.000

2,400

14,000
Fair value of net assets of subsidiary at
acquisition

(10,000)

(8,000)

(2,000)

Goodwill
Impairment of goodwill:

4,000
(1,500)

3,600
(1,200)

400
(300)

2,500

2,400

100

Note that the impairment is allocated 80:20 not 3,600:400 which might have
been expected.

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

P Group: Consolidated statement of financial position at 31 December 20X1

Assets
Rs.
Goodwill (W3)
345,000
Other assets (500 + 350)
850,000
Total assets
1,195,000
Equity
Share capital (P only)
100,000
Consolidated retained earnings (W4)
685,000
785,000
Non-controlling interest (W2)
60,000
845,000
Current liabilities (200 + 150)
350,000
Total equity and liabilities
1,195,000
Workings:
W1 Net assets summary

Share capital
Retained earnings
Net assets

At date of
consolidation
100,000
100,000
200,000*

At date of
acquisition
100,000
50,000
150,000

W2 Non--controlling interest
NCIs share of net assets at the date of acquisition
(30% u 150,000 (W1))
NCIs share of the post-acquisition retained earnings of S
(30% of 50,000 (W1))
NCIs share of net assets at the date of consolidation

Postacquisition
50,000

Rs.
45,000
15,000
60,000

Alternative working
NCIs share of net assets at the date of consolidation
(30% u 200,000*)
W3 Goodwill

60,000
Rs.

Cost of investment

450,000

Non-controlling interest at acquisition (see W2)

45,000
495,000

Net assets at acquisition (W1)

(150,000)
345,000

W4 Consolidated retained profits:

Rs.

All of Ps retained earnings

Ps share of the post-acquisition retained earnings of S
(70% of 50,000 (W1))

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650,000
35,000
685,000

The Institute of Chartered Accountants of Pakistan

Chapter 19: Business combinations and consolidation

Solution

P Group: Consolidated statement of financial position at 31 December 20X1

Assets
Goodwill (W3)
Other assets (500 + 350)
Total assets
Equity
Share capital (P only)
Consolidated retained earnings (W4)

Rs.
375,000
850,000
1,225,000
100,000
685,000
785,000
90,000
875,000
350,000
1,225,000

Non-controlling interest (W2)

Current liabilities (200 + 150)
Total equity and liabilities
Workings:
W1 Net assets summary
At date of
consolidation

At date of
acquisition

Share capital
Retained earnings

100,000
100,000

100,000
50,000

Net assets

200,000*

150,000

W2 Non--controlling interest

Postacquisition
50,000

Rs.

Fair value of NCI at the date of acquisition

NCIs share of the post-acquisition retained earnings of S
(30% of 50,000 (W1))

75,000

NCIs share of net assets at the date of consolidation

90,000

W3 Goodwill

15,000

Rs.

Cost of investment

450,000

Non-controlling interest at acquisition (given)

75,000
525,000

Net assets at acquisition (W1)

(150,000)
375,000

W4 Consolidated retained profits:

Rs.

All of Ps retained earnings

Ps share of the post-acquisition retained earnings of S
(70% of 50,000 (W1))

650,000
35,000
685,000

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Advanced accounting and financial reporting

Solution

A consolidated statement of financial position as at 31 December 20X1 can be

prepared as follows:
P Group: Consolidated statement of financial position at 31 December 20X1
Rs.
Assets
Brand (see working)
Goodwill (see working)
Property, plant and equipment (1,800 + 1000)
Other assets (400 + 300)
Total assets
Equity
Share capital (P only)
Consolidated retained earnings (see working)

90,000
360,000
2,800,000
700,000
3,950,000
100,000
3,212,000
3,312,000
238,000
3,550,000
400,000
3,950,000

Non-controlling interest
Current liabilities (200 + 200)
Total equity and liabilities
Workings:
Net assets summary of S

Share capital
Retained earnings
Given in the question
Extra depreciation on brand
(100,000 2 years/20 years)
Consolidation reserve on
recognition of the brand
Net assets

At date of
consolidation
100,000

At date of
acquisition

1,000,000

600,000

(10,000)
990,000


600,000

100,000

100,000

1,190,000

800,000

Postacquisition

100,000

390,000

Rs.

Non--controlling interest
NCIs share of net assets at the date of acquisition
(20% u 800,000)
NCIs share of the post-acquisition retained earnings of S
(20% of 390,000 (see above))

160,000

NCIs share of net assets at the date of consolidation

238,000

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The Institute of Chartered Accountants of Pakistan

Chapter 19: Business combinations and consolidation

Solution (continued)

3
Rs.

Goodwill
Cost of investment

1,000,000

Non-controlling interest at acquisition (20% u 800,000)

160,000
1,160,000
(800,000)

Net assets at acquisition (see above)

360,000
Rs.

Consolidated retained profits:

All of Ps retained earnings
Ps share of the post-acquisition retained earnings of S (80%
of 390,000 (see above))

2,900,000
312,000
3,212,000
Rs.

Brand
On initial recognition
Depreciation since acquisition (100,000 2 years/20 years)

100,000
(10,000)
90,000

Solution

P Group: Consolidated statement of financial position at 31 December 20X1

Rs.
Assets
Goodwill (see working)
200,000
PP and E (see working)
3,040,000
Other assets (400,000 + 300,000)
700,000
Total assets
3,940,000
Equity
Share capital (P only)
100,000
Consolidated retained earnings (see working)
3,172,000
3,272,000
Non-controlling interest
268,000
3,540,000
Current liabilities (200 + 200)
400,000
Total equity and liabilities
3,940,000

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Advanced accounting and financial reporting

Solution (continued)

Share capital

4
At date of
consolidation
100,000

At date of
acquisition
100,000

Postacquisition

Retained earnings
Given in the question
Extra depreciation on fair
value adjustment (300 2
years/10 years) see
explanation on next page
Fair value reserve
Net assets

1,000,000

600,000

(60,000)
940,000


600,000

300,000

300,000

1,340,000

1,000,000

Non--controlling interest
NCIs share of net assets at the date of acquisition
(20% u 1,000)
NCIs share of the post-acquisition retained earnings of S
(20% of 340 (see above))
NCIs share of net assets at the date of consolidation

340,000

Rs.
200,000
68,000
268,000
Rs.

Goodwill
Cost of investment

1,000,000

Non-controlling interest at acquisition (20% u 1,000)

200,000
1,200,000

Net assets at acquisition (see above)

(1,000,000)
200,000
Rs.

Consolidated retained profits:

All of Ps retained earnings
Ps share of the post-acquisition retained earnings of S (80%
of 340 (see above))

2,900,000
272,000
3,172,000

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Chapter 19: Business combinations and consolidation

Solution (continued)

4
Rs.

Property plant and equipment

Parents

1,800

Subsidiarys
Given in question

1,000

Fair value adjustment

300

Extra depreciation on fair value adjustment

(300 2 years/10 years)

(60)
1,240

To statement of financial position

3,040

Solution

P Group: Consolidated statement of financial position at 31 December 20X1

Assets
Goodwill (W3)
Other non-current assets (400 + (200 + 250  25))
Other assets (500 + 350)
Total assets
Equity
Share capital (P only)
Consolidated retained earnings (W4)
Non-controlling interest (W2)
Current liabilities (200 + 150)
Total equity and liabilities

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Rs.
720,000
825,000
850,000
2,395,000
100,000
1,757,500
1,857,500
187,500
2,045,000
350,000
2,395,000

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Solution

Workings:
W1 Net assets summary

Share capital

At date of
consolidation
100,000

At date of
acquisition
100,000

Postacquisition

Retained earnings
Given in the question

300,000

50,000

Extra depreciation on fair

value adjustment (250 1
years/10 years)

(25,000)
275,000


50,000

Fair value reserve

250,000

250,000

Net assets

625,000

400,000

W2 Non--controlling interest

225,000

Rs.

NCIs share of net assets at the date of acquisition

(30% u 400)
NCIs share of the post-acquisition retained earnings of S
(30% of 225 (W1))
NCIs share of net assets at the date of consolidation
W3 Goodwill

120,000
67,500
187,500
Rs..

Cost of investment

1,000,000

Non-controlling interest at acquisition (W2)

120,000
1,120,000

Net assets at acquisition (see above)

(400,000)
720,000

W4 Consolidated retained profits:

Rs.

All of Ps retained earnings

Ps share of the post-acquisition retained earnings of S
(70% of 225 (W1))

1,600,000
157,500
1,757,500

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The Institute of Chartered Accountants of Pakistan

CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

20

Consolidated statements of profit or

loss and other comprehensive income
Contents
1 Consolidated statement of profit or loss and other
comprehensive income
2 Consolidated statement of other comprehensive
income

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Advanced accounting and financial reporting

INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A3

IFRS 10: Consolidated financial statements

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Chapter 20: Consolidated statements of profit or loss and other comprehensive income

CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER

COMPREHENSIVE INCOME
Section overview

Consolidated statement of profit or loss: the basic rules

Inter-company items

Other adjustments

Pre- and post-acquisition profits

1.1 Consolidated statement of profit or loss: the basic rules

A consolidated statement of profit or loss brings together the sales revenue,
income and expenses of the parent and the sales revenue, income and expenses
of its subsidiaries.
Similarly a consolidated statement of other comprehensive income brings
together the gains and losses of the parent and the gains and losses of its
subsidiaries.
In the consolidated statements, all items of income, expenses, gains and losses
are a straight cross cast of equivalent items in the individual financial statements
of the members of the group.
Non-controlling interest
Consolidated financial statements must also disclose the profit or loss for the
period and the total comprehensive income for the period attributable to:

owners of the parent company; and

non-controlling interests.

The figure for NCI is simply their share of the subsidiarys profit for the year that
has been included in the consolidated statement of comprehensive income.
The amounts attributable to the owners of the parent and the non-controlling
interest are shown as a metric (small table) immediately below the statement of
comprehensive income.
Illustration: Amounts attributable to the owners of the parent and the non-controlling interest
Profit attributable to:
Owners of the parent (balancing figure)
Non-controlling interests (x% of y)

Rs.
X
X
X

Where:

x% is the NCI ownership interest

y is the subsidiarys profit for the year that has been included
in the consolidated statement of comprehensive income

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Advanced accounting and financial reporting

1.2 Inter-company items

Consolidated statements of profit or loss are prepared by combining the
information given in the statements of profit or loss of the individual companies.
It is usually necessary to make adjustments to eliminate the results of intercompany trading. This includes adjustments to cancel out inter-company trading
balances and unrealised profit.
Inter-company trading
Inter-company trading will be included in revenue of one group company and
purchases of another. These are cancelled on consolidation.
Illustration:
Debit
Revenue

Credit

Cost of sales (actually purchases within cost of sales)

Unrealised profits on trading

If any items sold by one group company to another are included in inventory (i.e.
have not been sold on outside the group by the year end), their value must be
adjusted to lower of cost and net realisable value from the group viewpoint (as for
the consolidated statement of financial position).
This is an inventory valuation adjustment made in the consolidated financial
statements.
Illustration:

Closing inventory Statement of comprehensive income

Closing inventory Statement of financial position

Debit
X

Credit
X

The adjustment in the statement of comprehensive income reduces gross profit

and hence profit for the year. The NCI share in this reduced figure and the
balance is added to retained earnings. Thus, the adjustment is shared between
both ownership interests.
If the sale is from S to P the unrealised profit adjustment must be shared with the
NCI.

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Chapter 20: Consolidated statements of profit or loss and other comprehensive income

Inter-company management fees and interest

All other inter-company amounts must also be cancelled.
Where a group company charges another group company, management
fees/interest, there is no external group income or external group expense and
they are cancelled one against the other like inter-company sales and cost of
sales.
Illustration:
Debit
Income (management fees)
Expense (management charges)

Credit

X
X

Inter-company dividends
The parent may have accounted for dividend income from a subsidiary. This is
cancelled on consolidation.
Dividends received from a subsidiary are ignored in the consolidation of the
statement of comprehensive income because the profit out of which they are paid
has already been consolidated.

1.3 Other adjustments

Fair value adjustments
Depreciation is charged on the carrying amount of assets.
If a depreciable asset is revalued on consolidation the depreciation stream that
relates to that asset will also need to be revalued.
This adjustment is carried out in the financial statements of the subsidiary. It will
affect the subsidiarys profit after tax figure and therefore will affect the NCI.
Accounting for Impairment of goodwill
When purchased goodwill is impaired, the impairment does not affect the
individual financial statements of the parent company or the subsidiary. The
effect of the impairment applies exclusively to the consolidated statement of
financial position and the consolidated income statement.
If goodwill is impaired:

It is written down in value in the consolidated statement of financial

position, and

The amount of the write-down is charged as an expense in the

consolidated income statement (normally in administrative expenses).

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Advanced accounting and financial reporting

Practice question

P acquired 80% of S 3 years ago. Goodwill on acquisition was Rs. 80,000. The
recoverable amount of goodwill at the year-end was estimated to be Rs. 65,000.
This was the first time that the recoverable amount of goodwill had fallen below
the amount at initial recognition.
S sells goods to P. The total sales in the year were Rs. 100,000. At the year-end P
retains inventory from S which had cost S Rs. 30,000 but was in Ps books at Rs.
35,000.
The distribution costs of S include depreciation of an asset which had been
subject to a fair value increase of Rs. 100,000 on acquisition. This asset is being
written off on a straight line basis over 10 years.
The statements of profit or loss for the year to 31 December 20X1 are as follows:
P
Rs.(000)
1,000
(400)

Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses

S
Rs.(000)
800
(250)

600
(120)
(80)

550
(75)
(20)

Dividend from S
Finance cost

400
80
(25)

455
(15)

Profit before tax

Tax

455
(45)

440
(40)

Profit for the period

410

400

Prepare the consolidated income statement for the year ended 31

December.

1.4 Pre- and post-acquisition profits

A change in ownership in the period will have an impact on the consolidated
statement of profit or loss and other comprehensive income.
The financial statements of a subsidiary must be consolidated from the date
control is achieved until the date that control is lost. In other words, the pattern of
ownership must be reflected in the statement of profit or loss and other
comprehensive income.

All of an entitys results are consolidated if it is controlled for the whole year

If an entity is controlled for only part of the year, only those results that
relate to that part of the year are consolidated.

For example, if a parent acquires a subsidiary during a financial year, the profits
of the subsidiary have to be divided into pre-acquisition and post-acquisition and
only post acquisition profits are consolidated.

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Chapter 20: Consolidated statements of profit or loss and other comprehensive income

The following straightforward example is of a type that you have seen in previous
papers. Later chapters on step acquisitions and disposals will show more
complex applications of the principle.
Example: Consolidated statement of profit or loss (mid-year acquisition)
Entity P acquired 80% of S on 1 October 20X1.
The statements of profit or loss for the year to 31 December 20X1 are as follows:

Revenue
Cost of sales

P
Rs.
400,000
(200,000)

S
Rs.
260,000
(60,000)

Gross profit
Other income

200,000
20,000

200,000
-

Distribution costs
Administrative expenses

(50,000)
(90,000)

(30,000)
(95,000)

Profit before tax

Income tax expense

80,000
(30,000)

75,000
(15,000)

Profit for the period

50,000

60,000

A consolidated statement of comprehensive income can be prepared as follows:

Working
S (3/12)

Consolidated

Revenue
Cost of sales

Rs.
400,000
(200,000)

Rs.
65,000
(15,000)

Rs.
465,000
(215,000)

Gross profit
Other income
Distribution costs

200,000
20,000
(50,000)

50,000

(7,500)

250,000
20,000
(57,500)

Administrative
expenses

(90,000)

(23,750)

(113,750)

Profit before tax

Income tax expense

80,000
(30,000)

18,750
(3,750)

98,750
(33,750)

Profit for the period

50,000

15,000

65,000

Total comprehensive income attributable to:

Owners of the parent (balancing figure)
Non-controlling interests (20% of 15,000)

62,000
3,000
65,000

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Advanced accounting and financial reporting

CONSOLIDATED STATEMENT OF OTHER COMPREHENSIVE INCOME

Section overview

A single statement or two statements

Consolidation of other comprehensive income

2.1 A single statement or two statements

The statement of profit or loss and other comprehensive income provides
information about the performance of an entity in a period. It consists of two
parts:

a statement of profit or loss a list of income and expenses which result in

a profit or loss for the period; and

a statement of other comprehensive income a list of other gains and

losses that have arisen in the period.

IAS 1 allows an entity to present the two sections in a single statement or in two
separate statements.
Information to be presented in the other comprehensive income section
The other comprehensive income section must present line items for amounts of
other comprehensive income in the period, classified by nature (including share
of the other comprehensive income of associates and joint ventures accounted
for using the equity method) and grouped into those that, in accordance with
other IFRSs:

will not be reclassified subsequently to profit or loss:

x

revaluation surpluses on property, plant and equipment (IAS 16) (but

remember in Pakistan such changes are not recognised in OCI as per
Companies Ordinance 1984);

revaluation surpluses on intangible assets (IAS 38) (but remember in

Pakistan such changes are not recognised in OCI as per Companies
Ordinance 1984);

remeasurements of defined benefit pension schemes (IAS 19); and

will be reclassified subsequently to profit or loss when specific conditions

are met, including:
x

gains and losses on retranslation of foreign operations (IAS 21);

gains and losses recognised on remeasurement of available for sale

financial assets (IAS 39); and

gains and losses recognised on the effective element of cash flow

hedges (IAS 39)

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2.2 Consolidation of other comprehensive income

Consolidation of the statement of other comprehensive income is carried out in a
similar way to the consolidation of the statement of profit or loss.
In the consolidated statements, all items of income, expenses, gains and losses
are a straight cross cast of equivalent items in the individual financial statements
of the members of the group.
Items in the statement of comprehensive income are unlikely to be affected by
inter-company trading or similar issues.
Non-controlling interest
Profit or loss and other comprehensive income in the period together are
described as total comprehensive income for the period.
Consolidated financial statements must disclose total comprehensive income for
the period attributable to the

owners of the parent company; and

non-controlling interests.

This is in addition to the disclosure for profit or loss described earlier.

The figure for NCI is simply their share of the subsidiarys other comprehensive
income for the year that has been included in the consolidated statement of other
comprehensive income.
The amounts attributable to the owners of the parent and the non-controlling
interest are shown as a metric (small table) immediately below the statement of
comprehensive income.
Illustration: Amounts attributable to the owners of the parent and the non-controlling interest
Total comprehensive income attributable to:
Owners of the parent (balancing figure)
Non-controlling interests

Rs.
X
X
X

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Example: Consolidated statement of profit or loss and other comprehensive

income
Entity P acquired 80% of S several years ago.
Entity P presents the statement of profit or loss and other comprehensive
income as a single statement. Items in other comprehensive income are shown
net of tax.
The summarised statements of profit or loss and other comprehensive income
for the year to 31 December 20X1 are as follows:
P
S
Profit or loss
Revenue
Cost of sales

Rs.
400,000
(200,000)

Rs.
260,000
(60,000)

Gross profit
Expenses

200,000
(90,000)

200,000
(95,000)

Profit before tax

110,000

105,000

Income tax expense

(30,000)

(15,000)

80,000

90,000

2,000

1,000

(1,200)

400

Other comprehensive income for the year

800

1,400

Total comprehensive income for the year

80,800

91,400

Profit for the year

Other comprehensive income
Items that will not be reclassified to profit or
loss
Remeasurement of defined benefit plan
Items that may be reclassified to profit or
loss
Cash flow hedge

A consolidated statement of profit or loss and other comprehensive income can

be prepared as follows:

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Example (continued): Consolidated statement of profit or loss and other

comprehensive income
A consolidated statement of profit or loss and other comprehensive income can
be prepared as follows:
Working
P
Rs.

S
Rs.

Consolidated
Rs.

Revenue
Cost of sales

400,000
(200,000)

260,000
(60,000)

660,000
(260,000)

Gross profit

200,000

200,000

400,000

Expenses

(90,000)

(95,000)

(185,000)

Profit before tax

Income tax expense

(30,000)

(15,000)

215,000
(45,000)

Profit for the period

80,000

90,000

170,000

2,000

1,000

3,000

(1,200)

400

(800)

800

1,400

2,200

91,400

172,200

Other comprehensive
income
Items that will not be
reclassified
Remeasurement of
defined benefit
plan
Items that may be
reclassified ..
Cash flow hedge
Other comprehensive
income for the year
Total comprehensive
income for the year

Profit attributable to:

Owners of the parent (balancing figure)
Non-controlling interests (20% of 90,000)

152,000
18,000
170,000

Total comprehensive income attributable to:

Owners of the parent (balancing figure)
Non-controlling interests (20% of 91,400)

62,000
18,820
153,380

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SOLUTIONS TO PRACTICE QUESTIONS

Solutions

Consolidated statement of comprehensive income for the year ended 31 December.

Workings
S
Rs.(000)
800
(250)

Dr
Rs.(000)
(100)
3(5)

Cr
Rs.(000)

Rs.(000)

Revenue
Cost of sales

P
Rs.(000)
1,000
(400)

100

1,700
(555)

Gross profit

600

550

(105)

100

1,145

Distribution costs
Fair value adjustment

(120)

Consol.

(75)
1(10)

(120)

(85)

(205)

Administrative
expenses

(80)

(20)

2(15)

Dividend from S
Finance cost

400
80
(25)

445
(15)

(80)

Profit before tax

455

430

785

Tax

(45)

(40)

(85)

Profit for the period

410

390

(115)

(40)

(200)

100

Total comprehensive income attributable to:

Owners of the parent (balancing figure)

700

Rs.(000)

633

Non-controlling interests (20% of 390,000)  (20% of 35,000)

77
700

Notes:
1: Extra depreciation on fair value adjustment (100/10 years)
2: Goodwill impairment
3: Unrealised profit

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

21

Associates and joint ventures

Contents
1 IFRS 11: Joint arrangements
2 IAS 28: Investments in associates and joint ventures

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A4

IAS 28: Accounting for associates and joint ventures

A5

IFRS 11: Joint arrangements

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IFRS 11: JOINT ARRANGEMENTS

Section overview

Introduction

Joint arrangements

Types of joint arrangements

Accounting for joint operations and joint ventures

1.1 Introduction
A controlling interest in an investee results in an investment (a subsidiary) which
is consolidated.
An interest in the equity shares of another company that gives no influence is
accounted for as follows:

The shares are shown in the statement of financial position as long-term

assets (an investment) and valued in accordance with IAS 39 (IFRS 9); and

Any dividends received for the shares are included in profit or loss for the
year as other income.

Other investments might result in joint control or significant influence. The rules
for accounting for these are given in:

IFRS 11 Joint Arrangements: and

IAS 28 Investments in Associates and Joint ventures.

This session introduces the rules on accounting for joint arrangements.

1.2 Joint arrangements

Definition
A joint arrangement is an arrangement of which two or more parties have joint
control.
Joint control is the contractually agreed sharing of control of an arrangement,
which exists only when decisions about the relevant activities require the
unanimous consent of the parties sharing control.
A joint arrangement has the following characteristics:

The parties are bound by a contractual arrangement; and

The contractual arrangement gives two or more of those parties joint

control of the arrangement.

Definition
A party to a joint arrangement is an entity that participates in a joint
arrangement, regardless of whether that entity has joint control of the
arrangement.

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Contractual arrangement
Any contractual arrangement will usually be evidenced in writing, usually in the
form of a contract or documented discussions between the parties.
A joint arrangement might be structured through a separate vehicle in which case
some aspects of the contractual arrangement might be incorporated in its
articles, charter or by-laws.
Any contractual arrangement sets out the terms upon which the parties
participate in the activity that is the subject of the arrangement and would
generally deal with such matters as:

the purpose, activity and duration of the joint arrangement;

how the members of the board of directors, or equivalent governing body,

of the joint arrangement, are appointed;

the decision-making process (the matters requiring decisions from the

parties, the voting rights of the parties and the required level of support for
those matters).

the capital or other contributions required of the parties.

how the parties share assets, liabilities, revenues, expenses or profit or loss
relating to the joint arrangement.

Joint control
IFRS 11 states that decisions about the relevant activities require unanimous
consent of all parties that collectively control the arrangement. It is not necessary
for every party to the arrangement to agree in order for unanimous consent to
exist. This requires agreement by only those parties that collectively control the
arrangement.
Day to day decision making might be delegated to a manager or to one of the
parties to the arrangement. In such cases, the situation would need to be
analysed to decide whether, in fact, decisions require the unanimous agreement
of the interested parties. Such an arrangement is still a joint arrangement when
the manager executes the policy decisions that have been agreed unanimously
by the investors.
Example: Joint control
In each of the following scenarios three entities A, B and C establish an
arrangement.
Scenario 1
Scenario 2
Scenario 3
Require the
Decisions
Require at
Require at least
unanimous
about relevant
least 75% of
75% of voting
consent of A, B
rights
activities
voting rights
and C
Ownership
interest
A
50%
50%
50%
B
30%
30%
25%
C
20%
20%
25%

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Required
For each scenario analyse whether a joint arrangement exists and which parties
have joint control.

Answer
Scenario 1
A, B and C have joint control of the arrangement and each must account for its
investment according to IFRS 11.
Scenario 2
Although A can block any decision, it does not control the arrangement because it
needs the agreement of B.
A and B have joint control of the arrangement. The terms of their contractual
arrangement requiring at least 75% of the voting rights to make decisions about
the relevant activities imply that A and B have joint control of the arrangement
because decisions about the relevant activities of the arrangement cannot be
made without both A and B agreeing.
A and B must each account for its investment according to IFRS 11.
C is a party to a joint arrangement but has no control.
Scenario 3
The arrangement can be controlled by A with B or by A with C. This means that no
party can be said to have joint control.
In order for this to be a joint arrangement the contractual terms would have to
specify which combination of parties is required to agree about the relevant
activities.
IFRS 11 does not apply to this investment.

1.3 Types of joint arrangements

There are two types of joint arrangement. A joint arrangement is either a joint
operation or a joint venture.
Definition
A joint operation is a joint arrangement whereby the parties that have joint
control of the arrangement have rights to the assets, and obligations for the
liabilities, relating to the arrangement. Those parties are called joint operators.
A joint venture is a joint arrangement where the parties that have joint control of
the arrangement have rights to the net assets of the arrangement. Those parties
are called joint venturers.
This classification depends on the rights and obligations of the parties to the
arrangement.
Investors may or may not establish a joint arrangement as a separate vehicle.

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Definition
A separate vehicle is a separately identifiable financial structure, including
separate legal entities or entities recognised by statute, regardless of whether
those entities have a legal personality.
The application guidance to IFRS 11 says that if a joint arrangement is not
structured through a separate vehicle it must be a joint operation.
If a joint arrangement is structured through a separate vehicle it could be a joint
operation or a joint venture.
For a joint arrangement to be a joint venture it is the separate vehicle that must
have the rights to the assets and the obligations to the liabilities with the investor
only having an interest in the net assets of the entity. If an investor has a direct
interest in specific assets and direct obligation for specific liabilities of the
separate vehicle then the joint arrangement is a joint operation.

1.4 Accounting for joint operations and joint ventures

The method of accounting for an interest in a joint arrangement depends on what
type of joint arrangement it is.
Joint operations
A joint operator must recognise the following in its own financial statements:

its assets, including its share of any assets held jointly;

its liabilities, including its share of any liabilities incurred jointly;

its revenue from the sale of its share of the output arising from the joint
operation;

its share of the revenue from the sale of the output by the joint operation;
and

its expenses, including its share of any expenses incurred jointly.

If an entity participates in, but does not have joint control of a joint operation but
has rights to the assets, and obligations for the liabilities, relating to the joint
operation it must also apply the above accounting treatment.
If an entity participates in, but does not have joint control of a joint operation and
also does not have rights to the assets, and obligations for the liabilities, relating
to the joint operation it must account for its interest in the joint operation in
accordance with the IFRSs applicable to that interest.
Amendment to IFRS 11
The amendment must be applied for annual periods beginning on or after 1
January 2016. Earlier application is permitted but must be disclosed.
When an entity acquires an interest in a joint operation in which the activity of the
joint operation constitutes a business (as defined in IFRS 3), it must apply the
principles on business combinations accounting in IFRS 3.

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This applies to the acquisition of both the initial interest and additional interests in
a joint operation.
The principles on business combinations include:

The measurement of identifiable assets and liabilities at fair value;

Expensing acquisition-related costs;

recognising goodwill; and

impairment testing goodwill.

Joint ventures
A joint venturer must recognise its interest in a joint venture as an investment and
account for it using the equity method in accordance with IAS 28 Investments in
Associates and Joint Ventures unless the entity is exempted from applying the
equity method as specified in that standard.
If an entity participates in, but does not have joint control of a joint operation it
must account for its interest in the arrangement in accordance with IFRS 9
Financial Instruments, unless it has significant influence over the joint venture, in
which case it must account for it in accordance with IAS 28.
Example Accounting for a joint operation
On 1 January 20X7, X and Y entered into a joint operation to purchase and
operate an oil pipeline.
Both entities contributed equally to the purchase cost of Rs.20 million and this
was financed by a joint loan of Rs.20,000,000.
Contract terms
Y carries out all maintenance work on the pipeline but maintenance expenses are
shared between X and Y in the ratio 40%: 60%.
Both entities use the pipeline for their own operations and share any income from
third parties 50%: 50%. Sales to third parties are invoiced by Y.
The full interest on the loan is initially paid by X but the expense is to be shared
equally.
During the year ended 31 December 20X7
Y carried out maintenance at a cost of Rs. 1,200,000.
Income from third parties was Rs. 900,000, all paid to Y.
Interest of Rs. 1,500,000 was paid for the year on 31 December by X.
Required
Show the relevant figures that would be recognised in the financial statements of
X and Y for the year to 31 December 20X7.

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Answer

Statement of financial position

Total
amount

In X
financial
statements

In Y
financial
statements

Rs.

Rs.

Rs.

Jointly--controlled assets
Property, plant and equipment
Cost

20,000,000 10,000,000 10,000,000

Share of liabilities incurred

Bank loan

20,000,000 10,000,000 10,000,000

Current: account with Y (owed by Y)

see workings

720,000

Current: account with X (owed to X)

see workings
Share of revenue
Income from third parties (50:50)

720,000
900,000

450,000

450,000

1,200,000
1,500,000

480,000
750,000

720,000
750,000

Share of expenses
Maintenance costs (40:60)
Interest on loan (50:50)

2,700,000
Workings
Statement of profit or loss
Income from third parties (50:50)
Maintenance costs (40:60)
Interest on loan (50:50)

1,230,000 1,470,000

900,000

450,000

450,000

1,200,000
1,500,000

480,000
750,000

720,000
750,000

(2,700,000) (1,230,000) (1,470.000)

(1,800,000)
Cash expense
Cash collected

(780,000) (1,020.000)
(1,500,000)(1,200,000)
900,000

Net cash expense

(1,500,000) (300,000)

Cash due to X from Y

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Chapter 21: Associates and joint ventures

IAS 28: INVESTMENTS IN ASSOCIATES AND JOINT VENTURES

Section overview

Associates and joint ventures

Accounting for associates and joint ventures

Trading with an associate or joint venture

2.1 Associates and joint ventures

Definition
An associate is an entity over which the investor has significant influence.
Significant influence
Significant influence is the power to participate in the financial and operating
policy decisions of the investee but is not control or joint control of those policies.

IAS 28 states that if an entity holds 20% or more of the voting power
(equity) of another entity, it is presumed that significant influence exists,
and the investment should be treated as an associate.

If an entity owns less than 20% of the equity of another entity, the normal
presumption is that significant influence does not exist.

Holding 20% to 50% of the equity of another entity therefore means as a general
rule that significant influence exists, but not control; therefore the investment is
treated as an associate, provided that it is not a joint venture.
The 20% or more rule is a general guideline, however, and IAS 28 states more
specifically how significant influence arises. The existence of significant influence
is usually evidenced in one or more of the following ways:

Representation on the board of directors;

Participation in policy-making processes, including participation in decisions

about distributions (dividends);

Material transactions between the two entities;

An interchange of management personnel between the two entities; or

The provision of essential technical information by one entity to the other.

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2.2 Accounting for associates and joint ventures

IAS 28 states that associates and joint ventures must be accounted for using the
equity method.
The equity method is defined as a method of accounting whereby the
investment is initially recognised at cost and adjusted thereafter for the postacquisition change in the investors share of the investees net assets.
The investors profit or loss includes its share of the investees profit or loss and
the investors other comprehensive income includes its share of the investees
other comprehensive income.
Statement of financial position: investment in the associate
In the statement of financial position of the reporting entity (the investor), an
investment in an associate is measured at:
Illustration: Equity method
Rs.
Cost of investment

Plus/(Minus): Parents share of profits (losses) of the associate

(or JV) since acquisition
Plus/(Minus): Parents share of OCI of the associate (or JV)
since acquisition
Minus any impairment of the investment recognised

X
X
(X)
X

There is no goodwill-recognised for an investment in an associate.

The accumulated profits of the reporting entity (or the consolidated accumulated
reserves when consolidated accounts are prepared) should include the investors
share of the post-acquisition retained profits of the associate (or JV), (minus any
impairment in the value of the investment since acquisition). This completes the
other side of the entry when the investment is remeasured.
Similarly any other reserve of the reporting entity (or any other consolidated
reserves when consolidated accounts are prepared) should include the investors
share of the post-acquisition movement in the reserve of the associate (or JV).
Statement of profit or loss and other comprehensive income
In the statement of profit or loss and other comprehensive income, there should
be separate lines for:

Share of profits of associate (or JV) in the profit and loss section of the
statement

Share of other comprehensive income of associate (or JV) in the other

comprehensive income section of the statement.

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Example: Equity method

Entity P acquired 30% of the equity shares in Entity A during Year 1 at a cost of
Rs. 147,000 when the fair value of the net assets of Entity A was Rs. 350,000.
Entity P is able to exercise significant influence over Entity A.
At 31 December Year 5, the net assets of Entity A were Rs. 600,000.
In the year to 31 December Year 5, the profits of Entity A after tax were Rs.
80,000.
The figures that must be included to account for the associate in the financial
statements of Entity P for the year to 31 December Year 5 are as follows:
Sttatement of financial position:
The investment in the associate is as follows:

Investment at cost
Investors share of post-acquisition profits of A (W
W1)

Rs.
147,000
75,000

Investment in the associate

222,000

W1 Retained post--acquisition profits of Entity A

Net assets of the associate at 31 December Year 5
Net assets of Entity A at date of acquisition of shares

Rs.
600,000
(350,000)

Retained post-acquisition profits of Entity A

Entity Ps share of A

250,000
30%

Entity Ps share of As profits since the date of acquisition

Rs.75,000

Note: Rs.75,000 will be included in the accumulated profits of Entity P

The journal to achieve the re-measurement is
Dr Cost Rs.75,000 and Cr Accumulated profits Rs.75,000

Statement of profit or loss

The share of the associates after-tax profit for the year is shown on a separate
line as:
Share of profits of associate (30% Rs. 80,000): Rs. 24,000.

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Practice question

Entity P acquired 40% of the equity shares in Entity A during Year 1 at a

cost of Rs. 128,000 when the fair value of the net assets of Entity A was Rs.
250,000.
Since that time, the investment in the associate has been impaired by Rs.
8,000.
Since acquisition of the investment, there has been no change in the issued
share capital of Entity A, nor in its share premium reserve or revaluation
reserve.
On 31 December Year 5, the net assets of Entity A were Rs. 400,000.
In the year to 31 December Year 5, the profits of Entity A after tax were Rs.
50,000.
What figures would be included for the associate in the financial
statements of Entity P for the year to 31 December Year 5?

2.3 Trading with an associate or joint venture

There might be trading between a parent and an associate (or JV). If in addition
to the associate (or JV) the parent holds investments in subsidiaries there might
also be trading between other members of the group and the associate (or JV).
In such cases there might be:

Inter-company balances (amounts owed between the parent (or group) and
the associate (or JV) in either direction); and

Unrealised profit on inter-company transactions.

The accounting rules for dealing with these items for associate (or JVs) are
different from the rules for subsidiaries.
Inter-company balances
Inter-company balances between the members of a group (parent and
subsidiaries) are cancelled out on consolidation.
Inter-company balances between the members of a group (parent and
subsidiaries) and associates (or JVs) are not cancelled out on consolidation. An
associate (or JV) is not a member of the group but is rather an investment made
by the group. This means that it is entirely appropriate that consolidated financial
statements show amounts owed by the external party as an asset and amount
owed to the external party as a liability.
This is also the case if a parent has an associate (or JV) and no subsidiaries. The
parent must equity account for the investment. Once again, it is entirely
appropriate that consolidated financial statements show amounts owed by the
external party as an asset and amount owed to the external party as a liability.

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Unrealised inter-group profit

Unrealised inter-company (intra-group) profit between a parent and a member of
a group must be eliminated in full on consolidation.
For unrealised profit arising on trade between a parent and associate (or JV)
only the parents share of the unrealised profit is eliminated.
IAS 28 does not specify the double entry to achieve this.
The following are often used in practice
Parent sells to associate (or JV):

The unrealised profit is held in inventory of the associate (or JV). The
investment in the associate (or JV) should be reduced by the parents share
of the unrealised profit.

The other side of the entry increases cost of sales

Illustration: Unrealised profit double entry when parent sells to associate

Debit
Cost of sales

Credit

Investment in associate

Associate (or JV) sells to parent:

The unrealised profit is held in inventory of the parent and this should be
reduced in value by the parents share of the unrealised profit.

The other side of the entry reduces the parents share of the profit of the
associate (or JV).

Illustration: Unrealised profit double entry when associate sells to parent

Debit
Share of profit of associate

Credit

Inventory

In both cases, there will also be a reduction in the post-acquisition profits of the
associate (or JV), and the investor entitys share of those profits (as reported in
profit or loss). This will reduce the accumulated profits in the statement of
financial position.

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Example: Unrealised profit

Entity P acquired 40% of the equity shares of Entity A several years ago. The cost
of the investment was Rs. 205,000.
As at 31 December Year 6 Entity A had made profits of Rs. 275,000 since the
date of acquisition.
In the year to 31 December Year 6, Entity P sold goods to Entity A at a sales price
of Rs. 200,000 at a mark-up of 100% on cost.
Goods which had cost Entity A Rs. 30,000 were still held as inventory by Entity A
at the year-end.
The necessary adjustments for unrealised profit, and the double entries are as
follows:
Rs.

Unrealised profit adjustment

Inventory sold by P to A

200,000

Profit on the sale (200,000 u 100%/200%)

100,000

Unrealised profit (100,000 u Rs.30,000/Rs.200,000)

Entity Ps share (40%)

15,000
6,000

Double entries:

Dr(Rs.)

Cr(Rs.)

Investment in associate
110,000
Accumulated profits
110,000
Being: Share of post-acquisition profits (40% of Rs.275,000)
Dr(Rs.)
6,000

Cost of sales (hence accumulated profit)

Investment in associate
Being: Elimination of share of unrealised profit (see above)

Cr(Rs.)
6,000

Investment in associate (see above for adjustments)

Cost of the investment

Rs.
205,000

Entity Ps share of post-acquisition profits of Entity A

Minus: Entity Ps share of unrealised profit in inventory

110,000
(6,000)
309,000

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Practice question

Entity P acquired 30% of the equity shares of Entity A several years ago at a
cost of Rs. 275,000.
As at 31 December Year 6 Entity A had made profits of Rs. 380,000 since
the date of acquisition.
In the year to 31 December Year 6, the reported profits after tax of Entity A
were Rs. 100,000.
In the year to 31 December Year 6, Entity P sold goods to Entity A for Rs.
180,000 at a mark-up of 20% on cost.
Goods which had cost Entity A Rs. 60,000 were still held as inventory by
Entity A at the year-end.
a)
b)

c)

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Calculate the unrealised profit adjustment and state the double

entry.
Calculate the investment in associate balance that would be
included in Entity Ps statement of fiancial position as at 31
December Year 6.
Calculate the amount that would appear as a share of profit of
associate in Entity Ps statement of profit or loss for the year
ending 31 December Year 6.

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

The figures that must be included to account for the associate in the financial
statements of Entity P for the year to 31 December Year 5 are as follows:
Statement of financial position:
The investment in the associate is as follows:

Investment at cost
Investors share of post-acquisition profits of A (W
W1)
Minus: Accumulated impairment in the investment

Rs.
128,000
60,000
(8,000)

Investment in the associate

180,000

W1 Retained post--acquisition profits of Entity A

Net assets of the associate at 31 December Year 5
Net assets of Entity A at date of acquisition of shares

Rs.
400,000
(250,000)

Retained post-acquisition profits of Entity A

Entity Ps share of A

150,000
40%

Entity Ps share of As profits since the date of acquisition

Rs.60,000

Statement of profit or loss

The share of the associates after-tax profit for the year is shown on a separate line as:
Share of profits of associate (40% Rs. 50,000): Rs. 20,000.

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Solution
a)

2
Rs.

Unrealised profit adjustment

Inventory sold by P to A

180,000

Profit on the sale (180,000 u 20%/120%)

30,000

Unrealised profit (30,000 u Rs.60,000/Rs.180,000)

10,000

Entity Ps share (30%)

3,000

Double entry
Dr(Rs.)
Cost of sales (hence accumulated profit)
3,000
Investment in associate
Being: Elimination of share of unrealised profit (see above)
b)

Investment in associate (see above for adjustments)

Cost of the investment
Entity Ps share of post-acquisition profits of Entity A (30% of
Rs.380,000)
Minus: Entity Ps share of unrealised profit in inventory

Cr(Rs.)
3,000

Rs.
275,000
114,000
(3,000)
386,000

c)

Statement of profit or loss

The share of the associates after-tax profit for the year is shown on a
separate line as:
Share of profits of associate (30% Rs. 100,000): Rs.30,000.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

22

Business combinations
achieved in stages
Contents
1 Acquisitions achieved in stages
2 Pattern of ownership in the consolidated statement of
profit or loss

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Advanced accounting and financial reporting

INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A3

IFRS 10: Consolidated financial statements

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 4

IFRS 3: Business combinations

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Chapter 22: Business combinations achieved in stages

ACQUISITIONS ACHIEVED IN STAGES

Section overview

Acquisitions achieved in stages

Purchase of additional equity interest after control is achieved

1.1 Acquisitions achieved in stages

As well as being achieved in a single transaction control might be achieved
through a series of transactions. (These are known as step acquisitions,
successive share purchases or piecemeal acquisitions).
Example: Step acquisition
A company may purchase a 35% stake, and then a year later, purchase a further
40%.
When the second purchase is made the companys interest in the subsidiary
increases from 35% to 75%.
This is a controlling interest.
In other words control is achieved at the date of the second acquisition.
This is the date of acquisition.
Consolidation is from the acquisition date which is the date that control is
achieved. Goodwill is calculated at the acquisition date with reference to the fair
value of the consideration:
IFRS 3 requires that, for a business combination achieved in stages, the parent
must remeasure any previously held equity interest in the new subsidiary to its
fair value at the date that control is achieved. This is added to the cost of the
investment that resulted in control. This figure is used to calculate goodwill.
Goodwill is measured as follows.
Illustration: Goodwill

Consideration transferred (cost of the business combination)

The acquisition-date fair value of the acquirers previously
held equity interest in the entity
Non-controlling interest

Rs.
X
X
X
X

The net of the acquisition date amounts of identifiable

assets acquired and liabilities assumed

(X)

Goodwill recognised

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The resulting gain or loss on the remeasurement of the previously held equity
interest is recognised in profit or loss or other comprehensive income, as
appropriate.
Example: Step acquisition
H bought 10% of S 2 years ago for Rs. 45m. The balance on Ss retained earnings
was Rs. 150m at this date.
H bought 60% of S 1 year ago for Rs. 540m. The balance on Ss retained earnings
was Rs. 300m at this date and S held a non-current asset with a fair value of Rs.
150m more than its carrying amount.
The fair value of the original investment (10%) in S was Rs. 60m at this date.
Statements of financial position for H and S as at 31 December 20X1:
Assets:
Investment in S:
First holding (10%)
Second holding (60%)

Rs. m

Rs. m

45
540
585
2,500

650

3,085

650

Equity
Share capital
Retained earnings

100
2,485

100
500

Current liabilities

2,585
500

600
50

3,085

650

Other assets

A consolidated statement of financial position as at 31 December 20X1 can be

prepared as follows:
H Group: Consolidated statement of financial position at 31 December
20X1
Rs. m
Assets
Goodwill (see working)
215
Other assets (2,500 + (650 + 150))
3,300
Total assets
Equity
Share capital (P only)
Consolidated retained earnings (see working)

3,515
100
2,640

Non-controlling interest (see working)

2,740
225

Current liabilities (500 + 50)

2,965
550

Total equity and liabilities

3,515

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Chapter 22: Business combinations achieved in stages

Example (continued): Net assets summary of S

At date of
consolidation

At date of
acquisition

Postacquisition

Share capital
Retained earnings

100
500

100
300

200

Fair value reserve

150

150

Net assets

750

550

Non--controlling interest

Rs. m

NCIs share of net assets at the date of acquisition (30% u 550)

NCIs share of the post-acquisition retained earnings of S
(30% of 200 (see above))
NCIs share of net assets at the date of consolidation
(30% u 550)
Goodwill

165
60
225
Rs. m

Cost of investment
Cost of second purchase (60%)

540

Fair value of first purchase (10%) (45 + 15)

60
600
165

Non-controlling interest at acquisition

Less: Net assets at acquisition (see above)

765
(550)
215

Consolidated retained earnings::

Rs. m

Hs retained earnings
Per the question
Gain on remeasurement of previously held equity interest in S
(60  45)

2,485
15
2,500

Hs share of the post-acquisition retained earnings of S (70% of

200 (see above))

140
2,640

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Practice question

Company P bought shares in Company T as follows:

Cost
Rs.

Retained
profits
Rs.

1 January Year 1

40,000 shares

180,000

500,000

30 June Year 4

120,000 shares

780,000

800,000

No fair value adjustments arose on the acquisitions.

Company T had issued share capital of 200,000 Rs. 1 ordinary shares
and retained profits at 31 December Year 4 were Rs. 900,000. The fair
value of its initial investment in 40,000 shares of T was Rs. 250,000 at
30 June Year 4.
What is the value goodwill on acquisition.

Practice question

Company P bought shares in Company T as follows:

Cost
Rs.

Retained
profits
Rs.

1 January Year 1

40,000 shares

180,000

500,000

30 June Year 4

120,000 shares

780,000

800,000

No fair value adjustments arose on the acquisition. Between 1 January

Year 1 and 30 June Year 4, Company T was treated as an associate
and the investment in T was accounted for by the equity method. There
was no impairment in the investment.
Company T had issued share capital of 200,000 Rs. 1 ordinary shares.
The fair value of its initial investment in 40,000 shares of T was Rs.
250,000 at 30 June Year 4.
What gain or loss should be recognised on 30 June Year 4 on the initial
investment in 40,000 shares of Company T?

1.2 Purchase of additional equity interest after control is achieved

A company may make a further purchase of shares after control has been
achieved.
This is a transaction between the owners of the subsidiary (the controlling
interest and the non-controlling interest) which will cause the non-controlling
interest to change.
Any difference between the purchase consideration and the change in the noncontrolling interest is recognised directly in equity.

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Chapter 22: Business combinations achieved in stages

The equity adjustment

Illustration: Equity adjustment

Consideration paid

Rs.
X

Reduction in non-controlling interest at the date of the purchase

(X)

Equity adjustment

The reduction in non-controlling interest at the date of the purchase is the share
of net assets given up by the non-controlling interest at that date. This requires a
working to show the net assets of the subsidiary at that date.
This is very similar to the goodwill working but this figure is not goodwill. Goodwill
arises at the acquisition date (the date at which control is achieved).
Non-controlling interest (NCI)
The NCI in the statement of financial position at the reporting date is based on
the percentage holdings at that date.
Group policy might be to measure NCI as a proportionate share of net assets at
the acquisition date. In this case the NCI at the reporting date can be easily
measured as the NCI share of assets at that date.
If group policy is to measure NCI at fair value at the acquisition date the
calculation can be quite tricky. In this case, you have to start with the NCI at the
acquisition date and adjust it by the appropriate NCI share of profits since that
date. This must be adjusted by NCI share of profits sold at the date of the second
purchase by the parent.
Illustration: Non-controlling interest (NCI)
Rs.
NCI at the date of acquisition (Original NCI % u Net assets at that
date)

NCIs share of retained earnings of S from the acquisition date to

the date of the second purchase (based on original NCI %)

NCIs share of retained earnings of S from the date of the second

purchase to the reporting date (based on the new NCI %)

Share of profits disposed of at date of second purchase

NCI at the date of consolidation

This is best demonstrated using figures and is shown in the following example.
Consolidated retained earnings
This must be calculated in the usual way by adding the parents share of the
subsidiarys post acquisition retained profits to those of the parent but
remembering to make the equity adjustment.
The parents share of the subsidiarys post acquisition retained profits must be
measured as two figures.

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Illustration: parents share of the subsidiarys post acquisition retained profits

Rs.
Parents share of retained earnings of S from the acquisition date
to the date of consolidation (Original % held)
Parents share of retained earnings of S from date of second
purchase to the date of consolidation (Incremental NCI% held)

X
X

Equity adjustment

X/(X)
X

Again this is best demonstrated using figures and is shown in the following
example. Work through it carefully.
Example: Purchase of additional equity interest after control is achieved
H bought 60% of S 2 years ago for Rs. 540m. The balance on Ss retained earnings
was Rs. 150m.
H bought 10% of S 1 year ago for Rs. 45m. The balance on Ss retained earnings
was Rs. 300m at this date.
Statements of financial position H and S as at 31 December 20X1:
H
Rs. m
585
2,500

Assets:
Investment in S:
Other assets

S
Rs. m
650

3,085

650

Equity
Share capital
Retained earnings

100
2,485

100
500

Current liabilities

2,585
500

600
50

3,085

650

The NCI was 40% at the date of the first acquisition and remained the same
until the date of the second purchase at which time it changed to 30%;

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Chapter 22: Business combinations achieved in stages

Example (continued) : Purchase of additional equity interest after control is

achieved
A consolidated statement of financial position as at 31 December 20X1 can be
prepared as follows:
H Group: Consolidated statement of financial position at 31 December
20X1
Rs. m
Assets
Goodwill (W
W3)
390
Other assets (2,500 + 650)
3,150
Total assets
Equity
Share capital (P only)
Consolidated retained earnings (see working)

3,540
100
2,710

Non-controlling interest (see working)

2,810
180

Current liabilities (500 + 50)

2,990
550

Total equity and liabilities

3,540

W1: Net assets summary of S

At date of
consolidation

1 year ago

2 years ago

Share capital

100

100

100

Retained earnings

500

300

150

Net assets

600

400

250

W2: Non-ccontrolling interest

Rs. m

NCIs share of net assets at the date of consolidation

(30% of 600 W1 )

180

A proof of this figure is shown at the end of the example

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Example (continued): Purchase of additional equity interest after control is

achieved
W3: Goodwill
Cost of investment

Rs. m
540

Non-controlling interest at acquisition (40% of 250)

100
640
(250)

Net assets at acquisition (see above)

390
W4: Equity adjustment

Rs. m

Cost of investment

45

Non-controlling interest sold (10% of 400)

(40)
5

Consolidated retained profits:

Rs. m

Hs retained earnings

2,485

Equity adjustment W4

(5)

Hs share of the post-acquisition retained earnings of S

(60% of (500  150) W1
(10% of (500  300) W1

210
20
2,710

Non--controlling interest (Proof)

Rs. m

NCIs share of net assets at the date of acquisition (40% u 250)

NCIs share of the post-acquisition retained earnings of S
from date of acquisition to the date of the later purchase
((40% of 300  150) W1))

100

60
160

Less movement in NCI at date of second purchase(10% of 400)

NCIs share of the post-acquisition retained earnings of S
from date of second purchase to the date of consolidation
((30% of 500  300) W1))
NCIs share of net assets at the date of consolidation
(30% of 600) W1

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Chapter 22: Business combinations achieved in stages

Practice question

Company H bought shares in Company S as follows:

Cost
Rs.

Retained
profits
Rs.

1 January Year 1

120,000 shares

600,000

500,000

30 June Year 4

40,000 shares

270,000

800,000

No fair value adjustments arose on the acquisition.

Company S has issued share capital of 200,000 Rs. 1 ordinary shares.
What was the goodwill arising on the acquisition?

Practice question

Company H bought shares in Company S as follows:

Cost

1 January Year 1
30 June Year 4

120,000 shares
40,000 shares

Rs.

Retained
profits
Rs.

600,000
270,000

500,000
800,000

No fair value adjustments arose on the acquisition. There has been no

impairment of goodwill since the acquisition. No goodwill is attributed
to non-controlling interests.
Company S has issued share capital of 200,000 Rs. 1 ordinary shares.
What journal is required on the acquisition of the 40,000 shares in
Company S on 30 June Year 4?

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PATTERN OF OWNERSHIP IN THE CONSOLIDATED STATEMENT OF

PROFIT OR LOSS
Section overview

Introduction

Step acquisition

Purchase of additional equity interest after control is achieved

Purchase turning significant influence into control

2.1 Introduction
The pattern of ownership must be reflected in the statement of profit or loss and
other comprehensive income.
A change in ownership in the period will have an impact on the consolidated
statement of profit or loss and other comprehensive income.
Illustration: Pattern of ownership
Date of
acquisition

Situation 1 is the basic situation which you will have seen before. The results
must be consolidated from the date that control is achieved.
Situations 2 to 4 are explained in more detail in the following sections

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Chapter 22: Business combinations achieved in stages

2.2 Step acquisition

Situation 2: In this case the parent had a previously held equity interest. This
gave the parent no influence. Control was achieved by the second acquisition
and consolidation commences from that point.
Example: Step acquisition
H has owned 10% of S for several years
H bought a further 60% of S on 30th September 20X1.
Statements of profit or loss for the year ended 31 December 20X1:

Revenue
Cost of sales

H
Rs. m
10,000
(7,000)

S
Rs. m
6,000
(4,800)

Gross profit
Expenses

3,000
(1,000)

1,200
(300)

Profit before tax

Income tax

2,000
(500)

900
(160)

Profit after tax

1,500

740

A consolidated statement of comprehensive income can be prepared as follows:

Working
S (3/12)

Consolidated

Revenue
Cost of sales

Rs.
10,000
(7,000)

Rs.
1,500
(1,200)

Rs.
11,500
(8,200)

Gross profit
Expenses

3,000
(1,000)

300
(75)

3,300
(1,075)

Profit before tax

Income tax expense

(500)

(40)

2,225
(540)

Profit for the period

1,500

185

1,685

Total comprehensive income attributable to:

Owners of the parent (balancing figure)
Non-controlling interests (30% of 185)

1,629
56
1,685

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2.3 Purchase of additional equity interest after control is achieved

Situation 3: In this case the parent has a subsidiary for the whole year.
Therefore the results of that subsidiary must be consolidated for the whole year.
However, the pattern of ownership changes during the year. The pattern of
ownership is reflected in the statement of profit or loss by applying the
appropriate NCI to the results for that part of the year in which that NCI was valid.
Example:
H has owned 60% of S for several years
H bought a further 10% of S on 30th September 20X1.
Statements of profit or loss for the year ended 31 December 20X1:

Revenue
Cost of sales

H
Rs. m
10,000
(7,000)

S
Rs. m
6,000
(4,800)

Gross profit
Expenses

3,000
(1,000)

1,200
(300)

Profit before tax

Income tax

2,000
(500)

900
(160)

Profit after tax

1,500

740

A consolidated statement of comprehensive income can be prepared as follows:

Working

Revenue
Cost of sales

H
Rs.
10,000
(7,000)

S
Rs.
6,000
(4,800)

Consolidated
Rs.
16,000
(11,800)

Gross profit
Expenses

3,000
(1,000)

1,200
(300)

4,200
(1,300)

Profit before tax

Income tax expense

2,000
(500)

900
(160)

2,900
(660)

Profit for the period

1,500

740

2,240

Total comprehensive income attributable to:

Owners of the parent (balancing figure)
Non-controlling interests

1,962

40% u 9/12 u 740

222

30% u 3/12 u 740

56
278
2,240

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Chapter 22: Business combinations achieved in stages

2.4 Purchase turning significant influence into control

Situation 4: In this case the parent had significant influence in the first part of the
years and then made an acquisition which achieved control. The results for the
year must be split into two parts. The results for the period in which the parent
had significant influence must be equity accounted. The results for the period in
which the parent had control must be consolidated.
Example: Step acquisition (associate to subsidiary)
H has owned 40% of S for several years. This holding gave H significant influence
over S.
H bought a further 30% of S on 30th September 20X1.
Statements of profit or loss for the year ended 31 December 20X1:

Revenue
Cost of sales

H
Rs. m
10,000
(7,000)

S
Rs. m
6,000
(4,800)

Gross profit
Expenses

3,000
(1,000)

1,200
(300)

Profit before tax

Income tax

2,000
(500)

900
(160)

Profit for the period

1,500

740

A consolidated statement of comprehensive income can be prepared as follows:

Revenue
Cost of sales
Gross profit
Expenses
Share of profit of
associate
(40% u 9/12 u 740)

Working
H
S (3/12)
Rs.
Rs.
10,000
1,500
(7,000)
(1,200)
3,000
(1,000)

300
(75)

Consolidated
Rs.
11,500
(8,200)
3,300
(1,075)

222

Profit before tax

2,447

Income tax expense

(500)

(40)

(540)

Profit for the period

1,500

185

1,907

Total comprehensive income attributable to:

Owners of the parent (balancing figure)
Non-controlling interests (30% of 185)

1,851
56
1,907

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

Goodwill is calculated when control is acquired (IFRS 3).

Rs.
Fair value of original investment

250,000

Cost of additional shares

780,000

Cost of investment to acquire T

1,030,000

Less: Net assets acquired (160/200 u (800 + 200))

(800,000)

Goodwill

230,000

Goodwill is calculated when control is acquired (IFRS 3)

Solution

A step acquisition occurs in June Year 4. The original investment is revalued at fair
value.
Rs.
Cost of original investment

180,000

Share of retained profits of associate (20% u (800 500)

60,000
240,000

Less: Fair value of original investment

(250,000)

Gain recognised in profit or loss

(10,000)

Goodwill is calculated when control is acquired (IFRS 3)

Solution

Goodwill is calculated when control is acquired (IFRS 3). This is on purchase of the
first investment.
Rs.
Fair value of original investment

600,000

Less: Net assets acquired (120/200 u (500 + 200))

(420,000)

Goodwill

180,000

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Solution

4
Dr
Rs. 70,000
Rs. 200,000

Equity attributable to parent

Non-controlling interest
Bank

Cr

Rs. 270,000

The acquisition of the extra 40,000 shares does not affect control of Company S, and
it is therefore accounted for as an equity transaction between equity owners of the
company in their capacity as owners. IAS 27 states that any difference between
cash paid and the adjustment made to NCI is attributed to parent equity

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

23

Complex groups
Contents
1 Introduction
2 Consolidation of sub-subsidiaries (two stage method)
3 Consolidation of mixed groups
4 Other issues

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A1

Presentation of financial statements (IAS 1)

A3

IFRS 10: Consolidated financial statements

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 4

IFRS 3: Business combinations

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Chapter 23: Complex groups

INTRODUCTION
Section overview

Vertical and mixed groups

Date of acquisition of the sub-subsidiary

1.1 Vertical and mixed groups

A subsidiary is an entity controlled by another entity (its parent). It follows that a
parent will also control its subsidiarys subsidiary. A group structure in which a
parent has a subsidiary which in turn is itself a parent of another subsidiary is
known as a vertical group.
In the following explanation we shall refer to the parent as H, its subsidiary as S
and the subsidiarys subsidiary as T.
Illustration: Vertical group

H Ltd owns 75% of S Ltd. S Ltd is thus a subsidiary of H Ltd.

S Ltd owns 60% of T Ltd. T Ltd is a subsidiary of S Ltd.
T Ltd is also a subsidiary of H Ltd.

Explanation
H Ltd has a direct interest in S Ltd and an indirect interest in T Ltd
(exercised via S Ltds holding in T Ltd).
T Ltd is a subsidiary of H Ltd because H Ltd has a controlling interest in S
Ltd and S Ltd has a controlling interest in T Ltd.
This is a vertical group consisting of H Ltd, S Ltd and T Ltd.
T Ltd is said to be a sub-subsidiary of H Ltd.
In practice, structures can be much more complex than this with groups
comprised of many layers of companies. However, they will be consolidated by
applying the same principles as explained in this chapter for the relatively
straightforward vertical group structure shown above.
Another group structure that could be examined is a mixed group (also known as
a D-shaped group).

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Illustration: Mixed group

H Ltd owns 60% of S Ltd and 40% of T Ltd

S Ltd owns 20% of W Ltd.
S Ltd is a subsidiary of H Ltd.
T Ltd is also a subsidiary of H Ltd.

Explanation
H Ltd and S Ltd between them own more than 50% of T Ltd (the fact that S
Ltd is not a wholly-owned subsidiary of H Ltd is irrelevant).
H Ltd controls T Ltd because it owns 40% directly and because it controls
another 20% through its control of S Ltd.
You may also come across examples where there is a sub-associate. This will be
covered in a later section of this chapter.
Status of the investment
The starting point in any question involving a complex structure is to draw a
diagram of the group and then decide on the status of the bottom company in
relation to the ultimate parent.
The bottom company will either be a sub-subsidiary as shown above or a subassociate. The status of the bottom investment is always decided in terms of
whether H can exercise control or significant influence either directly or indirectly.

1.2 Date of acquisition of the sub-subsidiary

A subsidiary must be consolidated from the date of acquisition. The issue is the
date of acquisition of the sub-subsidiary. It is not always obvious as to what that
date should be.
The acquisition date for a sub-subsidiary in a vertical group depends on whether:

the holding company H acquired its shares in subsidiary S before S

acquired its shares in the sub-subsidiary T; or

the holding company H acquired its shares in subsidiary S after S acquired

its shares in the sub-subsidiary T.

The date of acquisition of the sub-subsidiary is the later of the date on which the
main subsidiary (S) was purchased by the parent and the date on which the subsubsidiary (T) was purchased by the main subsidiary (S).
In other words:

Situation 1: If the holding company H acquired its shares in subsidiary S

before S acquired its shares in the sub-subsidiary T, the date that T
becomes a member of the H Group is the date that S acquired the shares
in T.

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Situation 2: If the holding company H acquired its shares in subsidiary S

after S acquired its shares in the sub-subsidiary T, the date that T becomes
a member of the H Group is the date that H acquired its shares in S.

Illustration: Date of acquisition Situation 1

Explanation
H acquired 75% of S on 1 January 20X1.
S acquired 60% of T two years later on 1 January 20X3.
H acquired control of T when S bought its interest on 1 January 20X3.
Therefore, the date of acquisition of T Ltd from H Ltds viewpoint is 1
January 20X3.

Illustration: Date of acquisition Situation 2

Explanation
H acquired 75% of S on 1 January 20X3.
S already held 60% of T.
H therefore acquired control of S and T at the same date.
Therefore, the date of acquisition of T Ltd from H Ltds viewpoint is 1
January 20X3.

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Advanced accounting and financial reporting

CONSOLIDATION OF SUB-SUBSIDIARIES (TWO STAGE METHOD)

Section overview

Consolidation of sub-subsidiaries: Two methods

Indirect method (2 stages)

Direct method (1 stage)

Rationale for splitting the cost of investment when using the direct method

2.1 Consolidation of sub-subsidiaries: Two methods

There are two methods (direct and indirect) which can be used for dealing with
sub-subsidiaries. The different methods may result in different balances for
certain items.

2.2 Indirect method (2 stages)

The consolidation takes place in two stages. Firstly, the S group accounts are
prepared by consolidating T into S. Then, the S group accounts are consolidated
into H.
Example: Consolidation of sub-subsidiary using the indirect method
H Ltd acquired 75% of S Ltd on 1 January 20X4 when the retained profits of S
were Rs. 40,000.
S Ltd acquired 60% of T Ltd on 30 June 20X4 when the retained profits of T Ltd
were Rs. 25,000. They had been Rs. 20,000 on the date of H Ltds acquisition of
S Ltd.
Draft statements of financial position of H Ltd, S Ltd and T Ltd, as at 31
December 20X4, are as follows:
H Ltd
Rs. 000
280
120

Other assets
Investment in S
Investment in T

Share capital
Retained profits
Liabilities

S Ltd
Rs. 000
110

T Ltd
Rs. 000
100

400

80
190

100

200
100
100
400

100
60
30
190

50
30
20
100

A consolidated statement of financial position as at 31 December 20X4 can be

prepared as follows:

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Example: Consolidation of sub-subsidiary using the indirect method

Step 1: Consolidate S Ltd and T Ltd
S Sub--Group:: Consolidated statement of financial position at 31 December
20X4
4
Rs. 000
Assets
Goodwill (W2)
35.00
Other assets (110 + 100)
210.00
Total assets
245.00
Equity
Share capital
100.00
Consolidated retained profits (W4)
63.00
163.00
Non-controlling interest (W3)
32.00
195.00
Current liabilities (30 + 20)
50.00
Total equity and liabilities
245.00
W1: Net assets summary of T
At date of
consolidation
Share capital

50

At date of
acquisition
50

Retained profits

30

25

Net assets

80

75

W2
2: Goodwill (on acquisition of T)

Postacquisition
5

Rs. 000

Cost of investment

80.00

Non-controlling interest at acquisition (40% u 75)

30.00
110.00

Net assets at acquisition (W1)

(75.00)
35.00

W3
3: NCI in T
NCIs share of net assets at the date of acquisition
(40% u 75)
NCIs share of the post-acquisition retained profits of S
(40% of 5 (W1))

30.00
2.00
32.00

W4
4: Consolidated retained profits:
All of Ss retained profits
Ss share of the post-acquisition retained profits of T
(60% of 5 (W1))

60.00
3.00
63.00

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Example: Consolidation of sub-subsidiary using the indirect method

Step 2: Consolidate H Ltd and S Group
H--Group:: Consolidated statement of financial position at 31 December
20X4
4
Rs. 000
Assets
Goodwill (15 (W2) + 35 (step 1))
50.00
Other assets (280 + 210 (step1))
490.00
Total assets
540.00
Equity
Share capital
200.00
Consolidated retained profits (W4)
117.25
317.25
Non-controlling interest (40.75 (W3) + 32 (step 1))
72.75
390.00
Current liabilities (100 + 50 (step1))
150.00
Total equity and liabilities
540.00
W1: Net assets summary of S
At date of
consolidation
100

At date of
acquisition
100

Postacquisition

Retained profits (step 1)

63

40

23

Net assets

163

140

Share capital

W2: Goodwill (on

n acquisition of S)

Rs. 000

Cost of investment

120.00

Non-controlling interest at acquisition (25% u 140)

35.00
155.00

Net assets at acquisition (W1)

(140.00)
15.00

W3: NCI in S
NCIs share of net assets of at the date of acquisition
(25% u 140)
NCIs share of the post-acquisition retained profits of S
(25% of 23 (W1))

35.00
5.75
40.75

W4: Consolidated retained profits:

All of Hs retained profits
Hs share of the post-acquisition retained profits of S Group
(75% u 23)

100.00
17.25
117.25

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In the above example H bought S before S had bought its interest in T. If H

bought S after S had bought its interest in T it would be necessary to calculate
the consolidated net assets of the S group at the date of its acquisition by H.
The indirect method is the way that most groups would perform consolidation in
practice. However, examiners usually expect the use of the direct approach when
answering exam questions.

2.3 Direct method (1 stage)

This approach involves identifying Hs effective holding in the sub-subsidiary and
then using this to consolidate the sub-subsidiary directly along with the main
subsidiary.
Illustration: Effective holding

H Ltd owns 75% of S Ltd.

S Ltd owns 60% of T Ltd.
H Ltd effectively owns 45% (75% of 60%) of T Ltd

Comment
H Ltd will consolidate a 75% of interest in S Ltd. The non-controlling
interest in S Ltd is 25%.
H Ltd will consolidate a 45% of interest in S Ltd. The non-controlling
interest in S Ltd is 55% (taken as a balancing figure).
Do not be confused by the existence of a non-controlling interest of 55%.
Remember that we have already established that T is a subsidiary of H.
The effective interests are mathematical conveniences which allow us to
produce the consolidation. (Ownership and control are two separate
issues).
The main subsidiary is consolidated by the parent in the usual way.
The sub-subsidiary is also consolidated by the parent in the usual way using the
effective holding with one further adjustment. The cost of investment in T is split.
Hs share is used in the goodwill working and the balance is charged to the noncontrolling interest.
To illustrate, in the next example the cost of investment in T is Rs. 80,000. This
number is split so that Hs share of Rs. 60,000 (75% u Rs. 80,000) is the cost
used in the goodwill calculation and the balance Rs. 20,000 (25% u Rs. 80,000)
is a deduction from the non-controlling interest.

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Example: Consolidation of sub-subsidiary using the direct method

H Ltd acquired 75% of S Ltd on 1 January 20X4 when the retained profits of S
were Rs. 40,000.
S Ltd acquired 60% of T Ltd on 30 June 20X4 when the retained profits of T Ltd
were Rs. 25,000. They had been Rs. 20,000 on the date of H Ltds acquisition of
S Ltd.
Draft statements of financial position of H Ltd, S Ltd and T Ltd, as at 31
December 20X4, are as follows:
H Ltd
Rs. 000
280
120

Other assets
Investment in S
Investment in T

Share capital
Retained profits
Liabilities

S Ltd
Rs. 000
110

T Ltd
Rs. 000
100

400

80
190

100

200
100
100
400

100
60
30
190

50
30
20
100

A consolidated statement of financial position as at 31 December 20X4 can be

prepared as follows:
H Group:: Consolidated statement of financial position at 31 December
20X4
4
Rs. 000
Assets
Goodwill (W2)
41.25
Other assets (280 + 110 + 100)
490.00
Total assets
531.25
Equity
Share capital
200.00
Consolidated retained profits (W4)
117.25
317.25
Non-controlling interest (W3)
64.00
381.25
Current liabilities
150.00
Total equity and liabilities
531.25

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Chapter 23: Complex groups

Example (continued): Consolidation of sub-subsidiary using the direct method

W1a: Net assets summary of S
At date of
consolidation
100

At date of
acquisition

Retained profits

60

40

Net assets

160

140

Share capital

W1b: Net assets summary of T

At date of
consolidation
Share capital
50

Postacquisition

100
20

At date of
acquisition
50

Postacquisition
5

Retained profits

30

25

Net assets

80

75

W2: Goodwill

Rs. 000

On acquisition of S
Cost of investment

120.00

Non-controlling interest at acquisition (25% u 140 (W1a))

35.00
155.00

Net assets at acquisition (see above)

(140.00)
15.00

On acquisition of T
Cost of investment (75% u 80)

60.00

Non-controlling interest at acquisition (55% u 75 (W1b))

41.25
101.25

Net assets at acquisition (see above)

(75.00)
26.25

Total goodwill

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Example (continued): Consolidation of sub-subsidiary using the direct method

W3: Non--controlling interest
NCI in S

Rs. 000

NCIs share of net assets of at the date of acquisition

(25% u 140 (W1a))
NCIs share of the post-acquisition retained profits of S
(25% of 20 (W1a))
NCIs share of net assets at the date of consolidation

35.00
5.00
40.00

NCI in T
NCIs share of net assets of at the date of acquisition
(55% u 75(W1b))
NCIs share of the post-acquisition retained profits of S
(55% of 5 (W1b))

41.25
2.75

NCIs share of net assets at the date of consolidation

44.00

Less NCI in S share of cost of investment in T (25% u 80)

(20.00)
24.00

Total NCI

64.00

W4: Consolidated retained profits:

Rs.

All of Hs retained profits

Hs share of the post-acquisition retained profits of S
(75% of 20 (W1a))
Hs share of the post-acquisition retained profits of T
(45% of 5 (W1b))

100.00
15.00
2.25
117.25

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Chapter 23: Complex groups

2.4 Rationale for splitting the cost of investment when using the direct method
Goodwill
Goodwill is the difference between the cost of investment and the share of net
assets acquired. This is not obvious from the format of the calculation but it can
be rearranged to demonstrate this as follows:
Example: Goodwill on acquisition
Returning to the facts of the previous example:
Goodwill on acquisition of S

Rs. 000

Cost of investment

120.00

Non-controlling interest at acquisition (25% u 140)

35.00
155.00

Net assets at acquisition (see above)

(140.00)
15.00

This could be rearrranged to:

Cost of investment

120.00

Less: Share of net assets at acquisition

Net assets at acquisition (see above)

140.00

Non-controlling interest at acquisition

(35.00)

(75% u 140)

105.00
15.00

The effective interest is the parents share of the main subsidiaries share of the
sub-subsidiary.

Goodwill calculated for the main subsidiary is cost less share of net assets.

Goodwill calculated for the sub-subsidiary must be the share of cost less
share of share of net assets.

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Non-controlling interest
In previous examples, the NCI in the sub-subsidiary was calculated as a
balancing figure. It is possible to prove this figure in terms of the shareholdings of
the main subsidiary and the sub-subsidiary.
Illustration: Non-controlling interest

Comment
H Ltd has an effective interest of 45% of T (75% u 60%).
The NCI is 55% (taken as a balancing figure).
The NCI in the sub-subsidiary is made up of the following:
NCI in T

40%

NCI in Ss share of investment in T (25% u 60%)

15%
55%

Consolidation involves replacing cost of investment with a share of net assets.

Using the effective interest to calculate the NCI in the sub-subsidiary gives the
NCI in the main subsidiary a share of the net assets of the sub-subsidiary (see
the 15% above). However, the NCI in the main subsidiary has already been given
a share of the net assets of the main subsidiary and this includes the cost of
investment in T. Therefore, the NCI in the main subsidiarys share of cost must
be eliminated to avoid double counting.
This sounds more complicated than it is. Always split the cost of investment in
the sub-subsidiary as shown in the worked example.

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Chapter 23: Complex groups

Practice question

The statements of financial position H, S and T as at 31 December 20X7

were as follows:
Assets:

H (R
Rs.)

Investment in S

S(R
Rs.)

T((Rs.))

5,000

Investment in T

750

Other assets

11,900

6,000

1,500

16,900

6,750

1,500

10,000

3,000

300

Retained profits

4,900

2,750

700

Liabilities

2,000

1,000

500

16,900

6,750

1,500

Equity
Share capital

H acquired its 80% investment in S on 1 January 20X7.

S acquired its 60% investment in T on 1 January 20X4.
At the dates of the share purchases, the following information is
available:
Retained
Retained
profits of S
profits of T
Date
1 January 20X4
2,000
500
1 January 20X7

2,300

650

Required
Prepare the consolidated statement of financial position for the H Group
as at 31 December 20X7.

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Practice question

The statements of financial position H, S and T as at 31 December 20X8

were as follows:
Assets:

H (R
Rs. 000)

Investment in S

S(R
Rs. 000)

T((Rs. 000)

3,300

Investment in T

2,200

Other assets

3,700

2,400

3,500

7,000

4,600

3,500

Share capital

4,000

2,500

2,000

Retained profits

2,000

1,100

1,000

Liabilities

1,000

1,000

500

7,000

4,600

1,500

Equity

H acquired its 80% investment in S on 1 January 20X7.

S acquired its 60% investment in T on 31 December 20X7.
H measures NCI on acquistion at its fair value.
At the dates of the share purchases, the following information is
available:
Date
1 January 20X7

Retained profits Retained profits

of S (Rs. 000)
of T (Rs. 000)
400
200

31 December 20X7

Date
1 January 20X7

700

320

Fair value of NCI Fair value of NCI

of S (Rs. 000)
of T (Rs. 000)
800
1,600

31 December 20X7

960

2,000

Required
Prepare the consolidated statement of financial position for the H Group
as at 31 December 20X8.

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Chapter 23: Complex groups

CONSOLIDATION OF MIXED GROUPS

Section overview

Mixed groups
Effective interest in mixed groups

Date of acquisition of the sub-subsidiary in a mixed group

Direct method consolidation of mixed group

3.1 Mixed groups

In a mixed group, the parent has both direct and indirect interests in the subsubsidiary. The following illustration was shown earlier in section 1 of this
chapter. It is repeated here for your convenience.
Illustration: Mixed group

H Ltd owns 60% of S Ltd and 40% of T Ltd

S Ltd owns 20% of W Ltd.
S Ltd is a subsidiary of H Ltd.
T Ltd is also a subsidiary of H Ltd.

3.2 Effective interest in mixed groups

In the above example of a mixed group, H has two interests in T:

It has a direct interest in T, with the shares that it owns in T.

It also has an indirect interest in T, through its control of S, which also owns
shares in T.

The group interest in the sub-subsidiary T is the sum of the direct interest and the
indirect interest in T as follows:
Illustration: Mixed group Effective interest in sub-subsidiary
Hs direct holding in T

40%

Hs indirect holding in T (60% u 20%)

12%

Hs effective holding in T

52%

Non-controlling interest in T (balance)

48%
100%

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3.3 Date of acquisition of the sub-subsidiary in a mixed group

The same rules apply to mixed groups as they do to vertical groups.
Illustration: Date of acquisition Situation 1

Commentary
H obtains control of S on 1 May 20X1.
H obtains control of T on 1 May 20X3 when S acquires its stake in T.
From 1 May 20X2 to 1 May 20X3, T is an associate of H.
From 1 May 20X3 onwards T is a subsidiary of H and H has an effective
holding of 66% (30% + (80% 45%)) in T.

Illustration: Date of acquisition Situation 2

Commentary
H achieves significant influence over T on 1 May 20X2.
H obtains control of S on 1 May 20X4. Thus H also obtains control of T. due
to gaining indirect control over Ss holding in T.
From 1 May 20X2 to 1 May 20X4, T is an associate of H.
From 1 May 20X4 onwards T is a subsidiary of H.
The above illustrations show that there is a further complication that must be
taken into account when consolidating mixed groups. If Hs direct and indirect
interests in the sub-subsidiary arise on different dates the step acquisition rules
apply.

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Chapter 23: Complex groups

3.4 Direct method consolidation of mixed group

Example: Consolidation of a mixed group
The statements of financial position H, S and T as at 31 December 20X7 were as
follows:
Assets:

H (R
Rs. 000)

S(R
Rs.000))

T((Rs.0
000)

Investment in S

5,000

Investment in T

1,000

1,750

11,900

9,000

2,400

17,900

10,750

2,400

10,000

3,000

300

Retained profits

5,900

4,750

1,600

Liabilities

2,000

3,000

500

17,900

10,750

2,400

Other assets
Equity
Share capital

H acquired its 80% investment in S on 1 June 20X1.

H acquired its 10% investment in S on 15 October 20X2.
S acquired its 45% investment in T on 1 May 20X3.
The following information is available:
Retained
profits of S

Retained
profits of T

Rs. 000

Rs. 000

1 June 20X1
15 October 20X2

2,000
2,300

500
650

1 May 20X3

3,000

800

Date

The fair value of Hs 10% holding in T was Rs. 1,500,000 on 1 May 20X3.
Required
Prepare the consolidated statement of financial position for the H Group
as at 31 December 20X7.

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Example: Consolidation of a mixed group

H Group: Consolidated statement of financial position at 31 December 20X7:
Rs. 000
Assets
Goodwill (W3)
Other assets (11,900 + 9,000 + 2,400)
Total assets
Equity
Share capital
Consolidated retained profits (W5)

3,394
23,300
26,694
10,000
8,968
18,968
2,226
21,194
5,500
26,694

Non-controlling interest (W2)

Liabilities (2,000 + 3,000 + 500)
Total equity and liabilities
Workings
W1: Group structure

T became a subsidiary of H on 1 May 20X3 when S bought its interest in T.

Hs effective holding in T
Direct holding

10%

Indirect holding (80% u 45%)

36%

Effective holding

46%

Non-controlling interest (balance)

54%
100%

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Chapter 23: Complex groups

Example (continued): Consolidation of a mixed group

W2a: Net assets summary of S

Share capital

At date of
consolidation
3,000

At date of
acquisition
3,000

Retained profits

4,750

2,000

Net assets

7,750

5,000

W2b: Net assets summary of T

At date of
consolidation
Share capital
300

Postacquisition
2,750

At date of
acquisition
300

Postacquisition
800

Retained profits

1,600

800

Net assets

1,900

1,100

W3: Goodwill

Rs. 000

On acquisition of S
Cost of investment

5,000

Non-controlling interest at acquisition (20% u 5,000 (W2a))

1,000
6,000

Net assets at acquisition (see above)

(5,000)
1,000

On acquisition of T
Direct holding
Cost of direct holding

1,000

Fair value adjustment

500

Fair value of first purchase (given)

1,500

Indirect holding
Cost of investment (80% u 1,750)

1,400

Total cost of control

2,900

Non-controlling interest at acquisition (54% u 1,100 (W2b))

594
3,494

Net assets at acquisition (see above)

(1,100)
2,394

Total goodwill

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Example (continued): Consolidation of a mixed group

W4: Non--controlling interest
NCI in S

Rs. 000

NCIs share of net assets of at the date of acquisition

(20% u 5,000 (W2a))
NCIs share of the post-acquisition retained profits of S
(20% of 2,750 (W2a))
NCIs share of net assets at the date of consolidation

1,000
550
1,550

NCI in T
NCIs share of net assets of at the date of acquisition
(54% u 1,100(W2b))
NCIs share of the post-acquisition retained profits of S
(54% of 800 (W2b))
NCIs share of net assets at the date of consolidation
Less NCI in S share of cost of investment in T (20% u 1,750)

594
432
1,026
(350)
676

Total NCI

2,226

W5: Consolidated retained profits:

Rs. 000

All of Hs retained profits

5,900

Revaluation of first investment in T

500
6,400

Hs share of the post-acquisition retained profits of S

(80% of 2,750 (W2a))
Hs share of the post-acquisition retained profits of T
(46% of 800 (W2b))

2,200
368
8,968

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OTHER ISSUES
Section overview

Accounting for sub-associates

Consolidated statements of profit or loss when there are sub-subsidiaries

4.1 Accounting for sub-associates

An associate is an entity over which an investor has significant influence.
Sub-subsidiaries may be consolidated either using the indirect (2 stage) method
or the direct (1 stage) method.
There is no such choice in accounting for interests in sub-associates. They must
be accounted for using a two stage approach.

Step 1: The investment is equity accounted into the financial statements of

the main subsidiary.

Step 2: The revised statements of the main subsidiary are then

consolidated with those of the parent. The main subsidiarys non-controlling
interest will share in the equity accounted associate in the usual way.

There is no concept of effective holding when accounting for investments in subassociates.

This is because when a member of a group has a holding that gives it significant
influence over another entity, that entity is not a member but an associate of the
group. As such it must be equity accounted into the group accounts based on the
groups share of the movement in its net assets since the date of acquisition.

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Example: Consolidation where there is a sub-associate

H Ltd acquired 75% of S Ltd on 1 January 20X4 when the retained profits of S
were Rs. 40,000.
S Ltd acquired 20% of T Ltd on 30 June 20X4 when the retained profits of T Ltd
were Rs. 25,000. They had been Rs. 20,000 on the date of H Ltds acquisition of
S Ltd.
Draft statements of financial position of H Ltd, S Ltd and T Ltd, as at 31
December 20X4, are as follows:
H Ltd
Rs. 000
280
120

Other assets
Investment in S
Investment in T

Share capital
Retained profits
Liabilities

S Ltd
Rs. 000
110

T Ltd
Rs. 000
100

400

80
190

100

200
100
100
400

100
60
30
190

50
30
20
100

A consolidated statement of financial position as at 31 December 20X1 can be

prepared as follows:
H Group:: Consolidated statement of financial position at 31 December
20X1
Rs.
Assets
Goodwill (see working)
Investment in associate
Other assets
Total assets
Equity
Share capital
Consolidated retained profits (see working)
Non-controlling interest (see working)
Current liabilities
Total equity and liabilities

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15
82
390
487
200
116.5
316.5
40.5
357
130
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Chapter 23: Complex groups

Example (continued): Consolidation where there is a sub-associate

Step 1:Equity account T into S
Net assets summary of T
At date of
consolidation
50

At date of
acquisition

Retained profits

30

25

Net assets

80

75

Share capital

Postacquisition

50

In Ss books

Dr

Cost of investment

Cr

Statement of profit or loss (retained profits)

(40% u 5)
Ss balances change as follows:

2
Investment in
S
80

Retained
profits

82

62

At date of
consolidation
100

At date of
acquisition
100

Postacquisition

Retained profits

62

40

22

Net assets

80

140

Per question
Share of post-acquisition profits

60

Step 2: Consolidate S into H

Net assets summary of S

Share capital

Goodwill on
n acquisition of S

Rs.

Cost of investment

120

Non-controlling interest at acquisition (25% u 140)

35
155

Net assets at acquisition (see above)

(140)
15

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Example (continued): Consolidation where there is a sub-associate

Non--controlling interest
NCI in S

Rs.

NCIs share of net assets of at the date of acquisition

(25% u 140)
NCIs share of the post-acquisition retained profits of S
(25% of 22 (see above))
NCIs share of net assets at the date of consolidation

35
5.5
40.5

Consolidated retained profits:

Rs.

All of Hs retained profits

Hs share of the post-acquisition retained profits of S
(75% of 22 (see above))

100
16.5
116.5

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Chapter 23: Complex groups

5.2 Consolidated statements of profit or loss when there are sub-subsidiaries

Consolidation of statements of profit or loss involving sub-subsidiaries and subassociates is carried out as normal. The effective rate may be used to
consolidated sub-subsidiaries and sub-associates are equity accounted using a
two stage process.
There is one possible complication when consolidating sub-subsidiaries..

If the sub-subsidiary has paid a dividend and the main subsidiary has
accounted for its share through the profit and loss account this will be part
of the subsidiarys profit before tax.

It must be eliminated (as a consolidation adjustment) during the noncontrolling interest calculation.

Example: Consolidated statement of profit or loss with a sub-subsidiary

H owns 80% of S which owns 60% of T.
Hs effective holding in T is 48% (80% u 60%) and the NCI in T is 52%.
T has paid a dividend of Rs. 200 and S has duly accounted for its share (Rs. 120
= 60% of Rs. 200) as follows
H
1,200

Operating profit
Dividend receivable from T
Taxation

S
600
120*

T
500

CP&L
2,300

2,300
(750)
1,550


1,200
(400)

720
(250)


500
(100)

800

470

400

PAT

Total comprehensive income attributable to:

Owners of the parent (balancing figure)
Non-controlling interests (working)

1,272
278
1,550

Working: Non-controlling interest

In S (20% u (470  120)

70

In T (52% u 400)

208
278

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

H Group:: Consolidated statement of financial position at 31 December 20X4

Rs.
Assets
Goodwill (W2)
904
Other assets (11,900 + 6,000 + 1,500)
19,400
Total assets
20,304
Equity
Share capital
10,000
Consolidated retained profits (W4)
5,284
15,284
Non-controlling interest (W3)
1,520
16,804
Current liabilities (2,000 + 1,000 + 500)
3,500
Total equity and liabilities
20,304
W1: Group structure

S acquired its interest in T before H purchased its interest in S.

Therefore, both S and T entered the H group on 1 January 20X7.
Hs effective holding in T (80% u 60%)
Non-controlling interest (balance)

48%
52%
100%

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Chapter 23: Complex groups

Solution (continued)

W1a: Net assets summary of S

At date of
consolidation
3,000

At date of
acquisition

Retained profits

2,750

2,300

Net assets

5,750

5,300

At date of
consolidation
300

At date of
acquisition
300

Postacquisition

700

650

50

1,000

950

Share capital

Postacquisition

3,000
450

W1b: Net assets summary of T

Share capital
Retained profits
Net assets
W2: Goodwill

Rs.

On acquisition of S
Cost of investment

5,000

Non-controlling interest at acquisition (20% u 5,300 (W1a))

1,060
6,060

Net assets at acquisition (see above)

(5,300)
760

On acquisition of T
Cost of investment (80% u 750)

600

Non-controlling interest at acquisition (52% u 950 (W1b))

494
1,094

Net assets at acquisition (see above)

(950)
144

Total goodwill

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Solution (continued)

W3: Non--controlling interest

NCI in S

Rs.

NCIs share of net assets at the date of acquisition

(20% u 5,300 (W1a))
NCIs share of the post-acquisition retained profits of S
(20% of 450 (W1a))
NCIs share of net assets at the date of consolidation

1,060
90
1,150

NCI in T
NCIs share of net assets at the date of acquisition
(52% u 950 (W1b))
NCIs share of the post-acquisition retained profits of S
(52% of 50 (W1b))
NCIs share of net assets at the date of consolidation
Less NCI in S share of cost of investment in T (20% u 750)

494
26
520
(150)
370

Total NCI

1,520

W4: Consolidated retained profits:

Rs.

All of Hs retained profits

Hs share of the post-acquisition retained profits of S
(80% of 450 (W1a))
Hs share of the post-acquisition retained profits of T
(48% of 50 (W1b))

4,900
360
24
5,284

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Chapter 23: Complex groups

Solution

H Group:: Consolidated statement of financial position at 31 December 20X4

Rs. 000
Assets
Goodwill (W2)
2,640
Other assets (3,700 + 2,400 + 3,500)
9,600
Total assets
12,240
Equity
Share capital
4,000
Consolidated retained profits (W4)
2,886
6,886
Non-controlling interest (W3)
2,854
9,740
Current liabilities (1,000 + 1,000 + 500)
2,500
Total equity and liabilities
12,240
W1: Group structure

S acquired its interest in T after H purchased its interest in S.

Therefore, the date of acquisition of S is 1 January 20X7 and the date of
acquisition of T is 31 December 20X7
Hs effective holding in T (80% u 60%)
Non-controlling interest (balance)

48%
52%
100%

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Solution (continued)

W1a: Net assets summary of S

Share capital

At date of
consolidation
2,500

At date of
acquisition

Postacquisition

2,500

Retained profits

1,100

400

Net assets

3,600

2,900

700

W1b: Net assets summary of T

Share capital

At date of
consolidation
2,000

At date of
acquisition
2,000

Postacquisition
680

Retained profits

1,000

320

Net assets

3,000

2,320

W2: Goodwill

Rs. 000

On acquisition of S
Cost of investment

3,300

Non-controlling interest at acquisition(fair value)

800
4,100

Net assets at acquisition (see above)

(2,900)
1,200

On acquisition of T
Cost of investment (80% u 2,200)
Non-controlling interest at acquisition (fair value)

1,760
2,000
3,760

Net assets at acquisition (see above)

(2,320)
1,440

Total goodwill

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Solution (continued)

W3: Non--controlling interest

NCI in S

Rs. 000

Fair value of NCI at the date of acquisition

NCIs share of the post-acquisition retained profits of S
(20% of 700 (W1a))

800
140

NCI at the date of consolidation

940

NCI in T
Fair value of NCI at the date of acquisition
NCIs share of the post-acquisition retained profits of S
(52% of 680 (W1b))

2,000

NCI at the date of consolidation

2,354

Less NCI in S share of cost of investment in T (20% u 2,200)

354
(440)
1,914
2,854

W4: Consolidated retained profits:

Rs. 000

All of Hs retained profits

Hs share of the post-acquisition retained profits of S
(80% of 700 (W1a))
Hs share of the post-acquisition retained profits of T
(48% of 680 (W1b))

2,000
560
326
2,886

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

24

Disposal of subsidiaries

Contents
1 Full disposals
2 Part disposals
3 Disposal of a subsidiary which does not contain a
business
4 IFRS 5 and disposals

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A3

IFRS 10: Consolidated financial statements

A9

IFRS 5: Non-current assets held for sale and discontinued operations

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Chapter 24: Disposal of subsidiaries

FULL DISPOSALS
Section overview

Introduction

Pattern of ownership

Profit or loss on disposal

Step by step approach

1.1 Introduction
A parent company might dispose of a holding in a subsidiary.
IFRS 10 Consolidated Financial Statements contains rules on accounting for
disposals of a subsidiary.
Accounting for a disposal is an issue that impacts the statement of profit or loss.
There are two major tasks in constructing a statement of profit or loss for a period
during which there has been a disposal of a subsidiary:

The statement of profit or loss must reflect the pattern of ownership of

subsidiaries in the period.

When control is lost, the statement of profit or loss must show the profit or
loss on disposal of the subsidiary.

The rules in IFRS 10 cover full disposals and part disposals.

When a parent makes a part disposal of an interest in a subsidiary it will be left
with a residual investment. The accounting treatment for a part disposal depends
on the nature of the residual investment.
If a part disposal results in loss of control the parent must recognise a profit or
loss on disposal in the consolidated statement of profit or loss.
A part disposal which does not result in loss of control is a transaction between
the owners of the subsidiary. In this case the parent does not recognise a profit
or loss on disposal in the consolidated statement of profit or loss. Instead the
parent recognises an equity adjustment.

1.2 Pattern of ownership

The pattern of ownership in a period is always reflected in the consolidated
statement of profit or loss.
IFRS 11 requires that an interest in a subsidiary is consolidated from the date of
acquisition to the date of disposal.

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Illustration: Disposal during the year

An interest in an associate must also be equity accounted from the date that
significant influence is achieved to the date that it is lost.
Thus, the figures from the statement of profit or loss and other comprehensive
income that relate to the period up to the date of disposal must be identified. In
practice, this would normally be achieved by constructing a set of accounts up to
the date of disposal. In exam questions we tend to use time apportionment.
There is another reason for consolidating up to the date of disposal. The
calculation of the profit on disposal involves comparing the sale proceeds to what
leaves the statement of financial positon as at the date of disposal. Therefore, the
results of the subsidiary must be consolidated up to the date of disposal in order
to establish the correct net assets figure.

1.3 Profit or loss on disposal

IFRS 10 specifies an approach to calculating the profit or loss on disposal.
This approach involves comparing the asset that is recognised as a result of the
disposal (i.e. the proceeds of the sale) to the amounts that are derecognised as a
result of the disposal.

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Chapter 24: Disposal of subsidiaries

The calculation is as follows:

Illustration: Profit (loss) on disposal
Recognise:

Rs.

Proceeds

Fair value of residual interest (only for part disposals)

X
X

Derecognise:
Net assets of subsidiary

Non-controlling interest

(X)

Share of net assets

(X)

Unimpaired goodwill

(X)

Profit(loss) on disposal recognised in profit or loss

Example: Profit on disposal of a subsidiary

On 1 January Year 9, H Ltd acquired 90% of the equity shares of S Ltd for Rs.120
million.
The fair value of the identifiable net assets in S Ltd at that date was Rs.111
million. The fair value of the NCI at 1 January Year 9 was Rs.9 million.
H Ltd uses the full goodwill method for consolidation leading to the recognition of
goodwill of Rs.18m ((Rs.120m + Rs.9m  Rs.111m).
H Ltd subsequently sold the shares on 31 December Year 9 for Rs.197 million.
The carrying value of the net assets of S Ltd at 31 December Year 9 was Rs.124
million.
The gain on disposal recognised in profit or loss should be calculated as follows:
Rs. m
Consideration received for shares in S Ltd on 31 December

197.0

Net assets de-recognised in consolidated accounts

Net assets de-recognised

124.0

Value of NCI at 31 December

(Rs. 9m + 10% u (124 million 111 million))

(10.3)
113.7

Goodwill derecognised: (120 + 9 111)

18.0

Net assets sold

(131.7)

Gain on disposal, reported in profit or loss

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The calculation of profit or loss on disposal must be supported by several other

calculations. These are:

the goodwill arising on acquisition, which in turn needs the net assets of the
subsidiary at the date of acquisition; and

the net assets of the subsidiary at the date of disposal, which in turn needs
a calculation of the equity reserves at the date of disposal.

Example:
At 1 January Year 9, H Ltd held 80% of the equity of S Ltd. The carrying value of
the net assets of S Ltd at this date was Rs.570 million.
There was also goodwill of Rs.20 million net of accumulated impairments
relating to the investment in S Ltd: all this goodwill is attributable to the equity
owners of H Ltd.
On 1 April Year 9, H Ltd sold its entire shareholding in S Ltd for Rs.575 million in
cash.
H Ltd has a financial year ending 31 December. It was subsequently established
that the profit after tax of S Ltd for the year to 31 December Year 9 was Rs.120
million.
S Ltd did not make any dividend payment during the year before the disposal of
the shares.
How should the disposal of the shares be accounted for? (Ignore deferred
taxation).

Answer
In the three months of the year to the date of disposal of the shares in S Ltd, the
after-tax profit of S Ltd was Rs.30 million (Rs.120 million u 3/12).
The carrying value of the net assets of S Ltd at the date that control was lost is
therefore Rs.600 million (Rs.570 million + Rs.30 million).
The gain on disposal of the shares is as follows:
Rs. million
Consideration received from sale of shares

575

Net assets derecognised (including goodwill)

NCI removed/derecognised

620
(120)

H Ltds share of assets derecognised

(500)

Total gain

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Chapter 24: Disposal of subsidiaries

Practice question

P bought 80% of the issued ordinary shares of S twenty five years ago at a
cost of Rs. 330,000 when the net assets of S amounted to Rs. 280,000.
No goodwill is attributed to the non-controlling interests. Goodwill arising on
the acquisition has suffered an impairment of 80% of its original value.
On the final day of the current accounting period P sold its entire
shareholding in S for proceeds of Rs.460,000. At this date the net assets of
S amounted to Rs. 400,000.
Required
What is the profit or loss on disposal reported in consolidated profit or loss
for the current period?

1.4 Step by step approach

The following approach can be used to prepare answers to questions requiring a
consolidated statement of profit or loss when there is a disposal of a subsidiary
during the year.
Step 1: Reflect the pattern of ownership
Construct a pro-forma answer with columns for the parent, the subsidiary and the
consolidated figures.
Enter the figures to be consolidated remembering to prorate the subsidiarys
figures up to the date of disposal and add across to give the consolidated figures.
The non-controlling interest can be calculated from the subsidiarys column.
Step 2: Construct the following workings:

Net assets summary as at the date of disposal and the date of acquisition

Retained earnings as at the date of disposal (for the above);

Goodwill arising on acquisition (using the net assets at the date of

acquisition from the net assets summary)

Step 3: Calculate the profit or loss on disposal

Step 4: Include the profit or loss on disposal into the consolidated statement of
profit or loss and finish it off.
Work through the following example carefully.

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Example: Facts
Example: Disposal of subsidiary
The following financial statements are to the year-end 31 December 20X4
H

Statements of profit or loss

Rs.000

Rs.000

Revenue

22,950

8,800

Expenses

(10,000)

(5,000)

Operating profit
Tax

12,950
(5,400

3,800
(2,150)

Profit after tax

7,550

1,650

Rs.000

Rs.000

Retained earnings b/f

3,760

1,850

Profit after tax

7,550

1,650

11,310

3,500

Statement of changes in equity

Retained earnings c/f

a.

H Ltd bought 90% of S Ltd 4 years ago for Rs. 3,750,000 when the
retained earnings of S ltd were Rs. 500,000.
S Ltd has share capital of Rs. 3,000,000.

b.

H Ltd sold its entire holding in S Ltd on 30 September 20X4 for Rs.
9,500,000.
S Ltd does not qualify to be treated as a discontinued operation
under IFRS5.

c.

Prepare the consolidated statement of profit or loss for the year ended
31 December 20X4.

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Chapter 24: Disposal of subsidiaries

Step 1: Reflect the pattern of ownership

Answer

S (9/12)

Group

Statements of profit or loss

Rs.000

Rs.000

Rs.000

Revenue

22,950

6,600

29,550

Expenses

(10,000)

(3,750)

(13,750)

12,950

2,850

15,800

(5,400)

(1,612)

(7,012)

7,550

1,238

Operating profit
Profit on disposal (W)
Profit before tax
Tax
Profit after tax

Profit attributable to:

Rs.000

Owners of the parent

Non-controlling interest (10% of 1,238)

124

Profit for the year

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Step 2: Key workings

Answer
W1: Net assets summary
At date of
disposal
Rs.000

At date of
acquisition
Rs.000

Share capital

3,000

3,000

Retained earnings (W2)

3,088

500

Net assets

6,088

3,500

W2: Retained earnings at date of disposal

Retained earnings at start of year
Profit for the period up to the date of disposal
(9/12 u 1,650,000)

Rs.000
1,850
1,238
3,088
Rs.000

W3: Goodwill
Cost of investment
Non-controlling interest at acquisition
(10% u 3,500,000 (W1))

3,750
350
4,100

Net assets at acquisition (see above)

(3,500)
600

Step 3: Profit on disposal

Answer
Rs.000

W4: Profit on disposal

Sale proceeds

9,500

Derecognise:
Net assets at date of disposal (W1)

6,088

NCI at date of disposal (10% u 6,088,000 (W1))

(609)
(5,479)

Goodwill (W3)

(600)
3,421

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Chapter 24: Disposal of subsidiaries

Step 4: Complete the answer

Answer
H Plc: Consolidated statement of profit or loss for the year ended 31 December
20X4

S (9/12)

Group

Statements of profit or loss

Rs.000

Rs.000

Rs.000

Revenue

22,950

6,600

29,550

Expenses

(10,000)

(3,750)

(13,750)

12,950

2,850

15,800
3,421

Operating profit
Profit on disposal (W)
Profit before tax

19,221

Tax

(5,400)

(1,612)

(7,012)

7,550

1,238

12,209

Profit after tax

Profit attributable to:

Rs.000

Owners of the parent (balancing figure)

12,085

Non-controlling interest (10% of 1,238)

124

Profit for the year

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PART DISPOSALS
Section overview

Part disposal with loss of control

Part disposal with no loss of control

2.1 Part disposal with loss of control

As stated previously there are two major tasks in constructing a statement of
profit or loss for a period during which there has been a disposal of a subsidiary:

The statement of profit or loss must reflect the pattern of ownership of

subsidiaries in the period.

When control is lost, the statement of profit or loss must show the profit or
loss on disposal of the subsidiary.

When a parent makes a part disposal of an interest in a subsidiary it will be left

with a residual investment. The accounting treatment for a part disposal depends
on the nature of the residual investment.
If a part disposal results in loss of control the parent must recognise a profit or
loss on disposal in the consolidated statement of profit or loss.
The pattern of ownership must reflect the nature of the residual investment.
IFRS calculation of profit on disposal has been shown before but is repeated
here for your convenience.
Illustration: Profit (loss) on disposal
Recognise:

Rs.

Proceeds

Fair value of residual interest (only for part disposals)

X
X

Derecognise:
Net assets of subsidiary

Non-controlling interest

(X)

Share of net assets

(X)

Unimpaired goodwill

(X)
X

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Chapter 24: Disposal of subsidiaries

Example: Profit on part disposal of a subsidiary

H Ltd acquired 90% of the equity shares of S Ltd for Rs.120 million.
Goodwill on consolidation was Rs.18m
There had been no impairment of goodwill since the date of acquisition.
H Ltd sold a 50% holding (leaving it with a 40% holding) for Rs.100 million. This
transaction resulted in H Ltd losing control of S ltd.
The fair value of the residual investment (i.e. the remaining 40%) was estimated
to be Rs.70
The carrying value of the net assets of S Ltd at 31 December Year 9 was Rs.124
million.
The gain on disposal recognised in profit or loss should be calculated as follows:
Recognised:

Rs. m

Consideration received for shares in S Ltd on 31 December

Fair value of residual investment

100.0
70.0
170.0

Derecognised:
Net assets de-recognised
NCI (10% u 124 million)

124.0
(12.4)

Goodwill derecognised

111.6
18.0

Net assets sold

(129.6)

Gain on disposal, reported in profit or loss

40.4

Practice question

Paprika, the holding company of a large group, had bought 90% of the
issued capital Saffron several years ago.
Both companies prepare accounts to 31 December each year.
On 31 October Year 5 Paprika sold 50% of its shareholding in Saffron for
Rs. 540,000.
At this date, the carrying value of the net assets of Saffron was Rs. 800,000
and the carrying value of the goodwill relating to the acquisition of Saffron
(all attributable to the parent company) was Rs. 100,000.
The fair value of the remaining investment in S is estimated at Rs.500,000.
What gain or loss should be recognised on the disposal of the shares in
Saffron?

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The same step by step approach shown earlier can be used to prepare answers
to questions requiring a consolidated statement of profit or loss when there is a
part disposal of a subsidiary during the year and that part disposal results in a
loss of control.
Work through the following example carefully.
Example: Facts
Example: Part disposal (loss of control but leaving significant influence)
The following financial statements are to the year-end 31 December 20X4
H

Statements of profit or loss

Rs.000

Rs.000

Revenue

22,950

8,800

Expenses

(10,000)

(5,000)

Operating profit
Tax

12,950
(5,400)

3,800
(2,150)

Profit after tax

7,550

1,650

Rs.000

Rs.000

Retained earnings b/f

3,760

1,850

Profit after tax

7,550

1,650

11,310

3,500

Statement of changes in equity

Retained earnings c/f

a.

H Ltd bought 90% of S Ltd 4 years ago for Rs. 3,750,000 when the
retained earnings of S ltd were Rs. 500,000.
S Ltd has share capital of Rs. 3,000,000.

b.

H Ltd sold 50% of S Ltd on 30 September 20X4 for Rs. 5,000,000.

c.

The remaining 40% investment in S Ltd held by H Ltd resulted in H

Ltd having significant influence over S Ltd. This residual investment
was estimated to have a fair value of Rs.3,500,000

d.

S Ltd does not qualify to be treated as a discontinued operation

under IFRS5.

Required
Prepare the consolidated statement of profit or loss for the year ended
31 December 20X4.

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Chapter 24: Disposal of subsidiaries

Step 1: Reflect the pattern of ownership

Answer

S (9/12)

Group

Statements of profit or loss

Rs.000

Rs.000

Rs.000

Revenue

22,950

6,600

29,550

Expenses

(10,000)

(3,750)

(13,750)

12,950

2,850

15,800

Operating profit
Share of profits of associate
(40% u 3/12 u 1,650)

165

Profit on disposal (W)

Profit before tax
Tax

(5,400)

(1,612)

7,550

1,238

Profit after tax

Profit attributable to:

(7,012)

Rs.000

Owners of the parent

Non-controlling interest (10% of 1,238)

124

Profit for the year

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Step 2: Key workings

Answer
W1: Net assets summary
At date of
disposal
Rs.000

At date of
acquisition
Rs.000

Share capital

3,000

3,000

Retained earnings (W2)

3,088

500

Net assets

6,088

3,500

W2: Retained earnings at date of disposal

Retained earnings at start of year
Profit for the period up to the date of disposal
(9/12 u 1,650,000)

Rs.000
1,850
1,238
3,088
Rs.000

W3: Goodwill
Cost of investment

3,750

Non-controlling interest at acquisition

(10% u 3,500,000 (W1))

350
4,100

Net assets at acquisition (see above)

(3,500)
600

Step 3: Profit on disposal

Answer
Rs.000

W4: Profit on disposal

Recognise
Sale proceeds

5,000

Fair value of residual investment

3,500
8,500

Derecognise:
Net assets at date of disposal (W1)

6,088

NCI at date of disposal (10% u 6,088,000 (W1))

(609)
(5,479)

Goodwill (W3)

(600)
2,421

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Step 4: Complete the answer

Answer
H Plc: Consolidated statement of profit or loss for the year ended 31 December
20X4

S (9/12)

Group

Statements of profit or loss

Rs.000

Rs.000

Rs.000

Revenue

22,950

6,600

29,550

Expenses

(10,000)

(3,750)

(13,750)

12,950

2,850

15,800

Operating profit
Share of profits of associate
(40% u 3/12 u 1,650)
Profit on disposal (W)

165
2,421

Profit before tax

18,386

Tax

(5,400)

(1,612)

(7,012)

7,550

1,238

11,374

Profit after tax

Profit attributable to:

Rs.000

Owners of the parent (balancing figure)

11,250

Non-controlling interest (10% of 1,238)

124

Profit for the year

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2.2 Part disposal with no loss of control

A part disposal does which does not result in loss of control is a transaction
between the owners of the subsidiary. In this case the parent does not recognise
a profit or loss on disposal in the consolidated statement of profit or loss. Instead
the parent recognises an equity adjustment.
Example: Part disposal with no loss of control
The following financial statements are to the year-end 31 December 20X4
H

Statements of profit or loss

Rs.000

Rs.000

Revenue

22,950

8,800

Expenses

(10,000)

(5,000)

Operating profit
Tax

12,950
(5,400

3,800
(2,150)

Profit after tax

7,550

1,650

Rs.000

Rs.000

Retained earnings b/f

3,760

1,850

Profit after tax

7,550

1,650

11,310

3,500

Statement of changes in equity

Retained earnings c/f

a.

H Ltd bought 90% of S Ltd 4 years ago for Rs. 3,750,000 when the
retained earnings of S ltd were Rs. 500,000.
S Ltd has share capital of Rs. 3,000,000.

b.

H Ltd sold 10% of S Ltd on 30 September 20X4 for Rs. 1,000,000.

Required
Prepare the consolidated statement of profit or loss for the year ended
31 December 20X4 and calculate the equity adjustment necessary to
reflect the change in ownership.

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Step 1: Reflect the pattern of ownership and complete the statement of profit and
loss
This is straightforward as the parent has held a subsidiary for the whole year.
The only complication is that the results have to be time apportioned so that the
relevant NCI can be measured.
Profit on disposal is NOT recognised where there is no loss of control.
Answer

Group

Statements of profit or loss

Rs.000

Rs.000

Rs.000

Revenue

22,950

8,800

31,750

Expenses

(10,000)

(5,000)

(15,000)

12,950
(5,400)

3,800
(2,150)

16,750
(7,550)

7,550

1,650

9,200

Profit before tax

Tax
Profit after tax

Profit attributable to:

Rs.000

Owners of the parent (as a balancing figure)

8,993

Non-controlling interest
(10% u 1,650 u 9/12)

124

(20% u 1,650 u 3/12)

83
207

Profit for the year

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9,200

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Step 2: Key workings

Answer
W1: Net assets summary
At date of
disposal
Rs.000

At date of
acquisition
Rs.000

Share capital

3,000

3,000

Retained earnings (W2)

3,088

500

Net assets

6,088

3,500
Rs.000

W2: Retained earnings at date of disposal

Retained earnings at start of year
Profit for the period up to the date of disposal
(9/12 u 1,650,000)

1,850
1,238
3,088
Rs.000

W3: Goodwill
Cost of investment

3,750

Non-controlling interest at acquisition

(10% u 3,500,000 (W1))

350
4,100

Net assets at acquisition (see above)

(3,500)
600

Step 3: Equity adjustment

Answer
Rs.000

W4: Profit on disposal

Sale proceeds

1,000

Net assets sold to the NCI (10% u 6,088,000 (W1))

(609)
391

The double entry to record the equity adjustment is as follows:

Debit
Credit
Cash

1,000

Non-controlling interest

609

Retained earnings

391

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DISPOSAL OF A SUBSIDIARY WHICH DOES NOT CONTAIN A

BUSINESS
Section overview

Background

New rules

3.1 Background
This section explains an amendment to IFRS 10 and IAS 28. The amendment
must be applied for annual periods beginning on or after 1 January 2016. Earlier
application is permitted but must be disclosed.
The amendment concerns a situation where a parent loses control of a subsidiary
that does not contain a business (as defined in IFRS 3) by selling an interest to
an associate (or joint venture) accounted for using the equity method.
Such a transaction is the same as selling an asset to the associate (or joint
venture).
Usually, if a parent loses control of a subsidiary, the parent must:

derecognise the assets and liabilities of the former subsidiary from the
consolidated statement of financial position.

recognise any investment retained in the former subsidiary at its fair value
when control is lost; and

recognise the gain or loss associated with the loss of control in the
statement of profit or loss.

In the case of a part disposal, the parent must measure any residual investment
at its fair value with any gain or loss being recognised in the statement of profit or
loss.

3.2 New rules

If the subsidiary sold does not contain a business (as defined in IFRS 3) by
selling an interest to an associate (or joint venture) accounted for using the equity
method the gain or loss resulting from the transaction is recognised in the
parents profit or loss only to the extent of the unrelated investors interests in that
associate or joint venture.
The remaining part of the gain is eliminated against the carrying amount of the
investment in that associate or joint venture.
Also any residual investment must be revalued to fair value and usually the gain
or loss is recognised in profit or loss.

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The residual investment might be an associate (or joint venture) accounted for
using the equity method. In that case the remeasurement gain or loss is
recognised in profit or loss only to the extent of the unrelated investors interests
in the new associate or joint venture.
The remaining part of that gain is eliminated against the carrying amount of the
investment retained in the former subsidiary.
Example: Loss of control of a subsidiary (that does not contain a business) by
selling it to an associate
H Ltd owns 100% of S Ltd (a company which does not contain a business).
H Ltd owns 20% of A Ltd.
H Ltd sold 70% of S Ltd to A Ltd for Rs.210 million.
The fair value of the identifiable net assets in S Ltd at the date of the sale was
Rs.100 million.
The fair value of the residual investment at the date of disposal was Rs.90
million.
The gain on disposal recognised in profit or loss should be calculated as follows:
Rs. m
Consideration received for shares in S Ltd
Fair value of the residual interest

210.0
90.0

Net assets de-recognised

300.0
(100.0)

Gain on disposal

200.0

H Ltd recognises the gain to the extent of the unrelated investors interests.
H Ltd s interests and those of unrelated investors after the disposal are as
follows:
Interests in A Ltd:
H Ltd
Unrelated investors

20%
80%

Total

100%

Interests in S Ltd:
H Ltd
Direct interest
Indirect interest (20% of 70%)

30%
14%

Unrelated investors (80% of 70%)

44%
56%

Total

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Example (continued): Loss of control of a subsidiary (that does not contain a

business) by selling it to an associate
The gain must be analysed into that part which relates to the actual sale and that
part which relates to the revaluation of the residual investment.
Total

Sale

Revaluation

Rs. m

Rs. m

Rs. m

Consideration received
Fair value of the residual interest

210.0
90.0

210.0

90.0

Net assets de-recognised

300.0
(100.0)

(70.0)

(30.0)

Gain on disposal

200.0

140.0

60.0

The recognition of the gain is based on the ownership interests as follows:

Sale
Rs. m
140.0

Gain on disposal
Interests in A Ltd:
H Ltd (20%)

Revaluation
Rs. m
60.0

28.0

Unrelated investors (80%)

112.0

Interests in S Ltd:
H Ltd (44%)
Unrelated investors (56%)

26.0
34.0

The double entry to account for the disposal may be summarised as:
Dr (R
Rs.
m)
210.0

Cash
Net assets

100.0

Investment in S (90  26)

Investment in A

64.0
28.0

Gain on disposal (reported in profit or loss)

(112.0 + 34.0)

146.0
274.0

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Cr (R
Rs.
m)

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IFRS 5 AND DISPOSALS

Section overview

IFRS 5: Discontinued operations

Presentation of discontinued operations

Discontinued operations and disposals

4.1 IFRS 5: Discontinued operations

This was covered in an earlier chapter but is repeated here for your convenience.
IFRS 5 Non-current assets held for sale and discontinued operations sets out
requirements for disclosure of financial information relating to discontinued
operations.
A discontinued operation is a disposal group that satisfies extra criteria. (IFRS 5
does not say as much but this is a helpful way to think of it).
Definition
Discontinued operation - A component of an entity that either has been disposed
of or is classified as held for sale and:
1.

represents a separate major line of business or geographical area of

operations,

2.

is part of a single co-ordinated plan to dispose of a separate major line of

business or geographical area of operations or

3.

is a subsidiary acquired exclusively with a view to resale.

A component of an entity comprises operations and cash flows that can be

clearly distinguished, operationally and for financial reporting purposes, from the
rest of the entity.
A disposal group might be, for example, a major business division of a company.

4.2 Presentation of discontinued operations

Presentation in the statement of profit or loss
The following must be disclosed for discontinued operations:

a single amount on the face of the statement of profit or loss comprising the
total of:
x

the post-tax profit or loss of discontinued operations; and

the post-tax gain or loss recognised on the measurement to fair value

less costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation.

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4.3 Discontinued operations and disposals

A disposal might satisfy the discontinued operations criteria.
This will not affect measurement but will affect presentation.
The consolidation of the subsidiary up to the date of disposal is not carried out on
a line by line basis. Instead, the profit after tax for this period combined with the
profit (loss) on disposal and shown as a single figure.
The answer to the previous example is used below to show the difference.
Example: Disposal of subsidiary Not a discontinued operation (as seen before)
H Ltd: Consolidated statement of profit or loss for the year ended 31 December
20X4

S (9/12)

Statements of profit or loss

Rs.000

Rs.000

Revenue

22,950

6,600

29,550

Expenses

(10,000)

(3,750)

(13,750)

12,950

2,850

15,800
3,421

Operating profit
Profit on disposal (W)
Profit before tax

Group

19,221

Tax

(5,400)

(1,612)

(7,012)

7,550

1,238

12,209

Profit after tax

Profit attributable to:

Rs.000

Owners of the parent (balancing figure)

12,085

Non-controlling interest (10% of 1,238)

124

Profit for the year

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Example: Disposal of subsidiary As a discontinued operation

H Ltd:
Consolidated statement of profit or loss for the year ended 31 December 20X4
Group
Statements of profit or loss

Rs.000

Revenue

22,950

Expenses

(10,000)

Profit before tax

Tax

12,950
(5,400)

Profit for the period from continuing operations

7,550

Profit for the year from discontinued operations

(1,238 + 3,421)

4,659

Profit for the year

12,209

Profit attributable to:

Rs.000

Owners of the parent (balancing figure)

12,085

Non-controlling interest (10% of 1,238)

124

Profit for the year

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12,209

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

Proceeds received

Rs.
460,000

Net assets disposed of at carrying value

Attributable to non-controlling interests (20%)

400,000
(80,000)
320,000

Unimpaired goodwill attributable to P

21,200

Gain to equity owners of P on disposal of S

341,200

Gain on disposal, reported in profit or loss

118,800

Goodwill on the acquisition attributable to P:

= Rs.330,000 - (80% u Rs.280,000) = Rs.106,000
Goodwill remaining after accumulated impairment (20% u Rs.106,000) =
Rs.21,200.

Solution

Proceeds received from sale of shares

Rs.
540,000

Fair value of remaining investment in S

500,000
1,040,000

Net assets disposed of at carrying value

800,000

Attributable to non-controlling interests (20%)

(80,000)

Unimpaired goodwill attributable to P

720,000
100,000

Gain to equity owners of P on disposal of S

(820,000)

Gain on disposal, reported in profit or loss

220,000

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

25

Other group standards

Contents
1 IAS 27 Separate financial statements
2 IFRS 12: Disclosure of interests in other entities

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A2

IAS 27: Separate financial statements

A6

IFRS 12: Disclosure of interests in other entities

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IAS 27 SEPARATE FINANCIAL STATEMENTS

Section overview

Introduction to IAS 27

Preparation of separate financial statements

Disclosure

1.1 Introduction to IAS 27

IAS 27 contains accounting and disclosure requirements for investments in
subsidiaries, joint ventures and associates when an entity prepares separate
financial statements.
IAS 27 requires an entity preparing separate financial statements to account for
those investments at cost or in accordance with IFRS 9 Financial Instruments.
IAS 27 does say which entities must produce separate financial statements.
Definition
Separate financial statements: Those presented by a parent or an investor with
joint control of, or significant influence over, an investee, in which the
investments are accounted for at cost or in accordance with IFRS 9 Financial
Instruments
Separate financial statements are those presented in addition to consolidated
financial statements or in addition to financial statements in which investments in
associates or joint ventures are accounted for using the equity method.
However, if a company is exempt from the need to consolidate or account for an
investment using the equity method the separate financial statements are its only
financial statements.

1.2 Preparation of separate financial statements

Separate financial statements must be prepared in accordance with all applicable
IFRSs.
Investments in subsidiaries, joint ventures and associates must be accounted for
in separate financial statements, either:

at cost; or

in accordance with IFRS 9.

A company must apply the same accounting for each category of investments.
A recent amendment issued in August 2014 extends this choice to allow an entity
to use the equity method in addition to the other two methods. The amendment
applies for annual periods beginning on or after 1 January 2016. However, earlier
application is permitted but if used it must be disclosed.
Investments accounted for at cost are subject to the rules in IFRS 5 when they
are classified as held for sale.

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IAS 28 Investments in Associates and Joint ventures allows a company to

measure its investments in associates or joint ventures at fair value through profit
or loss. Such investments must be accounted for in the same way in its separate
financial statements.
Dividends are recognised in profit or loss in separate financial statements when
the right to receive the dividend is established.

1.3 Disclosure
All applicable IFRSs apply when providing disclosures in separate financial
statements as well as the following requirements.
When a parent prepares separate financial statements, it must disclose:

the fact that the financial statements are separate financial statements;

a list of significant investments in subsidiaries, joint ventures and

associates, including:

the name of those investees.

the principal place of business (and country of incorporation, if

different) of those investees.

its proportion of the ownership interest (and its proportion of the

voting rights, if different) held in those investees.

a description of the method used to account for the investments listed.

In addition, if a parent is exempt from preparing consolidated financial statements

and elects not to do so, and instead prepares separate financial statements, it
must disclose:

the fact that the financial statements are separate financial statements;

that the exemption from consolidation has been used;

the name and principal place of business (and country of incorporation, if

different) of the entity whose consolidated financial statements that comply
with IFRS have been produced for public use; and

the address where those consolidated financial statements are obtainable.

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Chapter 25: Other group standards

IFRS 12: DISCLOSURE OF INTERESTS IN OTHER ENTITIES

Section overview

Introduction to IFRS 12
Significant judgements and assumptions

Interests in subsidiaries

Interests in joint arrangements and associates

Structured entities

2.1 Introduction to IFRS 12

The objective of IFRS 12 is to require companies to disclose information that
enables users of their financial statements to evaluate:

the nature of, and risks associated with, its interests in other entities; and

the effects of those interests on its financial position, financial performance

and cash flows.

This requires disclosure of:

the significant judgements and assumptions it has made in determining the

nature of its interest in another entity or arrangement, and in determining
the type of joint arrangement in which it has an interest; and

information about its interests in:

x

subsidiaries;

joint arrangements and associate); and

structured entities that are not controlled by the entity (unconsolidated

structured entities).

IFRS 12 sets out required disclosures but disclosure of additional information

might be necessary to meet IFRS 12s objective.
IFRS 12 must be applied by a company that has an interest in any of the
following:

subsidiaries;

joint arrangements (i.e. joint operations or joint ventures);

associates;

unconsolidated structured entities.

2.2 Significant judgements and assumptions

A company must disclose information about significant judgements and
assumptions it has made (and changes to those judgements and assumptions) in
determining:

that it has control of another entity;

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that it has joint control of an arrangement or significant influence over

another entity; and

the type of joint arrangement (i.e. joint operation or joint venture) when the
arrangement has been structured through a separate vehicle.

To comply with the above a company must disclose, for example, significant
judgements and assumptions made in determining that:

it does not control another entity even though it holds more than half of the
voting rights of the other entity;

it controls another entity even though it holds less than half of the voting
rights of the other entity;

it does not have significant influence even though it holds 20% or more of
the voting rights of another entity;

it has significant influence even though it holds less than 20% of the voting
rights of another entity.

2.3 Interests in subsidiaries

A company must disclose information that enables users of its consolidated
financial statements

to understand:
x

the composition of the group; and

the interest that non-controlling interests have in the groups activities

and cash flows; and

to evaluate:
x

the nature and extent of significant restrictions on its ability to access

or use assets, and settle liabilities, of the group;

the nature of, and changes in, the risks associated with its interests in
consolidated structured entities;

the consequences of changes in its ownership interest in a subsidiary

that do not result in a loss of control; and

the consequences of losing control of a subsidiary during the

reporting period.

When the financial statements of a subsidiary used in the preparation of

consolidated financial statements are as of a date or for a period that is different
from that of the consolidated financial statements, a company must disclose:

the date of the end of the reporting period of the financial statements of that
subsidiary; and

the reason for using a different date or period.

Non-controlling interests
A company must disclose for each of its subsidiaries that have non-controlling
interests that are material to the reporting entity:

the name of the subsidiary;

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the principal place of business (and country of incorporation if different) of

the subsidiary;

the proportion of ownership interests held by non-controlling interests;

the proportion of voting rights held by non-controlling interests, if different

from the proportion of ownership interests held;

the profit or loss allocated to non-controlling interests of the subsidiary

during the reporting period;

accumulated non-controlling interests of the subsidiary at the end of the

reporting period; and

summarised financial information about the subsidiary.

The nature and extent of significant restrictions

A company must disclose:

any significant restrictions on its ability to access or use the assets and
settle the liabilities of the group, such as:
x

those that restrict the ability of a parent or its subsidiaries to transfer

cash or other assets to (or from) other entities within the group;

guarantees or other requirements that may restrict dividends and

other capital distributions being paid, or loans and advances being
made or repaid, to (or from) other entities within the group; and

the carrying amounts in the consolidated financial statements of the assets

and liabilities to which those restrictions apply.

Consequences of losing control of a subsidiary during the reporting period

A company must disclose the gain or loss arising on the loss of control of a
subsidiary during the period together with the line item(s) in profit or loss in which
the gain or loss is recognised (if not presented separately).

2.4 Interests in joint arrangements and associates

A company must disclose information that enables users of its financial
statements to evaluate:

the nature, extent and financial effects of its interests in joint arrangements
and associates, including the nature and effects of its contractual
relationship with the other investors with joint control of, or significant
influence over, joint arrangements and associates; and

the nature of, and changes in, the risks associated with its interests in joint
ventures and associates.

Nature, extent and financial effects of interests in joint arrangements and

associates
A company must disclose:

for each material joint arrangement and associate:

x

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the name of the joint arrangement or associate.

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the nature of the entitys relationship with the joint arrangement or

associate;

the principal place of business (and country of incorporation, if

applicable and different from the principal place of business) of the
joint arrangement or associate.

the proportion of ownership interest or participating share held by the

entity and, if different, the proportion of voting rights held (if
applicable).

for each material joint venture and associate that is material to the reporting
entity:
x

whether the investment in the joint venture or associate is measured

using the equity method or at fair value.

summarised financial information about the joint venture or associate.

if the joint venture or associate is accounted for using the equity

method, the fair value of its investment in the joint venture or
associate, if there is a quoted market price for the investment.

financial information about the entitys investments in joint ventures and

associates that are not individually material:
x

in aggregate for all individually immaterial joint ventures and,

separately,

in aggregate for all individually immaterial associates.

A company must also disclose:

the nature and extent of any significant restrictions on the ability of joint
ventures or associates to transfer funds to the entity in the form of cash
dividends, or to repay loans or advances made by the entity.

when the financial statements used in applying the equity method are as of
a date or for a period that is different from that of the entity:

the date of the end of the reporting period of the financial statements
of that joint venture or associate; and

the reason for using a different date or period.

the unrecognised share of losses of a joint venture or associate, both for

the reporting period and cumulatively, if the entity has stopped recognising
its share of losses of the joint venture or associate when applying the equity
method.

Risks associated with an entitys interests in joint ventures and associates

A company must disclose:

commitments that it has relating to its joint ventures separately from the
amount of other commitments

contingent liabilities incurred relating to its interests in joint ventures or

associates (unless the probability of loss is remote)

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2.5 Structured entities

Definition
Structured entity: An entity that has been designed so that voting or similar rights
are not the dominant factor in deciding who controls the entity, such as when any
voting rights relate to administrative tasks only and the relevant activities are
directed by means of contractual arrangements.

A structured entity might be consolidated or unconsolidated depending on the

results of the analysis of whether control exists.
Consolidated structured entities
A company must disclose the terms of any contractual arrangements that could
require the parent or its subsidiaries to provide financial support to a consolidated
structured entity.
A company must also disclose any support given where there is no contractual
obligation and any intention to provide financial or other support to a consolidated
structured entity.
Unconsolidated structured entities
A company must disclose information that enables users of its financial
statements:

to understand the nature and extent of its interests in unconsolidated

structured entities; and

to evaluate the nature of, and changes in, the risks associated with its
interests in unconsolidated structured entities.

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

26

Foreign currency

Contents
1 IAS 21 The effects of changes in foreign exchange
rates
2 The individual entity: accounting rules
3 The foreign operation: accounting rules

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 22

IAS 21: The effects of changes in foreign exchange rates

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IAS 21: THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES

Section overview

The scope of IAS 21

The two main accounting issues

Terms and definitions used in IAS 21: currency definitions

Terms and definitions used in IAS 21: other definitions

1.1 The scope of IAS 21

Many businesses have transactions and investments that are denominated in a
foreign currency.

Individual companies often enter into transactions in a foreign currency.

These transactions need to be translated into the companys own currency
in order to record them in its ledger accounts. For example:
x

a Pakistani company may take out a loan from a French bank in

euros but will record the loan in its ledger accounts in rupees; or

a Pakistani company may sell goods to a Japanese company

invoiced in yen but will record the sale and the trade receivable in
rupees in its ledger accounts.

Groups often contain overseas entities. A parent company might own a

foreign subsidiary or associate. This foreign entity will normally maintain its
accounting records and prepare its financial statements in a currency that is
different from the currency of the parent company and the groups
consolidated accounts.
x

For example, if a Pakistani company has a US subsidiary, the

financial statements of the US subsidiary will be prepared in US
dollars, but will need to be translated into rupees for the purpose of
preparing the groups consolidated financial statements.

The rules on accounting for foreign currency items are concerned with translating
or converting items from one currency into another currency, at an appropriate
rate of exchange between the currencies. The rules are mostly contained in IAS
21 The effects of changes in foreign exchange rates. The rules in IAS 21 can be
divided into two areas:

Transactions affecting individual entities. IAS 21 deals with the translation

of these transactions when they occur and at subsequent reporting dates
when re-translation at a different exchange rate may be necessary.

Foreign operations (subsidiaries, associates etc) which affect the

consolidated financial statements. The rules in IAS 21 explain how to
translate the financial statements of the foreign subsidiaries, associates or
joint ventures. Once translated, the normal consolidation rules or equity
accounting rules will apply.

One area that IAS 21 does not deal with is the translation of any transactions and
balances that fall within the scope of IAS 39/IFRS 9 on financial instruments. For

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example, if a company takes out a forward foreign exchange contract to hedge

against foreign currency exposure, the accounting treatment is covered by the
rules in IAS 39, because a forward contract is a financial instrument.

1.2 The two main accounting issues

Transactions and assets and liabilities in foreign currencies are translated or
converted from the foreign currency into the currency of the reporting entity. The
process of translation would be quite simple if exchange rates between
currencies remained fixed. However, exchange rates are continually changing.
The translated valuation of foreign currency assets or liabilities in the statement
of financial position might therefore change if they are translated at different
times.
The two main accounting issues when accounting for foreign currency items are:

What exchange rate(s) should be used for translation?

How to account for the gains or losses that arise when exchange rates
change?

Before looking at these accounting rules in detail, it is important to understand

the precise meaning of some key terms used in IAS 21.

1.3 Terms and definitions used in IAS 21: currency definitions

IAS 21 identifies three types of currency: the presentation currency, the functional
currency and foreign currency.
Definitions
Presentation currency: The currency in which the financial statements of an entity
are presented
Functional currency: The currency of the primary economic environment in which
an entity operates.
Foreign currency: A currency other than the functional currency of the entity
Presentation currency
An entity is permitted to present its financial statements in any currency. This
reporting currency is often the same as the functional currency, but does not
have to be.
Functional currency
When a reporting entity records transactions in its financial records, it must
identify its functional currency and make entries in that currency. It will also,
typically, prepare its financial statements in its functional currency. This rule
applies to stand-alone entities, parent companies and foreign operations (such as
a foreign subsidiary or a branch). When financial statements prepared in a
functional currency are translated into a different presentation currency, the
translation of assets and liabilities must comply with the rules in IAS 21.
IAS 21 describes the functional currency as:

The currency that mainly influences:

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sales prices for goods and services

labour, material and other costs of providing goods or services.

The currency in which funds are generated by issuing debt and equity

The currency in which receipts from operating activities are usually

retained.

The functional currency is not necessarily the currency of the country in which the
entity operates or is based, as the next example shows.
Example: Presentation and functional currencies
P is a UK-registered mining company whose shares are traded on the London
Stock Exchange. Its operating activities take place in the gold and diamond
mines of South Africa.
(a)

What is the presentation currency of P?

(b)

What is its functional currency?

(c)

P bought specialised mining equipment from the US, invoiced in US dollars.

What type of currency is the US dollar, using the IAS 21 definitions?

Answer
(a)

The presentation currency (reporting currency) is sterling (UK pounds). This

is a requirement of the UK financial markets regulator for UK listed
companies.

(b)

The functional currency is likely to be South African rand, even though the
company is based in the UK. This is because its operating activities take
place in South Africa and so the company will be economically dependent
on the rand if the salaries of most of its employees, and most operating
expenses and sales are in rand.

(c)

The US dollars are foreign currency for the purpose of preparing Ps

accounts.

IAS 21 requires P to prepare its financial statements in its functional currency

(rand).
However, P is permitted to use sterling as its presentation currency. If it does use
sterling as its presentation currency (which it will do, given the UK rules), the
translation of assets and liabilities from rand to sterling must comply with the
rules in IAS 21.

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1.4 Terms and definitions used in IAS 21: other definitions

Exchange rate definitions
IAS 21 uses the following terms to describe which exchange rate should be used
in the translation.
Definitions
Exchange rate: The rate of exchange between two currencies
Spot rate: The exchange rate at the date of the transaction
Closing rate: The spot exchange rate at the end of the reporting period
For example, suppose that on 16 November a German company buys goods
from a US supplier, and the goods are priced in US dollars. The financial year of
the company ends on 31 December, and at this date the goods have not yet
been paid for.

The spot rate is the euro/dollar exchange rate on 16 November, when the
transaction occurred.

The closing rate is the exchange rate at 31 December.

Other definitions
IAS 21 also includes some other terms and definitions.
Definitions
Foreign operation: This is a subsidiary, associate, joint venture or branch whose
activities are conducted in a country or currency different from the functional
currency of the reporting entity.
Net investment in a foreign operation: The amount of the reporting entity's
interest in the net assets of a foreign operation.
Exchange difference: A difference resulting from translating the same assets,
liabilities, income or expenses from one currency into another currency at
different exchange rates.
Monetary items: Units of currency held, or assets and liabilities to be received or
paid (in cash), in a fixed number of currency units. Examples of monetary items
include cash itself, loans, trade payables, trade receivables and interest payable.
Non-monetary items are not defined by IAS 21, but they are items that are not
monetary items. They include tangible non-current assets, investments in other
companies, investment properties and deferred taxation (which is a notional
amount of tax rather than an actual amount of tax payable.)

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THE INDIVIDUAL ENTITY: ACCOUNTING RULES

Section overview

Introduction

Initial recognition: translation of transactions

Reporting at the end of each reporting period and gain or loss arising on
translation

Reporting at the settlement of a transaction

2.1 Introduction
An individual company may have transactions that are denominated in a foreign
currency. These must be translated into the companys functional currency for
the purpose of recording the transactions in its ledger accounts and preparing its
financial statements.
These transactions may have to be translated on several occasions. When a
transaction or asset or liability is translated on more than one occasion, it is:

translated at the time that it is originally recognised;, and

re-translated at each subsequent occasion.

Re-translation may be required, after the transaction has been recognised

initially:

at the end of a financial year (end of a reporting period);

when the transaction is settled (which may be either before, or after the end
of the financial year).

On each subsequent re-translation, an exchange difference will occur. This gives

rise to a gain or loss on translation from the exchange difference.

2.2 Initial recognition: translation of transactions

On initial recognition, a transaction in a foreign currency must be translated at the
spot rate on the date of the transaction.
If the company purchases goods on most days in the foreign currency, it might be
administratively difficult to record every transaction at the actual spot rate. For
practical reasons, IAS 21 therefore allows entities to use an average rate for a
time period, provided that the exchange rate does not fluctuate significantly over
the period.
For example, an entity might use an average exchange rate for a week or a
month for translating all the foreign currency-denominated transactions in that
time period.
These rules apply when an entity:

buys or sells goods or services that will be paid for in a foreign currency;

borrows or lends money when the interest payments and repayments of

principal are in a foreign currency;

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purchases or disposes of non-current assets in another currency; or

receives dividends and other payments in another currency.

Example: Initial recognition

A Pakistani company (with the rupee as its functional currency) has a financial
year ending on 31 December.
It buys goods from an Australian supplier (with the Australian dollar as its
functional currency) on 1 December 20X6 invoiced in A$10,000.
The Australian supplier is eventually paid in March 20X7.
Exchange rates over the period were as follows:
1 December 20X6 Rs.75/A$1
The purchase/inventory and the trade payable should be recorded initially by
translating the transaction at the spot rate of Rs.75/A$1.
This gives a translated value of Rs. 750,000 for recording in the ledger accounts
(Rs.75 u A$10,000).
On 1 December 20X6
Debit
Rs. 750,000

Purchases
Payables (Rs. 75 u A$10,000)

Credit
Rs. 750,000

Being the initial recognition of a purchase of inventory in a foreign

currency
Note that for practical purposes, if the entity buys items in A$ frequently, it may
be able to use an average spot rate for a period, for all transactions during that
period.
For example, if the Pakistani company bought items from Australia on an
ongoing basis it might adopt a policy of translating all purchases in a month at
the average rate for that month.

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2.3 Reporting at the end of each reporting period and gain or loss arising on
translation
Transactions in a foreign currency are recognised initially at the spot rate on the
date of the transaction.
Balances resulting from such transactions may still exist in the statement of
financial position at the end of the financial period.
Exchange rates change over time and the exchange rate at the end of the
reporting period will not be the same as the spot rate on the date of the
transaction.
Retranslation of items at a later date will lead to gains or losses if the rates have
moved.
The gain or loss is the difference between the original and re-translated value of
the item.

There is an exchange gain when an asset increases in value on retranslation, or when a liability falls in value.

There is an exchange loss when an asset falls in value on re-translation, or

when a liability increases in value.

The rules in IAS 21 for reporting assets and liabilities at the end of a subsequent
reporting period make a distinction between:

monetary items, such as trade payables and trade receivables, and

non-monetary items, such as non-current assets and inventory.

The rules are as follows, for entities preparing their individual financial
statements:
Asset or liability

Accounting treatment

Treatment of exchange
difference

Monetary items

Re-translate at the
closing rate.

Recognised in P&L

Non-monetary items
carried at cost

No re-translation. The
transaction is left at the
original spot rate.

Not applicable

Non-monetary items
carried at fair value

Re-translate at the
exchange rate ruling at
the date of the fair value
adjustment.

Recognised in the same

location as the
revaluation gain or loss

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Example: Subsequent measurement of monetary amount

A Pakistani company (with the rupee as its functional currency) has a financial
year ending on 31 December.
It buys inventory from an Australian supplier (with the Australian dollar as its
functional currency) on 1 December 20X6 invoiced in A$10,000.
The Australian supplier is eventually paid in March 20X7.
Exchange rates over the period were as follows:
1 December 20X6 Rs.75/A$1
31 December 20X6 Rs.80/A$1
The transaction would be recorded as follows:
On 1 December 20X6
Debit
Rs. 750,000

Purchases
Payables (Rs. 75 u A$10,000)

Credit
Rs. 750,000

Being the initial recognition of a purchase of inventory in a foreign

currency
On 31 December 20X6
Debit
Statement of profit or loss
Payables

Credit

Rs. 30,000
Rs. 30,000

Being the recognition of the exchange loss arising on the retranslation of

a payable denominated a foreign currency.
Working
Rs.
Liability on initial recognition

750,000

Exchange loss (balancing figure)

Liability on retranslation at the year-end
(Rs. 78 u A$10,000)

30,000
780,000

In the above example the Pakistani company had purchased inventory. Even if
this were still held at the year-end it would not be retranslated as it is a nonmonetary asset.
Sometimes there might be a movement on the carrying amount of a balance
denominated in a foreign currency during a period. The exchange difference
could be calculated by applying the above approach. However, this can be time
consuming where there is a lot of movements. An easier approach is to find the
exchange difference as a balancing figure.

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Example: Retranslation of monetary item with movement on the account

A Pakistani company whose functional currency is the rupee paid $90,000 into a
dollar account on 30 June.
The company paid an additional $10,000 into the account on 30 September.
There were no other movements on this account.
Exchange rates over the period were as follows:
30 June: Rs.100/$.
30 September Rs.99/$.
31 December (year-end): Rs.95/$.
The exchange difference arising at 31 December can be calculated as follows:
Exchange difference: gain or (loss)
a On re-translating June amount

Rs.

$90,000 at rate of 100

$90,000 at closing rate of 95

Rs.

9,000,000
8,550,000

Exchange loss
b On re-translating September amount:
$10,000 at average rate of 99
$10,000 at closing rate of 95

450,000
990,000
950,000

Exchange loss

40,000

Exchange loss

490,000

There is an exchange loss because the company has a dollar asset but the dollar
has weakened against the rupee over the period.
This approach might be cumbersome if there are more than a few movements on
an account. The following approach simply records all items at the appropriate
rates and identifies the exchange difference as a balancing figure.
$

Rate

Rs.

Balance at start (30 June)

90,000

100

9,000,000

Amount paid in (30 Sept.)

10,000

99

990,000

Exchange loss

(490,000)

Balance at end (31 Dec.)

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Example: Retranslation of monetary item with movement on the account

A Pakistani company whose functional currency is the rupee borrowed $90,000
on 30 June.
The company recognised an interest accrual of $10,000 at its year-end (31
December).
There were no other movements on this account.
Exchange rates over the period were as follows:
30 June: Rs.100/$.
Average for the period Rs.99/$.
31 December (year-end): Rs.95/$.
There is no rule in IAS 21 as to what rate should be used for the accrual of
interest. The accrual could be deemed to arise over the period in which case the
average rate would be used or it could be treated as a year-end transaction in
which case the closing rate would be used. The profit for the period is not
affected by the choice of rate as there would be a compensating adjustment in
the amount of the exchange difference.
This is demonstrated below.
Exchange difference (interest at closing rate))
$

Rate

Rs.

Balance at start (30 June)

90,000

100

9,000,000

Interest

10,000

95

950,000

Exchange gain

(450,000)

Balance at end (31 Dec.)

100,000

95

9,500,000

Exchange difference (interest at average rate))

$

Rate

Rs.

Balance at start (30 June)

90,000

100

9,000,000

Interest

10,000

99

990,000

Exchange gain

(490,000)

Balance at end (31 Dec.)

100,000

95

9,500,000

There is an exchange gain because the company has a dollar liability but the
dollar has weakened against the rupee over the period.
The balancing figure approach can be used in any situation where there are
movements on an amount denominated in a foreign currency.
For example, when consolidating foreign subsidiaries the parent consolidated the
subsidiarys net assets at the start of the period (in last years consolidated
statement of financial position) and its profit for the period (in this years
consolidated statement of profit or loss. These two figures will sum to the
subsidiarys net assets at the end of the period in the foreign currency but not
when translated into rupees. The difference is an exchange gain or loss.
This will be covered in a later section.

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Revaluations of non-current assets

A non-current asset in a foreign currency might be re-valued during a financial
period.
For example, a Pakistani company might own an office property in Thailand. The
cost of the office would have been translated at the spot rate when the property
was originally purchased. However, it might subsequently have been revalued.
The revaluation will almost certainly be in Thai baht. This revalued amount must
be translated into the functional currency of the entity (in this example, rupees).
Any gain or loss arising on retranslation of this property is recognised in the same
place as the gain or loss arising on the revaluation that led to the retranslation.

If a revaluation gain had been recognised in other comprehensive income

in accordance with IAS 16, the exchange difference would also be
recognised in other comprehensive income.

If a revaluation gain had been recognised in profit or loss in accordance

with IAS 40, the exchange difference would also be recognised in profit or
loss.

Example: Subsequent measurement of monetary amount

A Pakistani company (with the rupee as its functional currency) has a financial
year ending on 31 December.
It bought a building in Bahrain on 1 December 20X6 for 100,000 Bahraini dinar
(BD).
The building was revalued to BD 120,000 on 31 December 20X6 as permitted by
IAS 16.
Exchange rates:
1 December 20X6 Rs.275/BD1
31 December 20X6 Rs.290/BD1
The transaction would be recorded as follows:
On 1 December 20X6
Property, plant and equipment

Debit
27,500,000

Payables (Rs. 275 u BD100,000)

Credit
27,500,000

Being the initial recognition of building bought in a foreign currency

On 31 December 20X6
Debit
Property, plant and equipment
(5,800,000 + 1,500,000)

Credit

7,300,000

Other comprehensive income

7,300,000
Being the recognition of revaluation gain and exchange gain on
retranslation of carrying amount of a building denominated a foreign
currency.

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Example (continued): Subsequent measurement of monetary amount

Working

Building on initial recognition

Revaluation (year-end)

BD

Rate

Rs.

100,000

275

27,500,000

20,000

290

5,800,000

Exchange gain

1,500,000

Building at year end

120,000

290

34,800,000

If the building was an investment property, revalued following the rules in IAS 40
the credit of Rs.7,300,000 would be to the statement of profit or loss.
Practice question

A Pakistani company bought a machine from a German supplier for

200,000 on 1 March when the exchange rate was Rs. 120/.
By 31 December, the end of the companys accounting year, the
exchange rate was Rs. 110/.
At 31 December, the Pakistani company had not yet paid the German
supplier any of the money that it owed for the machine.
Required
Show the amounts that must be recognised to record this transaction.

2.4 Reporting at the settlement of a transaction

The settlement of a foreign currency transaction involves a receipt or payment in
foreign currency. The receipt or payment is a transaction in its own right and
must be recorded at the rate ruling at the date of the receipt or payment.
There will be exchange difference when the exchange rate at the date of
settlement is different to that at the date of initial recognition of the receivable or
payable in question. This is recognised in the statement of profit or loss.

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Example: Settlement of a transaction

A Pakistani company sells goods to a customer in Saudi Arabia for SR 72,000 on
12 September, when the exchange rate was Rs.28/SR (Saudi riyal).
It received payment on 19 November, when the exchange rate was Rs.30/SR.
The financial year-end is 31 December.
The sale will be initially translated at the spot rate giving rise to revenue and
receivables of Rs. 2,016,000 (SR 72,000 u Rs.28).
The receipt of the payment is recorded at Rs. 2,160,000 (SR 72,000 u Rs.30).
The necessary double entries are as follows:
On 19
9 September
Debit
2,016,000

Receivables
Revenue

Credit
2,016,000

On 19 November
Debit
2,160,000

Cash
Receivables

2,016,000

Exchange gain (statement of profit or loss)

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THE FOREIGN OPERATION: ACCOUNTING RULES

Section overview

Three stages in the consolidation process

The translation stage

The consolidation stage

Consolidation example

Consolidated statement of profit or loss and other comprehensive income

Disposal of a foreign subsidiary

3.1 Three stages in the consolidation process

If a company has a foreign operation (such as a foreign subsidiary) that prepares
its accounts in a functional currency that is different from the groups presentation
currency, there are three stages in the accounting process, for the purpose of
preparing consolidated financial statements (or including the foreign associate or
joint venture in the financial statements of the reporting entity).
Stage

Description

Adjust and update

Ensure that the individual financial statements of the

foreign entity are correct and up-to-date.

If any adjustments are required to correct the financial

statements of the foreign entity, these should be
made in the statements of the foreign entity and in its
own functional currency.

The assets and liabilities of the foreign entity should

be translated into the presentation currency of the
parent company. (As explained earlier, the
presentation currency of the parent company might
be the same or might be different from its functional
currency.)

The rules for translation are explained below.

After translation, all the financial statements are now

in the same currency.

Normal group accounting principles are now used to

prepare the consolidated accounts of the group.

Translate

Consolidate

Given the time pressure in the exam you might consider setting up a proforma
answer to allow you to consolidate translated figures as you go along. In other
words try to do stage 2 and part of stage 3 together. This will allow you to build
quickly the easier part of the answer leaving time to concentrate on the trickier
parts.

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3.2 The translation stage

The rules set out below apply where the functional currency of the foreign entity
is not a currency suffering from hyperinflation. (Hyperinflation is where the
countrys rate of inflation is very high. When there is hyperinflation, IAS 29
provides special accounting rules, which are described later.)
The normal rules for translation, contained in IAS 21, are as follows:
(1)

(2)

(3)

The statement of financial position

x

The assets and liabilities of the foreign operation are translated at the
closing rate for inclusion in the consolidated statement of financial
position.

This is different to the rule for transactions arising at the individual

entity level. Both monetary and non-monetary amounts of
subsidiaries are translated at the closing rate.

This rule also applies to purchased goodwill arising on the

acquisition of a foreign subsidiary.

The statement of profit or loss

x

Income and expenses are translated at the rates ruling at the date of
the transaction (spot rates) for inclusion in the consolidated
statement of profit or loss.

For practical reasons, average rates for a period may be used as

long as they provide a reasonable approximation of the spot rates
when the transactions took place. Average rates are widely used in
practice.

Exchange differences
x

All resulting exchange differences are recognised in other

comprehensive income for the period and are credited (gain) or
debited (loss) to a separate reserve within the equity section of the
consolidated statement of financial position, and this reserve is
maintained within equity until the foreign operation is eventually
disposed of.

Gains or losses are therefore reported as gains or losses in other

comprehensive income and movements in the separate reserve, and
not as a gain or loss in profit or loss and an increase or reduction in
retained earnings.

The gain or loss on translation

The exchange differences on translation (see (3) above) result in a gain or loss.
These gains or losses arise from a combination of two factors:

Income and expense items are translated at the exchange rates ruling
during the period (or an average rate as an approximation) but assets and
liabilities are translated at closing rates. The profit is therefore calculated at
the actual (average) exchange rates, but the accumulated profit in the

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consolidated statement of financial position is re-translated at the closing

rate.

The net assets of the subsidiary were translated at last years closing rate
at the end of the previous financial year. These net assets have now been
retranslated and included in this years statement of financial position at this
years closing rate.

IAS 21 states that these differences on translation are not recognised in profit or
loss because changes in the exchange rates for these items have little or no
effect on cash flows from operations. It would therefore be misleading to include
them in profit or loss.
Example: Exchange difference arising on retranslation of a foreign subsidiary
A Pakistani parent company has a Singapore subsidiary, which is 80% owned.
The following information is available about the subsidiary for the year to 31
December:
S$
Opening net assets, 1 January
Retained profit for the year

16,000
6,000

Closing net assets, 31 December

22,000

Relevant Rs./S$ exchange rates are as follows:

1 January
Average for the year
31 December

Rs.75/$
Rs.80/$
Rs.85/$

The exchange difference arising can be calculated as follows:

Exchange difference
$
Opening net assets
Retained profit for the year

Rate

Rs.

16,000

75

1,200,000

6,000

80

480,000

Exchange gain

190,000

Closing net assets

22,000

85

1,870,000

Note that the Rs. 190,000 would be reported as a gain in other comprehensive
income.
The amount attributable to the parent of Rs. 152,000 (80% of Rs. 190,000)
would then be recognised in a currency translation reserve.
The amount attributable to the non-controlling interest is Rs. 38,000 (20% of Rs.
190,000). This would be recognised in the non-controlling interest balance in the
statement of financial position.

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Practice question

A Pakistani parent company has a US subsidiary, which is 100% owned.

The following information is available about the subsidiary for the year to
31 December Year 5:
Opening net assets, 1 January

$20,000

Profit for the year

$10,000

Closing net assets, 31 December

$30,000

Dividends paid
Relevant Rs./$ exchange rates are as follows:
1 January Year 5
Average for the year
31 December Year 5

$0
Rs.100/$
Rs.106/$
Rs.110/$

Required
Calculate the total gain or loss on translation for the year.
Analyse it into:
a. the gain or loss on re-translating profit in the year; and
b. the gain or loss on re-translating the opening net assets.

3.3 The consolidation stage

After the translation stage, the financial statements of the overseas entity are in
the presentation currency of the parent company.
Consolidation can proceed as normal. However, there are several issues to be
aware of:

Goodwill must be retranslated at each reporting date; and

A foreign exchange reserve must be included in the consolidated statement

of financial position for the cumulative exchange differences.

Purchased goodwill and foreign subsidiaries

A net assets working can be constructed for the subsidiary. This should be
constructed in the foreign currency to identify the net asset balances in the
foreign currency at the dates of consolidation and acquisition. These are then
translated into the parents currency using the appropriate rate. This will be
shown later.
IAS 21 requires that goodwill and any fair value adjustments arising on the
acquisition of a foreign subsidiary are to be treated as part of the assets and
liabilities of the foreign subsidiary. The rules already described apply to these
items.
This means that:

Goodwill arising on the purchase of the foreign subsidiary (and also any fair
value adjustments to the value of assets of the subsidiary) should be stated
in the functional currency of the foreign subsidiary.

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The goodwill and fair value adjustments will therefore be translated each
year at the closing exchange rate.

A gain or loss on translation will therefore arise (as described above for other
assets and liabilities).
The effect of this rule is that goodwill and the acquisition of a foreign operation is
re-stated over time because it is re-translated every year at the new closing
exchange rate.
The rationale behind this accounting rule is that the amount paid for the
investment in the subsidiary has been based on the expected future earnings
stream. The goodwill relates to a business which operates in the economic
environment of another country and should therefore be expressed in the
functional currency of the foreign subsidiary.
Example: Goodwill arising on the acquisition of a foreign subsidiary and its
subsequent retranslation
A Pakistani parent company bought 80% of the shares of a Singapore company
on 1 January at a cost of Rs. 1,125,000.
The new subsidiary had retained earnings of S$11,000 at the date of acquisition.
It had share capital of S$5,000.
There were no fair value adjustments at the date of acquisition.
The parent recognises a proportionate share of non-controlling interest.
Relevant Rs./S$ exchange rates are as follows:
1 January

Rs.75/$

31 December
Rs.85/$
Goodwill is first calculated in the foreign currency as at the date of acquisition
using the rates appropriate to that date.
Goodwill arising on acquisition
Cost of investment

Rate

Rs.

15,000

75

1,125,000

(12,800)

75

(960,000)

Goodwill

2,200

75

165,000

Retranslation at 31 December

2,200

85

187,000

Less net assets acquired

80% u (S$ 5,000 + S$11,000)

Exchange gain

22,000

The Company would recognise goodwill of Rs. 187,000 in the consolidated

statement of financial position at 31 December.
The exchange gain of Rs. 22,000 would be reported as a gain in other
comprehensive income.
The amount attributable to the parent is the full Rs. 22,000 as it only relates to
the parents investment in the subsidiary.

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Practice question

A Pakistani holding company acquired 100% of the capital of a US

subsidiary on 30 September Year 6 at a cost of $800,000.
The fair value of the net assets of the subsidiary at that date was
$300,000.
The holding company prepares financial statements at 31 December each
year.
Relevant exchange rates are as follows:
30 September Year 6 Rs. 100/$
31 December Year 6 Rs.120/$
Required
Show how the goodwill would be accounted for at 31 December.

3.4 Consolidation example

The following example looks at the whole process of foreign currency
consolidation, beginning with the translation of the foreign subsidiarys accounts
and finishing with their consolidation into the parent group accounts.
Numbers from this example were used the previous two examples so you will be
familiar with these.
Example:
H bought 80% of S (a company in Singapore) on 31 December 2014 (one year
ago) when S had retained earnings of S$ 11,000.
Statements of financial position at 31
1 December 2015
H
Rs.
Investment in S
Property, plant and equipment
Current assets

S
S$

1,125,000
800,000
1,500,000

10,000
14,000

3,425,000

24,000

Share capital
Retained earnings

1,000,000
2,025,000

5,000
17,000

Current liabilities

3,025,000
400,000

22,000
2,000

3,425,000

24,000

1,425,000

11,000

600,000

6,000

2,025,000

17,000

Retained earnings b/f

Retained earnings in the year
Retained earnings c/f

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The following exchange rates are relevant:

31 December 2014 (date of acquisition)
Average for the year
31 December 2014

Rs. 75/S$
Rs. 80/S$
Rs. 85/S$

Prepare a consolidated statement of financial position at 31 December 2015.

This text will guide you through the answer process. Many of the numbers are
straightforward but some are little trickier to find.
Remember the three steps described earlier.
Step 1: Deal with any adjustments to the accounts of the subsidiary and parent,
e.g. inter-company trading transactions and inter-company loans. Apply the
normal rules for dealing with these.
There are no adjustments in this example so we can proceed to step 2.
Step 2: When the financial statements of the subsidiary have been updated and
adjusted as necessary, translate the subsidiarys accounts into the reporting
currency
Example: Step 2
The subsidiarys statement of financial position is translated at the closing rate.
Working 1: Translation working
S sttatement of financial position at 31 December 2015
S
S$
Rate
Property, plant and equip.
10,000
85
Current assets
14,000
85
24,000
85
Share capital
Retained earnings

5,000
17,000
22,000
2,000
24,000

Current liabilities

Balance
85
85

S
Rs.
850,000
1,190,000
2,040,000

1,870,000
170,000
2,040,000

The main purpose of this working is to identify values for the assets and liabilities
of the subsidiary so that they can be consolidated.
There is no need to translate the share capital and reserves at the closing rate.
These will be considered later when we look at the net assets summary.
In the above answer we have identified the sum of the share capital and reserves
as a balancing figure. This figure is based on the net assets at the reporting date
translated at the closing rate. Therefore it must include the exchange differences.
We will need to identify these separately.
Step 3: Carry out the consolidation. Some of the numbers are very
straightforward get the easy marks first by setting up a proforma answer and
filling in the blanks as far as you can. Only then go on to look at the more difficult
numbers (goodwill, retained earnings, exchange differences etc.)
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Example: Step 3 (easy numbers)

Consolidated statement off financial position at 31 December 2015
H
Rs.
Goodwill
Property, plant and
equipment
Current assets

800,000
1,500,000

Share capital
Retained earnings

1,000,000
2,025,000

Translation reserve
NCI
Current liabilities

400,000

S (W1)
Rs.

S
Rs.

850,000
1,190,000

1,650,000
2,690,000

1,000,000

170,000

570,000

We now need to start on the more difficult numbers.

We now need to start on the more difficult numbers. It is useful (though not
essential) to construct a net asset summary to help with these numbers.
Example: Step 3 (continued)
Working 2: Net asset summary of S
Net assets at
the date of
consolidation

Net assets at
the date of
acquisition

S$.
5,000
17,000

S$.
5,000
11,000

Net assets (S$)

Rate

22,000

16,000

85

75

Net assets (Rs.)

1,870,000

1,200,000

Share capital
Retained earnings

Postacquisition

670,000

This information can now be used to calculate NCI and goodwill.

The post-acquisition amount of Rs. 670,000 is not that useful as it is the sum of
post-acquisition profits plus exchange differences and these need to be
separated. However, it could be used to quickly finish off the statement of
financial position if you have no time to identify the separate reserves.

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Example: Step 3 (continued) NCI and goodwill

The fact pattern from this example was used to illustrate the calculation of
goodwill earlier in this section. It is repeated here for your convenience.
Non--controlling interest
20% of Rs. 1,870,000 (W2)

Rs.
374,000

Goodwill arising on acquisition

Cost of investment

$
15,000

Rate
75

Rs.
1,125,000

Less net assets acquired

80% u (S$ 16,000)

12,800

75

960,000

Goodwill

2,200

75

165,000

Retranslation at 31 December

2,200

85

187,000

Exchange gain

22,000

The exchange gain of Rs. 22,000 would be reported as a gain in other

comprehensive income.
The amount attributable to the parent is the full Rs. 22,000 as it only relates to
the parents investment in the subsidiary.
The next step is to calculate the consolidated equity balances. These are:

consolidated retained earnings; and

translation reserve.

The exchange difference working is useful for both of these calculations.

Example: Step 3 (continued): Exchange difference on retranslation
The fact pattern from this example was used to illustrate the calculation of the
exchange difference in an earlier section (3.2). It is repeated here for your
convenience.
Exchange difference
$
Opening net assets
Retained profit for the year

Rate

Rs.

16,000

75

1,200,000

6,000

80

480,000

Exchange gain

190,000

Closing net assets

22,000

85

1,870,000

The Rs. 190,000 would be reported as a gain in other comprehensive income.

The amount attributable to the parent of Rs. 152,000 (80% of Rs. 190,000)
would then be recognised in a currency translation reserve.
The amount attributable to the non-controlling interest is Rs. 38,000 (20% of Rs.
190,000). This would be recognised in the non-controlling interest balance in the
statement of financial position.

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Example: Step 3 (continued) Total exchange difference

Exchange difference arises on the retranslation of the goodwill and on the
retranslation of the financial statements of the subsidiary.
Exchange difference
Total

Attributable to
parent

Attributable to
NCI

Rs.

Rs.

Rs.

22,000

22,000

nil

On net assets of S

190,000

152,000

38,000

Closing net assets

212,000

174,000

38,000

On goodwill

The Rs. 212,000 is reported as a gain in other comprehensive income.

The amount attributable to the parent of Rs. 174,000 is recognised in a currency
translation reserve.
The amount attributable to the non-controlling interest is Rs. 38,000 is
recognised in the non-controlling interest balance in the statement of financial
position.
The next step is to calculate the equity balances for inclusion on the statement of
financial position.
Example: Step 3 (continued) Equity balances
These can be calculated as follows (by using a working which is in fact an extract
from the statement of changes in equity).
Retained
earnings

Non-controlling
interest

Rs.
1,425,000

Rs.
240,000

Profit for the year

984,000

96,000

All of H

600,000

Balance at start

Translation
reserve
Rs.

Share of S:
80% of (6,000 u Rs. 80)

384,000

20% of (6,000 u Rs. 80)

96,000
984,000

Exchange difference
Balance at end

2,409,000

96000
38,000

174,000

374,000

174,000

The non-controlling interest calculation is not needed but is shown for

completeness.

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The consolidated statement of financial position can now be completed as

follows:
Example: Step 3 Completion
Consolidated statement off financial position at 31 December 2015
H
Rs.
Goodwill
Property, plant and
equipment
Current assets

800,000
1,500,000

S (W1)
Rs.

850,000
1,190,000

S
Rs.
187,000
1,650,000
2,690,000
4,527,000

Share capital
Retained earnings
Translation reserve
NCI
Current liabilities

1,000,000
2,025,000

400,000

1,000,000
2,409,000
174,000
374,000
170,000

570,000
4,527,000

An aside
Note that in the above the retained earnings (Rs. 2,409,000) and the translation
reserve (Rs.174,000) sum to Rs. 2,583,000.
This can be proved by using the post-acquisition balance found in the net asset
working.
Example: Step 3 (continued) Proof of consolidated reserves total
Consolidated reserves (total)
All of H
Share of S (post acquisition) = 80% u Rs.670,000 (W2)
Exchange difference on retranslation of goodwill

Rs.
2,025,000
536,000
22,000
2,583,000

3.5 Consolidated statement of profit or loss and other comprehensive income

This section continues and expands (slightly) the previous example to show how
to prepare the consolidated statement of profit or loss and other comprehensive
income.
This is quite straightforward once the exchange differences arising in the period
have been calculated.

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Example: Consolidated statement of profit or loss and other comprehensive

income
H bought 80% of S (a company in Singapore) on 31 December 2014 (one year
ago).
The following exchange rates is relevant:
Average for the year

Rs. 80/S$

Statements of profit and loss for the year ended 31

1 December 2015
H
S
Revenue
Expenses
Profit

Rs.
2,200,000
(1,600,000)

S$
14,000
(8,000)

600,000

6,000

Consolidated statement of profit or loss and other comprehensive income is

prepared as follows.
Translation working
Example: Step 2
The subsidiarys statement of financial position is translated at the closing rate.
Working 1: Translation working
S statement of profit or loss for the year ending 31 December 2015
S
S
S$
Rate
Rs.
Revenue
14,000
80
1,120,000
Expenses
(8,000)
80
(640,000)
Profit

6,000

80

480,000

Consolidation
Example: Step 3
Consolidated statement of profit or loss and other comprehensive income
for the year ending 31 December 2015
Statement of profit or loss

Revenue
Expenses
Profit

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H
Rs.
2,200,000
(1,600,000)

S (W1)
Rs.
1,120,000
(640,000)

S
Rs.
3,320,000
(2,240,000)

600,000

480,000

1,080,000

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Other comprehensive income:

Exchange gain (as before Rs.22,000 + Rs. 190,000)
Total comprehensive income for the year

212,000
1,292,000

Profit attributable to:

Parent (balance)
Non-controlling interest (20% u Rs. 480,000)

984,000
96,000
1,080,000

Other comprehensive income attributable to:

Parent (Rs.22,000 + (80% u Rs. 190,000))
Non-controlling interest (20% u Rs. 190,000)
Total comprehensive income for the year

174,000
38,000
212,000

3.6 Disposal of a foreign subsidiary

Most of the accounting rules for the disposal of a foreign subsidiary, or for the
partial disposal of a foreign subsidiary, are set out in IFRS 10.
However IFRS 10 does not deal with the accounting treatment of the balance on
the separate equity reserve account when a foreign subsidiary is disposed of.
This matter is dealt with by IAS 21.

When the entire investment in a foreign subsidiary is disposed of, the

cumulative balance in the separate equity reserve (which represents
amounts previously recognised in other comprehensive income) should
now be reclassified from equity to profit and loss.

If there was a non-controlling interest in the subsidiary, the NCI is

derecognised in the consolidated statement of financial position. Amounts
previously recognised in other comprehensive income and attributed to NCI
must not be reclassified and recognised in profit or loss of the reporting
entity.

When a proportion of an investment in a foreign subsidiary is disposed of, a

proportionate share of the amounts previously recognised in other
comprehensive income (the cumulative balance in the separate equity
reserve) should now be reclassified from equity to profit or loss.

When income previously recognised as other comprehensive income is

reclassified as a gain or loss to profit or loss as a re-classification adjustment,
there must be an offsetting loss or gain in other comprehensive income, to avoid
double-counting of the gain (or loss).

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Example: Disposal
A company held 100% of the equity of a subsidiary S, but sold the entire
investment on 1 June when the carrying value of the net assets S and the
purchased goodwill were Rs.30 million. The consideration received from selling
the shares was Rs.37 million.
The company had previously recognised exchange gains of Rs.2 million in other
comprehensive income on its investment in S.
Required
Show the amount to be recognised in the statement of profit or loss in respect of
this disposal.

Answer
The company should recognise Rs.9 million in profit or loss for the financial
period when the disposal occurs as follows:
Rs.m
m
Consideration received from sale of shares
Carrying value of net assets of S

37.0
30.0

Gain
Exchange gain previously recognised in other comprehensive
income (reclassification adjustment)

7.0

Total gain recognised in profit or loss

9.0

2.0

A debit of Rs.2 million should be recognised in other comprehensive income, to

avoid double counting of the income previously recognised as other
comprehensive income but now reclassified in profit or loss.

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SOLUTIONS TO PRACTICE QUESTIONS

Solutions

On initial recognition
The machine and resulting liability are recognised initially at Rs. 24,000,000
(200,000 u Rs.120).
31 December
The liability is a monetary amount and must be retranslated at the closing rate. This
results in an amount of Rs. 22,000,000 (200,000 u Rs.110).
This is achieved by recognising an exchange gain of Rs. 2,000,000.
On 31 December
Debit
Rs. 2,000,000

Payables
Statement of profit or loss

Credit
Rs. 2,000,000

The machine is a non-monetary item carried at cost. Therefore, it is not re-translated.

Solutions
a

Exchange difference
$

Rate

Rs.

Opening net assets

20,000

100

2,000,000

Profit for the year

10,000

106

1,060,000

Exchange gain

240,000

Closing net assets

30,000

110

3,300,000

The entire profit for the year is included in accumulated profit at the end of the year,
because no dividends were paid during the year.
b

Exchange difference: gain or (loss)

On re-translating the opening net assets:

$20,000 at opening rate of 100
$20,000 at closing rate of 110

Rs.
2,000,000
2,200,000

Rs.

200,000
b

On re-translating the profit for the year:

$10,000 at average rate of 106
$10,000 at closing rate of 110

1,060,000
1,100,000
40,000

Exchange gain arising

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Solutions

Goodwill arising on acquisition

Cost of investment
Minus: Net assets acquired

$
800,000
300,000

Rate
100
100

Rs.
80,000,000
30,000,000

Goodwill

500,000

100

50,000,000

Retranslation at 31 December

500,000

120

60,000,000

Exchange gain

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

27

IAS 7: Statements of cash flows

Contents
1 Statements of cash flows: Introduction
2 Cash flows from investing activities
3 Cash flows from financing activities
4 Consolidated statement of cash flows
5 Non-controlling interests and associates (or JVs) in
the statement of cash flows
6 Acquisitions and disposals of subsidiaries in the
statement of cash flows

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A1

Presentation of financial statements (IAS 7)

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Chapter 27: IAS 7: Statements of cash flows

STATEMENTS OF CASH FLOWS: INTRODUCTION

Section overview

Purpose of statements of cash flows

Format

Direct method: Accruals based figures

Working capital adjustments: Introduction

1.1 Purpose of statements of cash flows

IAS 1 states that a statement of cash flows is a part of a complete set of the
financial statements of an entity. It provides information about:

the cash flows of the entity during the reporting period, and

the changes in cash and cash equivalents during the period.

A statement of cash flows groups inflows and outflows of cash under three broad
headings:

cash from operating activities;

cash used in (or obtained from) investing activities;

cash paid or received in financing activities.

It also shows whether there was an increase or a decrease in the amount of cash
held by the entity between the beginning and the end of the period.
Illustration: Statement of cash flows
Cash from operating activities
Cash used in (or obtained from) investing activities
Cash paid or received in financing activities.

X/(X)
X/(X)
X/(X)

Net cash inflow (or outflow) during the period

Cash and cash equivalents at the beginning of the period

X/(X)
X/(X)

Cash and cash equivalents at the end of the period

X/(X)

A statement of cash flows reports the change in the amount of cash and cash
equivalents held by the entity during the financial period.
Cash and cash equivalents
Definition: Cash, cash equivalents and cash flows
Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily
convertible to known amounts of cash and which are subject to an insignificant risk
of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.

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IAS 7 does not define a quantitative threshold for readily convertible. However,
normally investments that may be converted into cash within 90 days are treated
as readily convertible into cash.

1.2 Format
IAS 7 does not include a format that must be followed. However it gives illustrative
examples of formats that meet the requirements in the standard.
This section provides examples of these.
Illustration: Statement of cash flows
Rs.
Net cash flow from operating activities
Cash flows from investing activities:
Acquisition of shares (debentures, etc.)
Purchase of property, plant and machinery
Proceeds from sale of non-current assets
Interest received/dividends received
Net cash used in investing activities

Rs.
75,300

(5,000)
(35,000)
6,000
1,500
(32,500)

Cash flows from financing activities:

Proceeds from issue of shares
Proceeds from new loan
Repayment of loan
Dividends paid to shareholders
Net cash used in financing activities
Net increase/decrease in cash and cash equivalents
Cash and cash equivalents at the beginning of the year
Cash and cash equivalents at the end of the year

30,000
10,000
(17,000)
(25,000)
(2,000)
40,800
5,000
45,800

Operating cash flows

IAS 7 permits two methods of presenting the cash flows from operating activities:

the direct method, and

the indirect method.

For clarity, what this means is that there are two approaches to arriving at the
figure of Rs. 75,300 in the above example.
IAS 7 allows entities to use either method of presentation. It encourages entities
to use the direct method. However, the indirect method is used more in practice.
The two methods differ only in the way that they present the cash flows for cash
generated from operations. In all other respects, the figures in the statement of
cash flows using the direct method are identical to the figures in a statement
using the indirect method cash flows from investing activities and financing
activities are presented in exactly the same way.

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The indirect method

The indirect method identifies the cash flows from operating activities by
adjusting the profit before tax figure. It arrives at the cash from operating
activities figure indirectly by reconciling a profit figure to a cash figure.
The starting point for the statement of cash flows for a company is the operating
profit after deducting interest but before taxation.
This profit figure is adjusted to calculate the amount of cash received by the
business or the amount of cash paid out as a consequence of its trading
operations.
The adjustments are to remove the effect of:

Non-cash items, for example:

x

Depreciation and amortisation (depreciation of intangible non-current

assets);

Profit or loss on disposal of non-current assets; and

Accruals based figures, for example:

x

Interest expense or income;

Movement on working capital items (receivables, payables and

inventory).

The following illustration shows how the net cash flow from operating activities
figure seen in the previous example was arrived at using the indirect method.
Illustration: The indirect method
Statement of ca
ash flows: indirect method

Rs.

Rs.

Cash flows from operating activities

Profit before taxation

80,000

Adjustments for:
Depreciation and amortisation charges

20,000

Interest charges in the statement of comprehensive

income

2,300

Gains on disposal of non-current assets

(6,000)

Losses on disposal of non-current assets

4,500
100,800

Increase in trade and other receivables

(7,000)

Decrease in inventories

2,000

Increase in trade payables

3,000

Cash generated from operations

98,800

Taxation paid (tax on profits)

(21,000)

Interest charges paid

(2,500)

Net cash flow from operating activities

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The direct method

The direct method calculates the cash flow from operating activities by
calculating cash received from customers, cash paid to suppliers and so on.
The following illustration shows how the net cash flow from operating activities
figure seen in the previous example was arrived at using the direct method.
Illustration: The direct method
Statement of cash flows: direct method

Rs.

Cash flows from operating activities

Cash receipts from customers

348,800

Cash payments to suppliers

(70,000)

Cash payments to employees

(150,000)

Cash paid for other operating expenses

Cash generated from operations

(30,000)
98,800

Taxation paid (tax on profits)

(21,000)

Interest charges paid

(2,500)

Net cash flow from operating activities

75,300

The figures in the two statements are identical from Cash generated from
operations down to the end. The only differences are in the presentation of the
cash flows that produced the Cash generated from operations.
IAS 7 allows some variations in the way that cash flows for interest and dividends
are presented in a statement of cash flows, although the following should be
shown separately:

interest received

dividends received

interest paid

dividends paid.

1.3 Direct method: Accruals based figures

Interest
The interest liability at the start of the year and the interest charge during the year
is the most the business would pay. If the business had paid nothing it would owe
this figure. The difference between this amount and the liability at the end of the
year must be the amount that the business has paid.

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Example: Interest paid

A company had liabilities in its statement of financial position at the beginning and
at the end of 2014, as follows:
Interest (Rs.)
4,000

Beginning of 2014
End of 2014

22,000

During the year, interest charges in the income statement were Rs. 22,000.
The interest payment for inclusion in the statement of cash flows can be
calculated as follows:
Rs.
Liability at the start of the year

4,000

Charge for the year

22,000

Total amount payable in the year

26,000

Liability at the end of the year

(3,000)

Cash paid

23,000

Taxation
The tax paid is the last figure in the operating cash flow calculation.
Example: Taxation paid
A company had liabilities in its statement of financial position at the beginning and
at the end of 2014, as follows:
Taxation (Rs.)
53,000

Beginning of 2014
End of 2014

61,000

During the year, taxation on profits was Rs. 77,000.

The tax payment (cash flows) for inclusion in the statement of cash flows
can be calculated as follows:
Rs.
Taxation liability at the start of the year

53,000

Charge for the year

77,000

Total amount payable

130,000

Taxation liability at the end of the year

(61,000)

Cash paid

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69,000

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Deferred taxation
A question might include deferred taxation.
A deferred tax balance might be an asset or a liability. Deferred tax liability is
more common (in practice and in questions) so this discussion will be about
liabilities.
A deferred tax liability is an amount that a company expects to pay in the future.
Therefore it has had no cash effect to date.
Any movement on the deferred tax liability will be due to a double entry to tax
expense in the profit or loss section of the statement of comprehensive income.
There are two possible courses of action in dealing with deferred tax. Either:

ignore it entirely and work with numbers that exclude the deferred tax (in
effect this was what happened in the example above where there was no
information about deferred tax); or

include it in every tax balance in the working.

The second approach is usually used.

Example: Deferred tax
A company had liabilities in its statement of financial position at the beginning and
at the end of 2014, as follows:
Taxation
(Rs.)
Beginning of 2014

53,000

End of 2014

61,000

Deferred
taxation (Rs.)
20,000
30,000

The tax expense for the year in the statement of profit or loss was Rs.
87,000. This was made up of the current tax expense of Rs. 77,000 and
the deferred tax of Rs. 10,000.
The tax payment (cash flows) for inclusion in the statement of cash flows
can be calculated as follows:
Rs.
Liability at the start of the year

(53,000 + 20,000)

73,000

Charge for the year

(77,000 + 10,000)

87,000

Total amount payable in the year

Liability at the end of the year
Cash paid

Emile Woolf International

160,000
(61,000 + 30,000)

(91,000)
69,000

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1.4 Working capital adjustments: Introduction

Definition
Working capital is current assets less current liabilities.
The previous section showed that taxation and interest cash flows can be
calculated by using a figure from the statement of comprehensive income and
adjusting it by the movement on the equivalent balances in the statement of
financial position.
This section shows how this approach is extended to identify the cash generated
from operations by making adjustments for the movements between the start and
end of the year for elements of working capital, namely:

trade receivables and prepayments;

inventories; and

trade payables and accruals.

Any change in the balance of each line item of working capital from one period to
another will affect a firm's cash flows. For example, if a company's accounts
receivable increase at the end of the year, this means that the firm collected less
money from its customers than it recorded in sales during the same year. This is
a negative event for cash flow and may contribute to the "Net changes in current
assets and current liabilities" on the firm's cash flow statement to be negative. On
the flip side, if accounts payable were also to increase, it means a firm is able to
pay its suppliers more slowly, which is a positive for cash flow.
Assuming that the calculation of the cash flow from operating activities starts with
a profit (rather than a loss) the adjustments are as follows:
Increase in balance from start
to the end of the year

Decrease in balance from

start to the end of the year

Receivables

Subtract from profit before tax

Add back to profit before tax

Inventory

Subtract from profit before tax

Add back to profit before tax

Payables

Add back to profit before tax

Subtract from profit before tax

Balance

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Practice question

A company made an operating profit before tax of Rs. 16,000 in the year
just ended.
Depreciation charges were Rs. 15,000.
There was a gain of Rs. 5,000 on disposals of non-current assets and there
were no interest charges. Values of working capital items at the beginning
and end of the year were:

Beginning of the year

End of the year

Receivables

Inventory

Trade payables

Rs. 9,000
Rs. 6,000

Rs. 3,000
Rs. 5,000

Rs. 4,000
Rs. 6,500

Taxation paid was Rs. 4,800.

Required
Calculate the amount of cash generated from operations, as it would be shown in a
statement of cash flows using the indirect method.

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CASH FLOWS FROM INVESTING ACTIVITIES

Section overview

Cash paid for the purchase of property, plant and equipment

Cash from disposals of property, plant and equipment

Cash paid for the purchase of investments and cash received from the sale of
investments

2.1 Cash paid for the purchase of property plant and equipment
This is the second part of a statement of cash flows, after cash flows from
operating activities.
The most important items in this part of the statement are cash paid to purchase
non-current assets and cash received from the sale or disposal of non-current
assets but it also includes interest received and dividends received on
investments.
Movement on non-current assets might be summarised as follows:
Illustration: Movement on non-current assets
Rs.
At cost or valuation, at the beginning of the year

Disposals during the year (cost)

(X)

Upward/(downward) revaluation during the year

X/(X)
X

Additions to non-current assets (balancing figure)

At cost or valuation, at the end of the year

Alternatively carrying amount (NBV) can be used

Non-current assets at the beginning of the year at NBV
Depreciation
Disposals during the year (NBV)
Upward/(downward) revaluation during the year
Additions to non-current assets (balancing figure)
Non-current assets at the end of the year at NBV

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Rs.
X
(X)
(X)
X/(X)
X
X
(X)

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Advanced accounting and financial reporting

Example: Cash paid for property, plant and equipment

The statements of financial position of Grand Company at the beginning and end of
2014 include the following information:
Property, plant and equipment

2013

2014

Rs.

Rs.

At cost/re-valued amount

1,400,000

1,900,000

Accumulated depreciation

(350,000)

(375,000)

1,050,000

1,525,000

Carrying value

During the year, some property was revalued upwards by Rs. 200,000.
An item of equipment was disposed of during the year at a profit of Rs.
25,000. This equipment had an original cost of Rs. 260,000 and
accumulated depreciation of Rs. 240,000 at the date of disposal.
Depreciation charged in the year was Rs. 265,000.

Example (continued): Cash paid for property, plant and equipment

Additions may be calculated as follows:

Balance at the start of the year

Cost

NBV

1,400,000

1,050,000

Disposals during the year:

At cost

(260,000)

At carrying amount: (260,000 240,000)

(20,000)

Depreciation

(265,000)

Revaluation

Additions (balancing figure)

Balance at the end of the year

200,000

200,000

1,340,000

965,000

560,000

560,000

1,900,000

1,525,000

The revaluation recognised in the year can be found by comparing the opening
and closing balances on the revaluation surplus account. There might also be
revaluation double entry recognised as a gain or loss in other comprehensive
income (incremental depreciation). You need to total revaluation recognised in
the year so you may have to add or net both amounts.

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2.2 Cash from disposals of property, plant and equipment

A statement of cash flows should include the net cash received from any
disposals of non-current assets during the period.
This might have to be calculated from the gain or loss on disposal and the
carrying amount of the asset at the time of its disposal.
Illustration: Disposal of property, plant and equipment

At cost (or re-valued amount at the time of disposal)

Accumulated depreciation, at the time of disposal
Net book value/carrying amount at the time of disposal
Gain or (loss) on disposal

Rs.
X
(X)
X
X/(X)

Net disposal value (= assumed cash flow)

2.3 Cash paid for the purchase of investments and cash received from the sale
of investments
A statement of cash flows should include the net cash paid to buy investments in
the period and the cash received from the sale of investment in the period.
It is useful to remember the following relationship:
Illustration: Movement on investments

Carrying amount at the start of the year

Disposals
Additions
Revaluation

(X)
X
X/(X)

Carrying amount at the end of the year

Emile Woolf International

Rs.
X

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CASH FLOWS FROM FINANCING ACTIVITIES

Section overview

Examples of cash flows from financing activities

Cash from new share issues

Cash from new loans/cash used to repay loans

Dividend payments to equity shareholders

Repayments on finance leases

3.1 Examples of cash flows from financing activities

Examples of cash flows from financing activities are listed below:
Cash payments

Cash receipts

Cash payments to redeem/buy back

shares

Cash proceeds from issuing shares

Cash payments to repay a loan or

redeem bonds

Cash proceeds from a loan or issue of

bonds

Cash payments to a lessor under a

finance lease agreement that
represent a reduction in the remaining
finance lease obligation (= a reduction
in the creditors for finance leases)
Dividends are also usually included within cash flows from financing activities, in
this part of the statement of cash flows. (Some entities may also include interest
payments in this section, instead of including them in the section for cash flows
from operating activities.)

3.2 Cash from new share issues

The cash raised from new share issues can be established by comparing the
equity share capital and the share premium in the statements of financial position
at the beginning and the end of the year.
Illustration: Cash from new share issues

Share capital + Share premium at the end of the year

Rs.
X

Share capital + Share premium at the beginning of the year

Cash obtained from issuing new shares in the year

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Example: Cash from new share issues

The statements of financial position of Company P at 1 January and 31 December
included the following items:

Equity shares
Share premium

1 January 2014
Rs.
600,000
800,000

31 December 2014
Rs.
750,000
1,100,000

There was a 1 for 6 bonus issue during the year funded out of retained earnings.
The bonus issue was followed later in the year by a rights issue to raise cash for the
purchase of new plan.
(The information about the bonus issue means that for every 6 shares held at the
start of the year one new share was issued. Therefore, the share capital changed
from Rs. 600,000 to Rs. 700,000. The double entry to achieve this was Dr
Retained earnings and Cr Share capital).
The cash obtained from issuing shares during the year is calculated as follows.
Share capital + Share premium at the end of 2014
Share capital + Share premium at the beginning of 2014
Bonus issue (600,000 u 7/6 )
Cash obtained from issuing new shares in 2014

Rs.
1,850,000
(1,400,000)
(100,000)
350,000

If a bonus issue is funded out of share premium it can be ignored because the
balances on the two accounts are added together so the total would not be
affected.

3.3 Cash from new loans/cash used to repay loans

Cash from new loans or cash paid to redeem loans in the year can be calculated
simply by looking at the difference between the liabilities for loans and bonds at
the beginning and the end of the year.

An increase in loans or bonds means there has been an inflow of cash.

A reduction in loans or bonds means there has been a payment (outflow) of

cash.

Remember to add any loans, loan notes or bonds repayable within one year
(current liability) to the loans, loan notes or bonds repayable after more than one
year (non-current liability) to get the total figure for loans, loan notes or bonds.
Illustration: Cash from loans

Loans at end of year (current and non-current liabilities)

Rs.
X

Loans at beginning of year (current and non-current liabilities)

Cash inflow or outflow

Note: The same calculation can be applied to bonds or loan notes that the
company might have issued. Bonds and loan notes are long-term debt.

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3.4 Dividend payments to equity shareholders

These should be the final dividend payment from the previous year and the
interim dividend payment for the current year. The dividend payments during the
year are shown in the statement of changes in equity (SOCIE).
You might be expected to calculate dividend payments from figures for retained
earnings and the profit after tax for the year.
If there have been no transfers to the retained earnings reserve from the
revaluation reserve in the year, the equity dividend payments can be calculated
as follows:
Illustration:
Rs.
Retained earnings reserve at the beginning of the year
Profit for the year after tax

X
X

Increase in the retained earnings reserve

Retained earnings reserve at the end of the year

X
(X)

Equity dividend payments

Practice questions

From the following information, calculate the cash flows from investing
activities for Company X in 2014.
Beginning of
End of
2014
2014
Rs.
Rs.
Share capital (ordinary shares)
400,000
500,000
Share premium
275,000
615,000
Retained earnings
390,000
570,000

Loans repayable after more than 12 months

Loans repayable within 12 months or less

1,065,000

1,685,000

600,000

520,000

80,000

55,000

The company made a profit of Rs. 420,000 for the year after taxation.
Required
Calculate for 2014, for inclusion in the statement of cash flows:
(a)
(b)
(c)

the cash from issuing new shares

the cash flows received or paid for loans
the payment of dividend to ordinary shareholders.

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Chapter 27: IAS 7: Statements of cash flows

3.5 Repayments on finance leases

When non-current assets are acquired under a finance lease, the lessee makes
payments under the lease agreement. For accounting purposes, payments under
finance leases are treated:

partly as interest payments; and

partly as repayment of the lease finance.

For the purposes of the statement of cash flows:

The interest element in the lease payments is treated as an interest

payment. It is included either as a cash flow from operating activities or a
cash flow from financing activities

The repayment of the lease liability is treated as a repayment of a debt, and

is included as a cash flow from financing activities.

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Advanced accounting and financial reporting

CONSOLIDATED STATEMENT OF CASH FLOWS

Section overview

The special features of a consolidated statement of cash flows

Illustrative format

4.1 The special features of a consolidated statement of cash flows

A consolidated statement of cash flows is prepared largely from the consolidated
statement of financial position, statement of profit or loss and other
comprehensive income and statement of changes in equity. The rules for
preparing a group statement of cash flows are similar to the rules for a statement
of cash flows for an individual entity.
However, there are additional items in a consolidated statement of cash flows
that are not found in the statement of cash flows of an individual company. The
most significant of these are cash flows (or adjustments to profit before tax)
relating to:

non-controlling interests;

associates (or JVs);

and acquiring or disposing of subsidiaries during the year.

Exchange rate differences

A gain or loss arising from exchange rate differences is not a cash flow item.
When the indirect method is used to present cash flows from operating activities,
it is therefore necessary to make an adjustment to get from profit to cash flow.

A loss arising from exchange rate differences (shown in the example that
follows as a foreign exchange loss) must be added back.

A gain arising from exchange rate differences must be subtracted.

4.2 Illustrative format

It might be useful to look at the format of a consolidated statement of cash flows,
to see where these items appear. The indirect method is used here to present the
cash flows from operating activities.

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Chapter 27: IAS 7: Statements of cash flows

Illustration: X Plc: Consolidated statement of cash flows for the year ended 31
December 20X7
Rs. 000

Rs. 000

Cash flows from operating activities

Profit before tax

440

Adjustments for:
Depreciation and amortisation charges

450

Loss on disposal of plant and machinery

50

Share of profit of associates and joint ventures

(100)

Foreign exchange loss

40

Investment income

(25)

Interest expense

25

Increase in trade and other receivables

880
(80)

Increase in inventories

(60)

Increase in trade payables

40

Cash generated from operations

Interest paid

780
(30)

Income taxes paid

(200)

Net cash from operating activities

550

Cash flows from investing activities

Acquisition of subsidiary, net of cash acquired (note 1)

(450)

Purchase of property, plant and equipment (note 2)

Proceeds from the sale of equipment

(220)
30

Interest received

25

Dividends received from associates

45

Net cash used in investing activities

(570)

Cash flows from financing activities

Proceeds from the issue of share capital

500

Proceeds from long-term loan

100

Redemption of debt securities

(150)

Payment of finance lease liabilities

(80)

Dividends paid to non--controlling interests

Dividends paid to parent company shareholders

(70)
(200)

Net cash inflow from financing activities

100

Net increase in cash and cash equivalents

Cash and cash equivalents at the start of the year (note 3)

80
150

Cash and cash equivalents at the end of the year (note 3)

230

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Notes to the statement of cash flows

Illustration: Notes to the statement of cash flows
Note 1: Acquisition of subsidiary
During the year, the group acquired a subsidiary A Limited. The fair value of
assets acquired and liabilities assumed were as follows:
Rs. 000
50
90

Cash
Inventories
Trade receivables

60

Property, plant and equipment

870

Trade payables

(70)

Long-term loan

(200)

Total purchase price

Minus cash of A Limited

800
(50)
750

Shares issued as part of the purchase price

(300)

Cash flow on acquisition net of cash acquired

450

Note 2: Property, plant and equipment

During the year, the group acquired property, plant and equipment with a total
cost of Rs. 400,000, of which Rs. 180,000 was acquired by means of finance
leases. Cash payments of Rs. 220,000 were made to acquire property, plant and
equipment.
Note 3: Cash
h and cash equivalents
Cash and cash equivalents consist of cash in hand, bank balances, and money
market investments. Cash and cash equivalents in the statement of cash flows
comprise the following amounts in the statement of financial position:
20X7

20X6

Rs. 000

Rs. 000

Cash in hand and balances with banks

120

110

Short-term investments

210

80

Cash and cash equivalents as previously

reported

330

190

(40)

330

150

Effect of exchange rate changes

Cash and cash equivalents as re-stated

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NON-CONTROLLING INTERESTS AND ASSOCIATES (OR JVS) IN THE

STATEMENT OF CASH FLOWS
Section overview

Obtaining the required figures for cash flows

Non-controlling interests and the group statement of cash flows

Dividends paid to non-controlling interests and foreign exchange adjustments

Associates (or JVs) and the group statement of cash flows

Calculating dividends received from an associate (or JV)

5.1 Obtaining the required figures for cash flows

The cash flows and adjustments in a group statement of cash flows are obtained
from the other group financial statements. You should expect an examination
question to provide you with an opening and closing consolidated statement of
financial position, together with the related consolidated statement of profit or
loss and other comprehensive income, and possibly a statement of changes in
equity. Other relevant information may also be provided.
A group statement of cash flows reports the cash flows that affect the groups
consolidated cash (and cash equivalents). Any transactions not affecting the
group cash position should not be shown in the statement of cash flows , except
(with the indirect method) where a non-cash item is presented as an adjustment
to the profit before tax to calculate the Cash generated from operations.

5.2 Non-controlling interests and the group statement of cash flows

Unless there is an acquisition or a disposal of a subsidiary during the year, the
only cash flow relating to non-controlling interests is the amount of dividends paid
to the non-controlling interests by subsidiaries.
This might have to be calculated as a balancing figure, using the following
calculation:
Illustration: Dividends paid to NCI
Rs.
Non-controlling interest in group net assets at the beginning of
the year
Non-controlling interest in profits after tax for the year
Dividends paid to non-controlling interests (balancing figure)
Non-controlling interest in group net assets at the end of the
year

X
(X)
X
(X)
X

The dividends paid to non-controlling interests by subsidiaries are usually

included in the Cash flows from financing activities part of the statement of
cash flows. (This is the same part of the statement of cash flows where dividends
paid to the parent company shareholders are usually shown.)

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Example: Dividends paid to NCI

The following information has been extracted from consolidated financial
statements of P, a holding company which prepares accounts to 31 December. P
has a subsidiary Q, for which a final dividend is declared before the end of the
financial year.

Non-controlling interest in group net assets

Non-controlling interest in consolidated profit after
taxation

20X7
Rs. 000
1,510

20X6
Rs. 000
1,380

250

470

Required
What figure should appear in the consolidated statement of cash flows for the
year to 31 December 20X7 for the dividends paid to non-controlling interests?
Under what heading will this figure appear in the group statement of cash flows?

Answer
Rs. 000
Non-controlling interest in group net assets at the beginning of
the year
Non-controlling interest in profits after tax for the year

1,380
250

Dividends paid to non-controllinginterests (balancing figure)

1,630
(120)

Non-controlling interest in group net assets at the end of the

year

1,510

The dividend paid of Rs. 120,000 will be disclosed as a cash flow from financing
activities.

Practice question

The following information has been extracted from the consolidated

financial statements of P, a holding company which prepares accounts to
31 December each year:
Year 4
Year 3
Dividends payable to non-controlling interests
Non-controlling interests in group equity
Non-controlling interest in profit for the year

Rs. 000
200

Rs. 000
320

1,560

1,380

240

220

Required
What figure will appear in the consolidated statement of cash flows for
the year to 31 December Year 4 for dividend paid to non-controlling
interests?

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Chapter 27: IAS 7: Statements of cash flows

Practice question

The following information has been extracted from the consolidated

financial statements of X Plc:
Year 4

Year 5

Rs. 000

Rs. 000

NCI dividends payable at 31 December

20

25

NCI share of group profits after tax for

the year

270

300

NCI share in group net assets as at 31

December

600

630

Required
What figure will appear in the consolidated statement of cash flows for
the year to 31 December Year 5 in respect of non-controlling interests?

Practice question

The consolidated financial statements of Entity P for the year ended 31

March Year 6 showed the following balances:
Non-controlling interests in the consolidated statement of financial position
at 31 March Year 6 are Rs. 6 million (Rs. 3.6 million at 31 March Year 5).
Non-controlling interests in the consolidated profit for the year ended 31
March Year 6 is Rs. 2 million.
During the year ended 31 March Year 6, the group acquired a new 75%
subsidiary whose net assets at the date of acquisition were Rs. 6.4 million.
On 31 March Year 6, the group revalued all its properties and the noncontrolling interest in the revaluation surplus was Rs. 1.5 million.
There were no dividends payable to non-controlling interests at the
beginning or end of the year.
Required
What is the dividend paid to non-controlling interests that will be shown in
the consolidated statement of cash flows of Entity P for the year ended 31
March Year 6?

5.3 Dividends paid to non-controlling interests and foreign exchange

adjustments
If there is a gain or loss on translation for a foreign subsidiary, the non-controlling
interest has a share of this exchange gain or loss. This means that the amount
shown as the non-controlling interest in the consolidated statement of financial
position includes the non-controlling interest share of any foreign exchange gains
or is after deducting any foreign exchange losses.
A gain or loss arising from exchange rate differences is not a cash flow, but it
changes the amount for non-controlling interest in the consolidated statement of

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financial position. When the figures for non-controlling interest in the opening and
closing statements of financial position are used to calculate dividend payments
to non-controlling interests, we must therefore remove the effect of exchange rate
differences during the year.
The calculation of the dividends paid to the non-controlling interests should then
be calculated as follows:
Illustration: Dividends paid to NCI
Rs.
Non-controlling interest in group net assets at the beginning of
the year
Non-controlling interest in profits after tax for the year
Add non-controlling interest share of foreign exchange gain (or
subtract NCI share of a loss)
Dividends paid to non-controlling interests (as a balancing
figure)
Non-controlling interest in group net assets at the end of the
year

X
X
X/(X)
X
X
X

5.4 Associates (or JVs) and the group statement of cash flows
When a group has an interest in an associate entity, the consolidated statement
of cash flows must show the cash flows that occur between the associate (or JV)
and the group. The consolidated statement of cash flows shows the effect on the
groups cash position of transactions between the group and its associate (or JV).
The cash held by an associate (or JV) is not included in the groups cash figure in
the consolidated statement of financial position. This is because the equity
method of accounting does not add the associates (or JVs) cash to the cash of
the holding company and subsidiaries. As far as cash flows are concerned, the
associate (or JV) is outside the group. (The same principles apply to other
investments accounted for under the equity method, such as joint ventures
accounted for by the equity method).
Share of profit (or loss) of an associate (or JV)
In the consolidated statement of profit or loss, the group profit includes the
groups share of the profits of associates (or JVs). These profits are not a cash
flow item. When the indirect method is used to present the cash flows from
operating activities, an adjustment is therefore needed to get from profit to cash
flow.

The groups share of the profit of an associate (or JV) must be deducted
from profit.

The groups share of the loss of an associate (or JV) must be added to
profit.

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Cash flows involving associates (or JVs)

The cash flows that might occur between a group and an associate (or JV), for
inclusion in the consolidated statement of cash flows are as follows:

Investing activities
x

cash paid to acquire shares in an associate (or JV) during the year

cash received from the disposal of shares in an associate (or JV)

during the year

dividends received from an associate during the year.

Financing activities
x

cash paid as a new loan to or from an associate (or JV) during the
year

cash received as a repayment of a loan to or from an associate (or

JV) during the year.

Note that dividends received from an associate (or JV) are shown as cash flows
from investing activities; whereas dividends paid to non-controlling interests in
subsidiaries are (usually) shown as cash flows from financing activities.

5.5 Calculating dividends received from an associate (or JV)

In an examination, you may be required to calculate the dividends received from
an associate (or JV), using information in the opening and closing consolidated
statements of financial position and the consolidated statement of profit or loss.
The technique is similar to the calculation of dividends paid to non-controlling
interests.
Illustration: Dividends received from an associate (or JV)
Rs.
Group investment in net assets of associate (or JV) at the
beginning of the year

Group share of associates (or JVs) profits before tax

(X)
X

Dividends received from associate (or JV) in the year

(X)

Group investment in net assets of associate (or JV) at the end of

the year

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Example: Dividends received from an associate (or JV)

The following information has been extracted from the consolidated financial
statements of P for the year ended 31 December 20X7. The group has neither
purchased nor disposed of any investment during this period.
Group statement of profit or loss
Rs. 000
Group operating profit

1,468

Share of associates profit after tax

136
1,604

Tax on profit on ordinary activities:

Income taxes: group

(648)

Profit on ordinary activities after tax

956

Group statement of financial position at 31 December

20X7

20X6

Rs. 000

Rs. 000

932

912

Investments in associates
Share of net assets

Required
(a) What figure should appear in the group statement of cash flows for the year
to 31 December 20X7 for the associate?
(b) Under which heading would you expect this figure to appear in the group
statement of cash flows?

Answer
(a)

Rs. 000
Group investment in net assets of associate at the
beginning of the year

912

Group share of associates profits after tax

136
1,048

Dividends received from associate in the year (as a

balancing figure)
Group investment in net assets of associate at the end of
the year
(b)

(116)
932

The cash flow of Rs. 116,000 will be shown as a cash flow from investing
activities in the group statement of cash flows.

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Chapter 27: IAS 7: Statements of cash flows

Practice question

The following information has been extracted from the consolidated

financial statements of P, a holding company which prepares accounts to
31 December each year:
Consolidated statement of financial position (extract):

Investments in associated undertakings

Year 4

Year 3

Rs. 000

Rs. 000

932

912

96

58

Current assets
Dividend receivable from associate
Consolidated statement of profit or loss (extract):
Investments in associated undertakings

Year 4
Rs. 000

Group operating profit

1,468

Share of operating profit of associate

136
1,604

Income taxes:

(648)

Profit after tax

956

Required
Calculate the figure that will appear in the consolidated statement of
cash flows for the year to 31 December Year 4 in respect of dividend
received from associates?

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Advanced accounting and financial reporting

ACQUISITIONS AND DISPOSALS OF SUBSIDIARIES IN THE

STATEMENT OF CASH FLOWS
Section overview

Acquisition of a subsidiary in the statement of cash flows

Note to the statement of cash flows on acquisitions

Avoiding double counting when a subsidiary has been acquired

Disposal of a subsidiary in the statement of cash flows

6.1 Acquisition of a subsidiary in the statement of cash flows

When a subsidiary is acquired:

the group gains control of the assets and liabilities of the subsidiary, which
might include some cash and cash equivalents, and

the group pays for its share of the subsidiary, and the purchase
consideration might consist partly or entirely of cash.

In the group statement of cash flows, a single figure is shown (under the heading
Cash flows from investing activities) for the net effect of the cash flows from
acquiring the subsidiary. This net effect is:
Illustration: Cash paid for a subsidiary

Cash element in the purchase consideration

Minus: Cash assets of the subsidiary at the acquisition date
Cash payment on acquisition of subsidiary, net of cash received

Rs.
X
(X)
X

This net cash payment is the amount shown in the group statement of cash
flows.
Example: Cash paid for a subsidiary
Blue Group acquired 80% of the shares in Green Entity on 5 September 20X6,
when the net assets of Green Entity were Rs. 800,000, including Rs. 25,000 in
cash and cash equivalents. The purchase consideration was Rs. 700,000,
consisting of Rs. 500,000 in new shares of Blue (the holding company) and Rs.
200,000 in cash.
The cash flow shown in the group statement of cash flows for the year to 31
December 20X6 is:

Cash element in the purchase consideration

Minus: Cash assets of the subsidiary at the acquisition date

Rs.
200,000
(25,000)

Cash payment on acquisition of subsidiary, net of cash received

175,000

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Note that in the above example, even though only 80% of the shares in Green
Entity have been acquired, the full Rs. 25,000 of cash held by the subsidiary is
brought into the group statement of financial position at the acquisition date. The
figure deducted from the cash in the purchase consideration is therefore 100% of
the subsidiarys cash and cash equivalents acquired.

6.2 Note to the statement of cash flows on acquisitions

In an examination, it is useful to prepare a statement summarising the cash flow
effects of an acquisition. This statement is actually required by IAS 7, and should
be presented as a note to the statement of cash flows.
The statement should be presented as follows:
Illustration: Note to the cash flow statements re acquisition
Rs.
Assets of the subsidiary at the acquisition date, at fair
value
Liabilities of the subsidiary at the acquisition date

(X)

Net assets of the subsidiary at the acquisition date

Minus non-controlling interest in the subsidiary at this date

(% Non-controlling interest Net assets)
Purchased goodwill

(X)

Fair value of net assets acquired

Satisfied by:
New shares in holding company

Cash

Purchase consideration

The total purchase consideration equals the fair value of the net assets acquired.
The cash of the subsidiary at the acquisition date (C2) is then deducted from the
cash paid (C1) to arrive at the figure that appears in the statement of cash flows
for the Acquisition net of cash received

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Example: Note to the cash flow statements re acquisition

A typical note to the statement of cash flows, using illustrative figures, might
appear as follows for a subsidiary in which 80% of the shares are acquired:
Rs. 000
Net assets acquired:
Cash (C2)
Trade receivables
Inventories
Property, plant and equipment
Trade payables
Bank loan

3
85
139
421
(68)
(100)

Non-controlling interest (20% 480)

480
(96)

Purchased goodwill

384
76

Fair value of net assets acquired

460

Satisfied by:
Issue of shares
Cash paid (C1)

152
308
460

Extract from statement of cash flows

Investing activities
Acquisition of subsidiary net of cash received (Rs. 308,000 Rs. 3,000)
305,000

Rs.

In the statement of cash flows itself, the cash payment on the acquisition of the
subsidiary is not Rs. 308,000, because the cash flow is shown as the payment
minus the cash held by the subsidiary at the acquisition date (which is cash
brought into the group by acquiring the subsidiary).
In this example, the cash brought into the group on acquisition, as a part of the
net assets of the subsidiary, is Rs. 3,000.

6.3 Avoiding double counting when a subsidiary has been acquired

Cash flow information is often calculated from information in the opening and
closing statements of financial position.
If there is an acquisition during the year, it is important to make an adjustment to
the calculation for the assets or liabilities in the subsidiary that were acquired.
Unless this adjustment is made, the assets and liabilities in the subsidiary at the
acquisition date will be counted twice and the calculations will be incorrect.
An adjustment will be needed for every item of asset or liability acquired, except
for cash and cash equivalents.

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Inventory, trade receivables, trade payables

When the indirect method is used to present cash flows from operating activities,
the changes in receivables, inventory and trade payables are shown as
adjustments to the profit figure, to get to a figure for cash flow.
When preparing a statement of cash flows for an individual company, the
changes in these items are calculated by calculating the difference in the figure in
the closing statement of financial position and the corresponding value in the
opening statement of financial position.
However, when a subsidiary has been acquired, the working capital brought into
the group (receivables plus inventory minus trade payables of the acquired
subsidiary) is paid for in the purchase price to acquire the subsidiary. As we have
seen, this is treated as a separate item in the investing activities section of the
statement of cash flows.
To avoid double counting of the effects of the working capital in the subsidiary at
the acquisition date, we need to deduct from the value in the closing statement of
financial position, or add to the value in the opening statement of financial
position:

the receivables in the net assets of the subsidiary acquired, as at the

acquisition date

the inventory in the net assets of the subsidiary acquired, as at the

acquisition date, and

the trade payables in the net assets of the subsidiary acquired, as at the
acquisition date.

Example: Adjustment to calculation

D Group is preparing a group statement of cash flows for the year using the
indirect method. In the group opening and closing statements of financial
position, inventories were:
At the beginning of the year

Rs. 120,000

At the end of the year

Rs. 190,000

During the year, the group acquired a 75% interest in a new subsidiary, Entity S,
which had inventories of Rs. 40,000 at the acquisition date.
Required
What figure should be shown in the group statement of cash flows as the
adjustment for the increase or decrease in inventories?

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Answer

Group inventories at the beginning of the year

Add: Inventories acquired in the subsidiary

Rs.
120,000
40,000
160,000

Adjustment for increase in inventories on acquisition of new

subsidiary

30,000

Group inventories at the end of the year

190,000

Inventories have increased by Rs. 30,000 after allowing for the Rs. 40,000 of
inventories brought into the group when the subsidiary was purchased.
This would usually be shown as a working on the face of the answer as (Rs.
190,000  (120,000 + 40,000))
Purchases of non-current assets
When non-current assets are shown at their carrying amount (net book value)
and a subsidiary has been acquired during the year, purchases of non-current
assets (assumed to be cash payments) are calculated as follows.
Example: Cash paid to buy non-current assets
Rs.
Non-current assets at carrying amount, at the beginning of
the year

240,000

Net book value of disposals of non-current assets during

the year

(30,000)

Depreciation charge for the year

(40,000)

Cash paid to acquire non-current assets during the year

(second balancing figure)

55,000

Non-current assets acquired on acquisition of the

subsidiary

65,000

Total additions (first balancing figure)

Non-current assets at carrying amount, at the end of the
year

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Other items
Similar principles can be applied to all other assets and liabilities to find the cash
effect, for example to calculate loan repayments and repayments of leasing
obligations
Example: Tax paid
The Spot Group had the following items in its opening and closing group
statements of financial position at the beginning and at the end of 20X6:
At 1 January 20X6
Rs. 000

At 31 December 20X6
Rs. 000

250
136

325
165

Current tax payable

Deferred tax (liability)

The Spot Group acquired a 60% holding in a subsidiary, Entity B, on 7 May 20X6.
The total tax liability of Entity B at this date was Rs. 120,000. The total charge for
taxation in the consolidated statement of profit or loss of the Spot Group for the
year to 31 December 20X6 was Rs. 950,000.
Required
What was the cash payment for taxation during the year, for inclusion on the
group statement of cash flows?

Answer
The tax liability in the subsidiary when it was acquired should be deducted from
the closing tax liability for the group (or added to the opening tax liability for the
group) to avoid double counting.
Group tax liability at the beginning of the year
Tax liability acquired in the subsidiary
Group tax charge in the year

Rs. 000
386
120
950

Tax paid in the year

1,456
(966)

Group tax at the end of the year (325 + 165)

490

Note
To calculate the tax payment for the year, you should take the entire tax charge at
the beginning and at the end of the year both current tax and deferred tax.

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Example: dividends paid to non-controlling interest when a subsidiary has been

acquired
The Spot Group had the following items in its opening and closing group
statements of financial position at the beginning and at the end of 20X6:

Non-controlling interest

At 1 January 20X6
Rs. 000
350

At 31 December 20X6
Rs. 000
415

The Spot Group acquired a 60% holding in a subsidiary, Entity B, on 7 May 20X6.
The net assets of Entity B at this date were Rs. 800,000 at fair value. The profit
attributable to non-controlling interests in the groups statement of profit or loss
for the year to 31 December 20X6 was Rs. 270,000.
Required
What dividends were paid to the non-controlling interests during the year to 31
December 20X6?

Answer
Again, to avoid double counting we need to:
a.

deduct the non-controlling interest acquired from the value for noncontrolling interest in the closing consolidated statement of financial
position, or

b.

(as shown below) add the non-controlling interest acquired to the noncontrolling interest in the opening consolidated statement of financial
position.

Non-controlling interest at the beginning of the year

Non-controlling interest acquired in the subsidiary
(40% 800)
Non-controlling interest share of profits for the year
Dividends paid to non-controlling interest during the year
Non-controlling interest at the end of the year

Rs. 000
350
320
270
940
(525)
415

The cash outflow will be shown as a cash flow from financing activities.

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Example: adjustment for the impairment of goodwill

The Spot Group had the following items in its opening and closing group
statements of financial position at the beginning and at the end of 20X6:

Goodwill

At 1 January 20X6
Rs. 000
600

At 31 December 20X6
Rs. 000
540

The Spot Group acquired a 60% holding in a subsidiary, Entity B, on 7 May 20X6.
Purchased goodwill arising on the acquisition of Entity B was Rs. 110,000. The
Spot Group uses the indirect method to present its group statement of cash
flows.
Required
What is the impairment to goodwill for the year, and where would it appear in the
group statement of cash flows?

Answer
The impairment of goodwill
indirect method is used to
impairment of assets during
back to the profit figure (in
charges are added back).

is a non-cash item that reduces profit. When the

present cash flows from operating activities, any
the year and charged against profit must be added
the same way that depreciation and amortisation

When a subsidiary is acquired during the year, the calculation of the impairment
must allow for the purchased goodwill in the newly-acquired subsidiary. An
adjustment is needed to avoid double-counting.

Goodwill at the beginning of the year

Goodwill acquired in the subsidiary

710
(170)

Impairment
Goodwill at the end of the year

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6.4 Disposal of a subsidiary in the statement of cash flows

The procedures for reporting the cash effect of disposals of subsidiaries in a
group statement of cash flows are similar to those used for acquisitions, except
that the process applies in reverse.
In the group statement of cash flows, the cash received from the disposal is the
cash actually received from the disposal, minus any cash in the subsidiary at the
disposal date.
A note to the statement of cash flows should show the details of the disposal,
including the cash received from the sale minus the cash in the subsidiary at the
disposal date.
The assets and liabilities disposed of, and the non-controlling interest leaves the
group on the disposal.
Example: Disposal
Entity D disposed of its 80% interest in the equity capital of Entity S for a cash
sum of Rs. 550 million. The statement of financial position of Entity S at the date
of disposal showed the following balances:
Rs. 000
500
200
300

Tangible non current assets

Inventories
Trade receivables
Trade payables
Taxation (including deferred taxation)
Bank overdraft

(200)
(80)
(320)
400

D acquired its interest in S at the date of incorporation of that company, so no

goodwill arose.
Required
Prepare a statement summarising the effect of the disposal as a note to the
consolidated statement of cash flows.

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Answer
Cash received from the sale of the shares in the subsidiary is Rs. 550,000.
However, a note to the statement of cash flows should present the details of the
net assets disposed of, the proceeds from the sale, and the profit or loss on
disposal.
The profit or loss is the difference between the value of the net assets disposed of
and the proceeds from the sale. It is a balancing figure, in the same way that the
purchased goodwill is the balancing figure in a similar note to the statement of
cash flows when a subsidiary has been acquired.
In this example, the subsidiary had a bank overdraft when it was disposed of. The
cash in the subsidiary at the date of disposal was therefore a negative amount.
The group no longer has the bank overdraft, which means that its cash flow
position improved by selling off the subsidiary.
In the statement of cash flows itself, the cash proceeds from the disposal of the
subsidiary (net of cash lost) is the cash from the disposal proceeds plus the bank
overdraft that is no longer in the group (Rs. 550,000 + Rs. 320,000 = Rs.
870,000).
Rs. 000
Net assets disposed of:
Tangible non current assets
Inventories
Trade receivables
Trade payables
Taxation
Bank overdraft

500
200
300
(200)
(80)
(320)

Non-controlling interest (20% 400)

400
(80)

Profit on disposal

320
230

Proceeds
Satisfied by:

550

Cash

550

Extract from the statement of cash flows

Investing activities
Sale of subsidiary (550 + 320)

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To avoid double counting of the effects of the working capital in the subsidiary at
the disposal date, we need to deduct from the value in the opening statement of
financial position, or add to the value in the closing statement of financial
position:

the receivables in the net assets of the subsidiary sold as at the date of
disposal;

the inventory in the net assets of the subsidiary sold as at the date of
disposal; and

the trade payables in the net assets of the subsidiary sold as at the date of
disposal.

Example: Disposal
Suppose that the group in the previous example uses the indirect method of
computing the cash flow from operating activities. Inventories were Rs.
1,600,000 in the opening group statement of financial position at the beginning
of the year and Rs. 1,500,000 in the closing group statement of financial
position.
Required
What figure in respect of inventories would be used as an adjustment in
calculating the cash flows from operating activities?

Answer
Rs.
000
Group inventories at the beginning of the year
Inventories disposed of in the subsidiary

1,600
(200)

Adjustment for increase in inventories

1,400
100

Group inventories at the end of the year

1,500

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

1
Rs.

Rs.

Cash flows from operating activities

Profit before taxation
Adjustments for:
Depreciation and amortisation charges
Gains on disposal of non-current assets

16,000
15,000
(5,000)
26,000
3,000
(2,000)

Decrease in trade and other receivables

Increase in inventories
Increase in trade payables

2,500

Cash generated from operations

29,500

Taxation paid (tax on profits)

(4,800)

Net cash flow from operating activities

24,700

Solution

Workings
Proceeds from new issue of shares
Share capital and share premium:
At the end of the year (500,000 + 615,000)
At the beginning of the year (400,000 + 275,000)
Proceeds from new issue of shares during the year
Repayment of loans

Rs.
1,115,000
675,000
440,000
Rs.

Loans repayable:
At the end of the year (520,000 + 55,000)
At the beginning of the year (600,000 + 80,000)

575,000
680,000

Repayment of loans during the year

105,000

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Payment of dividends

Rs.

Retained earnings at the beginning of the year

Profit after taxation for the year

390,000
420,000

Retained earnings at the end of the year

810,000
(570,000)

Dividends paid during the year

240,000

Cash flows from financing activities can now be presented as follows.

Cash flows from financing activities
Proceeds from issue of shares

Rs.
440,000

Repayment of loans
Dividends paid to shareholders

Rs.

(105,000)
(240,000)

Net cash from financing activities

95,000

Solution

Dividend paid to non-controlling interest is as follows:

Rs. 000
Opening balances (320 + 1,380)

1,700

Share of profit for the year

240
1,940
(1,760)

Closing balances (200 + 1,560)

Dividend paid

180

Solution

Dividend paid to non-controlling interest is as follows:

Rs. 000
Balances at start of Year 5 (20+ 600)

620

Attributable to NCI in profit or loss for the year

300

Balances at end of Year 5 (25 + 630)

920
655

Cash paid to NCI

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Solution

Dividend paid to non-controlling interest is as follows:

Rs. m
Opening balance, NCI

3.6

NCI in profit for the year

2.0

Effect of acquisition: addition to NCI (25% u Rs. 6.4)

1.6

Revaluation surplus: addition to NCI

1.5

Closing balance, NCI

8.7
6.0

Dividend paid to NCI (balancing figure)

(2.7)

Solution

Dividend from associate is as follows:

Rs. 000
Opening balances (912 + 58)

970

Share of profit after tax for the year

136
1,106
(1,028)

Closing balances (932 + 96)

Dividend received

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

28

IAS 33: Earnings per share

Contents
1 P/E ratio and earnings per share
2 Calculating basic EPS
3 Diluted EPS
4 IAS 33: Presentation and disclosure requirements
5 Earnings per share as a performance measure

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply application abilities of the
requirements of the international pronouncements, the Companies Ordinance, 1984, and
other applicable regulatory requirements in respect of financial reporting and the
presentation of financial statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse the financial data in order to arrive at arriving at

firm decisions on about the accounting treatment and reporting of the
same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 26

IAS 33: Earnings per share

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Chapter 28: IAS 33: Earnings per share

P/E RATIO AND EARNINGS PER SHARE (EPS)

Section overview

The need for a standard on earnings per share

IAS 33: Earnings per share

1.1 The need for a standard on earnings per share

Earnings per share
Earnings are profits available for equity (ordinary shareholders). Earnings per
share (EPS) is a measure of the amount of earnings in a financial period for each
equity share.
As its name implies, EPS is calculated as reported earnings divided by the
number of ordinary shares in issue.
The price/earnings ratio
The price/earnings ratio (P/E ratio) is a key stock market ratio. It is a measure of
the companys current share price (market price) in relation to the EPS. The P/E
ratio is calculated as follows:
Formula: Price earnings ratio
Market value of share
P/E ratio

=
Earnings per share

The P/E ratio can be used by investors to assess whether the shares of a
company appear expensive or cheap. A high P/E ratio usually indicates that the
stock market expects strong performance from the company in the future and
investors are therefore prepared to pay a high multiple of historical earnings to
buy the shares.
EPS is used by investors as a measure of the performance of companies in
which they invest or might possibly invest. Investors are usually interested in
changes in a companys EPS over time trends and also in the size of EPS
relative to the current market price of the companys shares.
EPS should therefore be calculated by all companies in a standard way, so that
investors can obtain a reliable comparison between the EPS and P/E ratios of
different companies.

1.2 IAS 33: Earnings per share

The rules for calculating EPS are set out in IAS 33 Earnings per share
The concept of EPS is quite straightforward. It is simply the profit for the year
(adjusted for a few things) divided by the weighted average number of ordinary
shares in that year.

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IAS 33 specifies the profit figure that should be used and explains how to
calculate the appropriate number of shares when there have been changes in
share capital during the period under review.
IAS 33 also describes the concept of dilution which is caused by the existence of
potential ordinary shares.
Each of these issues is dealt with in later sections.
Objective of IAS 33
The objective of IAS 33 is to set out principles for:

the calculation of EPS; and

the presentation of EPS in the financial statements.

The purpose of standardising the calculation and presentation of EPS is to make

it easier for the users of financial statements to compare the performance of:

different entities in the same reporting period; and

the same entity for different reporting periods over time.

Scope of IAS 33
IAS 33 applies only to publicly-traded entities or those which are about to be
publicly traded. A publicly-traded entity is an entity whose shares are traded by
the investing public, for example on a stock exchange.
Most publicly-traded entities prepare consolidated financial statements as well as
individual financial statements. When this is the case, IAS 33 requires disclosure
only of EPS based on the figures in the consolidated financial statements.
Definition
Definition
An ordinary share is an equity instrument that is subordinate to all other classes
of equity instruments.
The ordinary shares used in the EPS calculation are those entitled to the residual
profits of the entity, after dividends relating to all other shares have been paid. As
stated earlier, if you are given an examination question on this topic, preference
shares are not ordinary shares because they give more rights to their holders
than ordinary shares.
Preference shares and EPS
Preference shares are not ordinary shares. The interest of preference
shareholders is in the company is pre-defined as opposed to that of ordinary
shareholders who have a residual interest in the company. Since EPS is a
measure of earnings per ordinary share in a financial year, preference shares are
excluded from the number of shares.
The dividends paid to preference shareholders must therefore be excluded from
the total earnings for the period. A broad definition of earnings is therefore profit
after tax less preference dividends paid.

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Chapter 28: IAS 33: Earnings per share

Basic and diluted earnings per share

IAS 33 requires entities to calculate:

the basic earnings per share on its continuing operations

the diluted earnings per share on its continuing operations.

Additional requirements apply to earnings relating to discontinued operations.

Diluted EPS and basic EPS will usually differ when there are potential ordinary
shares in existence.
Definition
A potential ordinary share is a financial instrument or other contract that may
entitle its holder to ordinary shares at some time in the future.
IAS 33 gives the following examples of potential ordinary shares:

financial liabilities or equity instruments that are convertible into new

ordinary shares at some time in the future (convertible debentures,
convertible preference shares);

share options and warrants. Options and warrants are financial instruments
that give the holder the right (but not the obligation) to purchase new
ordinary shares at some time in the future, at a fixed price;

shares that will be issued if certain contractual conditions are met, such as
contractual conditions relating to the purchase of a business.

The chapter explains the calculation of basic EPS and then the calculation of
diluted EPS.

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CALCULATING BASIC EPS

Section overview

Basic EPS

Total earnings

Changes in the number of shares during a period

Issue of shares at full market price

Bonus issues of shares

Rights issues of shares

2.1 Basic EPS

Basic earnings per share is calculated by dividing the profit or loss on continuing
operations by the weighted average number of ordinary shares in issue during
the period.
The calculation of the basic EPS is as follows:
Formula: Basic EPS
Net profit (or loss) attributable to ordinary shareholders during a period
weighted average number of shares in issue during the period
As you can see above IAS 33 gives guidance on:

the earnings figure that must be used being the net profit (or loss)
attributable to ordinary shareholders during a period (commonly referred to
as total earnings); and

the number of shares to be used in the calculation being the weighted

average number of shares in issue during the period. Changes in share
capital during a period must be taken into account in arriving at this
number. IAS 33 provides guidance on how to do this.

2.2 Total earnings

The total earnings figure is the profit or loss from continuing operations after
deducting tax and preference dividends (and in the case of consolidated financial
statements, after excluding the earnings attributable to non-controlling interests).
Total earnings include any income from associates (i.e. any share of profits or
losses of associates).
When there is a net loss, total earnings, and therefore, the EPS are negative.
Earnings from discontinued operations are dealt with separately. An EPS from
any discontinued operations must also be disclosed, but this does not have to
be disclosed on the face of the statement of profit or loss. Instead, it may be
shown in a note to the financial statements.

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Chapter 28: IAS 33: Earnings per share

The total earnings figure must be adjusted for the interests of preference
shareholders before in can be used in EPS calculations.
Preference shares
Preference shares must be classified as equity or liability in accordance with the
rules in IAS 32: Financial Instruments: Presentation.
If a class of preference shares is classified as equity, any dividend relating to that
share is recognised in equity. Any such dividend must be deducted from the profit
or loss from continuing operations as stated above.
If a class of preference shares is classified as liability (redeemable preference
shares), any dividend relating to that share is recognised as a finance cost in the
statement of profit or loss. It is already deducted from the profit or loss from
continuing operations and no further adjustment need be made.
Example: Basic EPS
In the year ended 31 December Year 1, Entity G made profit after tax of Rs.
3,500,000.
Of this, Rs. 3,000,000 was from continuing operations and Rs. 500,000 from
discontinued operations.
It paid ordinary dividends of Rs. 150,000 and preference dividends of Rs. 65,000.
The preference shares were correctly classified as liabilities in accordance with
IAS 32.
Entity G had 1 million ordinary shares in issue throughout the year.
Entity Gs basic EPS for the year ended 31 December Year 1 is calculated as
follows:
Net profit (or loss) attributable to ordinary shareholders during a period
EPS =
weighted average number of shares in issue during the period
=

Rs. 3,000,000
1,000,000

Rs. 3 per share (EPS from

continued operations)

Rs. 500,000
1,000,000

Rs. 0.5 per share (EPS from

discontinued operations)

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Example: Basic EPS

In the year ended 31 December Year 1, Entity G made profit after tax of Rs.
3,500,000.
Of this, Rs. 3,000,000 was from continuing operations and Rs. 500,000 from
discontinued operations.
It paid ordinary dividends of Rs. 150,000 and preference dividends of Rs. 65,000.
The preference shares were correctly classified as equity in accordance with IAS
32.
Entity G had 1 million ordinary shares in issue throughout the year.
Entity Gs basic EPS for the year ended 31 December Year 1 is calculated as
follows:
Net profit (or loss) attributable to ordinary shareholders during a period
EPS =
weighted average number of shares in issue during the period
=

Rs. 3,000,000  Rs. 65,000

1,000,000

Rs. 2.94 per share

(continued operations)

Rs. 500,000
1,000,000

Rs. 0.5 per share

(discontinued operations)

Cumulative preference shares

There is a further complication concerning preference shares. Some preference
shares are cumulative preference shares. This means that if a company fails to
declare a preference dividend in a period the holders are entitled to receive the
missed dividend sometime in the future. In other words, their right to receive a
dividend accumulates when a dividend is not declared. If there are cumulative
preference shares in issue the dividend must be deducted from profit or loss from
continuing operations regardless of whether the dividend has been declared or
not.
Example: Cumulative preference shares
In the year ended 31 December Year 1, Entity G made profit after tax from
continuing operations of Rs. 3,500,000.
Entity G has Rs. 1,000,000 10% preference share capital in issue. (This would
entitle investors to receive a dividend of Rs. 100,000 (10% of Rs. 1,000,000) if
declared).
Entity G had 1 million ordinary shares in issue throughout the year.
Entity Gs basic EPS for the year ended 31 December Year 1 is calculated as
follows:
Net profit (or loss) attributable to ordinary shareholders during a period
EPS =
weighted average number of shares in issue during the period
=

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Rs. 3,500,000  Rs. 100,000

1,000,000

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Chapter 28: IAS 33: Earnings per share

Note that the Rs. 100,000 deducted above would be deducted irrespective of
whether a dividend had been declared or not. However, if these had been noncumulative then the dividend would have been deducted only in case of
declaration by the company.
Increasing rate preference shares:
These are preference shares that provide for a low initial dividend to compensate
an entity for selling the preference shares at a discount, or an above-market
dividend in later periods to compensate investors for purchasing preference
shares at a premium.
According to the rules contained in IAS 32: Financial instruments: Presentation
and IAS 39: Financial instruments: Recognition and measurement the discount or
premium arising on the issue of increasing rate preference shares is amortised
using the effective interest method and treated as a preference dividend for the
purposes of calculating earnings per share. In addition, there may be other
elements amortised such as transaction costs.
All these elements should be deducted in arriving at the earnings attributed to
ordinary equity holders.
Example: Increasing rate preference shares
Entity D issued non-convertible, non-redeemable class A cumulative preference
shares of Rs. 100 par value on Year 1.
The class A preference shares are entitled to a cumulative annual dividend of Rs.
7 per share starting in Year 4.
At the time of issue, the market rate dividend yield on the class A preference
shares was 7% per annum.
Thus, Entity D could have expected to receive proceeds of approximately Rs. 100
per class A preference share if the dividend rate of Rs. 7 per share had been in
effect at the date of issue.
There was, however, to be no dividend paid for the first three years after issue.
In consideration of these dividend payment terms, the class A preference shares
were issued at Rs. 81.63 per share, i.e. at a discount of Rs. 18.37 per share.
(The issue price can be calculated by taking the present value of Rs. 100,
discounted at 7 per cent over a three-year period).

The imputed dividends attributable to preference shares that need to be

deducted from earnings to determine the profit or loss attributable to ordinary
equity holders are calculated as follows:

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Example (continued): Increasing rate preference shares

Analysis
The shares are non-redeemable and would be classified as equity.
The original issue discount is amortised to retained earnings using the
effective interest method and treated as a preference dividend for earnings
per share purposes.
The following imputed dividend per class A preference share is deducted to
determine the profit or loss attributable to ordinary equity holders of the
parent in order to calculate basic earnings per share.
Opening
carrying
amount of
Imputed
Closing
preference
dividend
carrying
Dividend
shares (Rs.)
Year
(Rs.)
amount (Rs.)
paid (Rs.)
1
81.63
5.71
87.34
2
3
Year 4
onwards

87.34
93.46

6.12
6.54

93.46
100.00

100

7.00

107.00

(7)

Early conversion of preference shares

An entity may achieve early conversion of convertible preference shares by
improving the original conversion terms or paying additional consideration.
Where this is the case, the excess amount transferred as a result of the
improvement of conversion terms is treated as a return to the preference
shareholders and must be deducted in arriving at earnings attributable to ordinary
equity holders.
Illustration: Deduction
Deduction

Fair value of ordinary

shares issued
(consideration paid)

Fair value of ordinary

shares issuable under
original terms

Repurchase of preference shares

Where the fair value of consideration paid to preference shareholders exceeds
the carrying value of the preference shares repurchased, the excess is a return to
the preference shareholders and must be deducted in calculating profits
attributable to ordinary equity holders.
Where the carrying value of preference shares repurchased exceeds the fair
value of consideration paid, the excess is added in calculating profit attributable
to ordinary equity holders.
In respect of preference shares that are classified as liabilities, the above
adjustments, where these are relevant, would have already been made in arriving
at the profit or loss for the period.
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Chapter 28: IAS 33: Earnings per share

Participating securities and two-class ordinary shares

The equity of some entities includes:

instruments that participate in dividends with ordinary shares according to a

predetermined formula (for example, two for one) with an upper limit on the
extent of participation (for example, up to, but not beyond, a specified
amount per share), or

a class of ordinary shares with a different dividend rate from that of another
class of ordinary shares.

Profit or loss for the period is allocated to the different classes of shares and
participating equity instruments in accordance with their dividend rights or other
rights to participate in undistributed earnings.
To calculate basic earnings per share:
Step 1: Adjust profit or loss attributable to ordinary equity holders of the parent
entity as previously discussed.
Step 2: Allocate the profit or loss to ordinary shares and participating equity
instruments to the extent that each instrument shares in earnings as if all of the
profit or loss for the period had been distributed. The total profit or loss allocated
to each class of equity instrument is determined by adding together the amount
allocated for dividends and the amount allocated for a participation feature.
Step 3: Divide the total amount of profit or loss allocated to each class of equity
instrument by the number of outstanding instruments to which the earnings are
allocated to determine the earnings per share for the instrument.

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Example: Participating securities

X Limited has non-convertible preference shares in issue.
These have the right to participate in any additional dividends after ordinary
shares have been paid at a dividend of Rs. 2.10 per share in a 20:80 ratio with
ordinary shares
The following information relates to the financial year just ended.
Profit attributable to equity shareholders
Rs. 100,000
Number of ordinary shares
10,000
Number of non-convertible preference shares
6,000
Non-cumulative annual dividend on preference shares
Rs. 5.50 per
(before any dividend is paid on ordinary shares)
share
The earnings attributable to ordinary shareholders is as follows:
R
Rs.
Profit attributable to equity holders of the parent entity
100,000
Less dividends paid:
Preference (6,000 shares u Rs. 5.50 per share)

33,000

Ordinary (10,000 shares u Rs. 2.1 per share)

21,000
(54,000)

Undistributed earnings

46,000

Note: It is irrelevant whether the ordinary dividend has been paid or not.
The point is that the ordinary shareholders would be entitled to Rs. 2.1 per
share before a further distribution to the preference shareholders could
take place.
Allocation of the undistributed earnings
Let A be the allocation of undistributed earnings per ordinary share.
Let B be the allocation per preference share.
Therefore, the undistributed earnings belongs to each group as follows:
(10,000A) + (6,000B) = Rs. 46,000
But Bs entitlement is one quarter that of As so the equation simplifies to:
(10,000A) + (0.25 6,000A) = Rs. 46,000
Therefore
Therefore
Final allocation

A = Rs. 4
B = Rs. 1
Participating preference
share

Distributed
earnings
Undistributed
earnings
Total

Per share

Total
(u 6,000)

Rs. 5.50

33,000

Rs. 2.10

21,000

Rs. 1.00

6,000

Rs. 4.00

40,000

Rs. 6.50

39,000

Rs. 6.10

61,000

EPS

Emile Woolf International

Ordinary share
Total
Per share
(u 10,000)

EPS

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Chapter 28: IAS 33: Earnings per share

2.3 Changes in the number of shares during a period

IAS 33 gives guidance on how to incorporate changes in share capital during a
period into the calculation of the weighted average of shares that must be used in
the EPS calculation.
There are different ways in which the number of shares may change:

Issues for full consideration (issue or redemption) of shares at a full market

price).

Issues for no consideration (issue or redemption) of shares with no change

in net assets), for example:

Bonus issues

Share splits (where one share is split into several others)

Reverse share splits (share consolidation)

Bonus elements in other issues (see later discussion on rights issues)

Rights issues (issue of shares for consideration but at less than the full
market price of the share).

IAS 33 gives guidance on each of these.

Overall approach
At this point we will provide an overall approach designed to enable you to deal
with complicated situations where there has been more than one capital change
in the period.
Step 1: Write down the number of shares at the start of the year.
Step 2: Write down the date of the first capital change and the number of shares
in existence after that capital change. Repeat this step until all capital changes
have been dealt.
Step 3: Multiply each number of shares by the fraction of the year that it was in
existence.
Step 4: Add up the results from step 4 to give the weighted average number of
shares.
Note: If any capital change is due to or contains a bonus issue multiply each
preceding number of shares by the bonus fraction.
This will not make much sense to you at first but it will become clear as you study
later examples.

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Example: Time apportionment to find weighted average

On 1 January a company had 5,000,000 ordinary shares in issue.
On 1 April, 1,000,000 new shares were issued.
On 1 July an extra 1,000,000 shares came into existence
On 1 November 500,000 more shares were issued.
(All issues were at full market price the implication of this will be explained in
more detail in the next section).
The weighted average number of shares is calculated as follows.
Weighted
average
Number of
Time
shares
factor
Date
number
1 January to 31 March
New issue on the 1 April

5,000,000
1,000,000

u 3/12

1,250,000

1 April to 30 June
New issue on the 1 July

6,000,000
1,000,000

u 3/12

1,500,000

1 July to 31 October
New issue on the 1 November

7,000,000
500,000

u 4/12

2,333,333

1 November until 31 December

7,500,000

u 2/12

1,250,000
6,333,333

2.4 Issue of shares at full market price

The consideration received is available to boost earnings. Therefore, the shares
are included from the date of issue to ensure consistency between the numerator
(top) and denominator (bottom) of the EPS calculation.
As explained above, the starting point for the weighted average number of shares
is the number of shares in issue at the beginning of the period. This is then
adjusted for any shares issued during the period and a time weighting factor must
then be applied to each figure.
There is no adjustment to comparatives resulting from an issue at full price.
Exxample: Isssue of shares at full market price
Company A has a financial year ending 31 December.
On 1 January Year 1 there were 6,000,000 ordinary shares in issue.
On 1 April, it issued 1,000,000 new shares at full market price.
Total earnings in Year 1 were Rs. 27,000,000.
EPS in Year 1 is calculated as follows.

Date
1 January to 31 March
New issue on the 1 April

Number of
shares
6,000,000
1,000,000

1 April to 31 December

7,000,000

Time
factor
u 3/12
u 9/12

Weighted
average
number
1,500,000
5,250,000
6,750,000

EPS = Rs. 27,000,000/6,750,000 shares = Rs. 4

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Practice question

Company B has a financial year ending 31 December.

On 1 January Year 3, there were 9,000,000 ordinary shares in issue.
On 1 May, Company B issued 1,200,000 new shares at full market price.
On 1 October, it issued a further 1,800,000 shares, also at full market
price.
Total earnings in Year 3 were Rs. 36,900,000.
Required
Calculate the EPS for the year to 31 December Year 3.
Partly paid shares
The number of ordinary shares is calculated based on the number of fully paid
shares. In order to do this partly paid shares are included as an equivalent
number of fully paid shares to the extent they are entitled to participate in
dividends.
Example: Issue of shares at full market price
Company A has a financial year ending 31 December.
On 1 January Year 1 there were 6,000,000 ordinary shares in issue.
1,000,000 of these shares were partly paid to 75% of their value which entitles
them to 75% dividend as compared to a fully paid share.
On 1 April, the remaining 25% of the value of the partly paid shares was received.
Total earnings in Year 1 were Rs. 24,750,000.
EPS in Year 1 is calculated as follows.
Number of
shares

Time
factor

Weighted
average
number

1 January to 31 March
Receipt of partly of balance on
partly paid shares (25% of
1,000,000)

6,000,000

u 3/12

1,500,000

1 April to 31 December

6,250,000

u 9/12

4,687,500

Date

250,000

6,187,500
EPS = Rs. 24,750,000/6,187,500 shares = Rs. 4

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2.5 Bonus issues of shares

A bonus issue of shares (also called a scrip issue or a capitalisation issue) is an
issue of new shares to existing shareholders, in proportion to their existing
shareholding, for no consideration. In other words, the new shares are issued
free of charge to existing shareholders.
The new shares are created by converting equity reserves in the statement of
financial position, often some or all of the share premium account, into ordinary
share capital.
No cash is raised from a bonus issue, therefore is no earnings boost from the
issue. Bonus issued shares are treated as if they have always been in issue.
The new number of shares (i.e. the number of shares after the bonus issue) can
be found by multiplying the number of shares before the bonus issue by the
bonus issue fraction.
The bonus issue fraction is
Formula: Bonus issue fraction
Number of shares in holding after the bonus issue
Number of shares in holding before the bonus issue

Example: Bonus fraction

A company has 4,000,000 shares in issue.
It made a 1 for 4 bonus issue (25%)
The bonus fraction is
Number of shares in holding after the bonus issue
Number of shares in holding before the bonus issue
4+1

5
=
4

Number of shares in issue after the bonus issue:

4,000,000 u 5/4 = 5,000,000
The above example is very straightforward but it illustrates an approach of wider
applicability.

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Chapter 28: IAS 33: Earnings per share

Example: Bonus issue

Company C has a 31 December financial year end.
On 1 January Year 5 it has 4,000,000 shares in issue.
On 1 July Year 5 it made a 1 for 4 bonus issue.
The financial results for Company C in Year 4 and Year 5 were as follows.
Year 5
Year 4
Total earnings
Rs. 20,000,000
Rs. 20,000,000
There were no share issues in Year 4.
Basic EPS in Year 4 was: Rs. 20,000,000/4,000,000 shares = Rs. 5 per share.
Basic EPS for Year 5 financial statements can be calculated as follows
The weighted average number of shares in the current year (using the method
explained earlier) is calculated as:

Date
1 January to 30 June
Bonus issue on 1 July

Number of
shares
4,000,000
1,000,000

Time
factor
6/12

1 July to 31 December

5,000,000

6/12

Bonus
fraction
5/4

Weighted
average
number
2,500,000
2,500,000
5,000,000

Remember that if a capital change is due to a bonus issue each preceding

must be multiplied by the bonus fraction.
This must be done so that the new shares issued are not time apportioned.
The new shares are included from 1 July to 31 December so they must also
be included in the period(s) before this.
There is a much easier way to arrive at the number of shares in this
example. It is simply the number in issue at the end of the year. However,
this only works if the bonus issue is the only capital change in a year. In
such cases do it this way but if there is more than one capital change in a
period you must use the longer method shown above.
Basic EPS in Year 5 is: Rs. 20,000,000/5,000,000 shares = Rs. 4 per share.
In the above example nothing changed between Year 4 and Year 5 except for the
number of shares, yet the EPS figures calculated indicate deterioration from Rs. 5
per share to Rs. 4 per share.
Comparatives
There is no time apportionment for a bonus issue. This means that all
comparative figures must be restated into the same terms to take account of the
bonus. Unless a suitable adjustment is made to the EPS calculation, the
comparison of EPS in the current year (after the bonus issue) with EPS in the
previous year (before the bonus issue) would be misleading.

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Advanced accounting and financial reporting

In order to ensure that the EPS in the year of the bonus issue is comparable with
the previous years EPS, IAS 33 requires that the weighted average number of
shares should be calculated as if the bonus shares had always been in issue.
This means that:

the current periods shares are adjusted as if the bonus shares were issued
on the first day of the year; and

the comparative EPS for the previous year is restated on the same basis.

The restatement of the comparatives is easily achieved by multiplying it by the

inverse of the bonus fraction.
Example (continued): Bonus issue restatement of comparatives
Company C made a 1 for 4 bonus issue in Year 5.
Basic EPS in Year 4 was: Rs. 20,000,000/4,000,000 shares = Rs. 5 per share.
This is restated by multiplying it by the inverse of the bonus fraction as follows:
Rs. 5 per share u4/5 = Rs. 4 per share
The figures presented in Company Cs Year 5 accounts would be:

Earnings per share

Year 5

Year 4

Rs. 4

Rs. 4

Practice question

Company D has a 31 December year end and had 2,000,000 ordinary

shares in issue on 1 January Year 2.
On 31 March Year 2, it issued 500,000 ordinary shares, at full market price.
On 1 July Year 2, Company D made a 1 for 2 bonus issue.
In Year 1, the EPS had been calculated as Rs. 30 per share.
In Year 2, total earnings were Rs. 85,500,000.
Required
Calculate the EPS for the year to 31 December Year 2, and the comparative
EPS figure for Year 1.
Comparatives are also restated for share consolidation and share splits.

2.6 Rights issues of shares

A rights issue of shares is an issue of new shares for cash, where the new
shares are offered initially to current shareholders in proportion to their existing
shareholdings.

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The issue price of the new shares in a rights issue is always below the current
market price for the shares already in issue. This means that they include a
bonus element which must be taken into account in the calculation of the
weighted average number of shares. Also note that any comparatives must be
restated by multiplying them by the inverse of the rights issue bonus fraction.
The rights issue bonus fraction is calculated as follows:
Formula: Rights issue bonus issue fraction
Actual cum rights price
Theoretical ex rights price
The actual cum-rights price is the market price of the shares before the rights
issue.
The theoretical ex-rights price is the price that the shares ought to be, in
theory, after the rights issue. It is a weighted average price of the shares before
the rights issue and the new shares in the rights issue.
The calculation of the theoretical ex rights price looks a little complicated at first
but it is always done this way. This is demonstrated in the following example.
Example:
Company E had 3,600,000 shares in issue on 1 January Year 2.
It made a 1 for 4 rights issue on 1 June Year 2, at a price of Rs. 40 per share.
(After the rights issue, there will be 1 new share for every 4 shares previously in
issue).
The share price just before the rights issue was Rs. 50.
Total earnings in the financial year to 31 December Year 2 were Rs. 25,125,000.
The reported EPS in Year 1 was Rs. 6.4.
EPS for the year to 31 December Year 2 and the adjusted EPS for Year 1 for
comparative purposes are calculated as follows:
Theoretical ex--rights price
4 existing shares have a cum rights value of (4 Rs. 50)
1 new share is issued for
5 shares after the issue have a theoretical value of

Rs.
200
40
240

Therefore, the theoretical ex-rights price = Rs. 240/5 = Rs. 48

Rights issue bonus fraction:
Actual cum rights price/Theoretical ex rights price = 50/48.
Weighted average number of shares

Date
1 January to 31 May
Rights issue on 1 June

Number of
shares
3,600,000
900,000

Time
factor
5/12

1 June to 31 December

4,500,000

7/12

Rights
fraction
50/48

Weighted
average
number of
shares
1,562,500
2,625,000
4,187,500

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Advanced accounting and financial reporting

Calculation of EPS
EPS Year 2 = Rs. 25,125,000/4,187,500 = Rs. 6 per share
Comparative EPS in Year 1 = Rs. 6.4 (Rs. 48/Rs. 50) = Rs. 6.14 per share

Practice question

Company F had 3 million ordinary shares in issue on 1 January Year 7.

On 1 April Year 7, it made a 1 for 2 rights issue of 1,500,000 ordinary shares
at Rs. 20 per share.
The market price of the shares prior to the rights issue was Rs. 50.
An issue of 400,000 shares at full market price was then made on 1 August
Year 7.
In the year to 31 December Year 7, total earnings were Rs. 17,468,750. In
Year 6 EPS had been reported as Rs. 3.5.
Required
Calculate the EPS for the year to 31 December Year 7, and the adjusted EPS
for Year 6 for comparative purposes.

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DILUTED EPS
Section overview

The meaning of dilution

IAS 33 and diluted EPS

Diluted EPS: convertible preference shares and convertible bonds

Diluted EPS: options and warrants

Diluted EPS: Employee share options

Potential ordinary shares that are not dilutive

Contingently issuable shares

Actual conversion during the year

3.1 The meaning of dilution

Dilution means watering down or reduction in strength.
An entity might have potential ordinary shares in issue. There is a possibility that
these will become actual ordinary shares at some time in the future.
For example, if an entity has issued some convertible bonds or convertible
preference shares, these might be converted into ordinary shares at some time in
the future.
Similarly, holders of share options or warrants might exercise their right at a
future date to subscribe for new shares at a fixed price.
If potential shares become actual ordinary shares, the earnings figure will be
shared with a larger number of ordinary shares. This would dilute the EPS.

3.2 IAS 33 and diluted EPS

IAS 33 requires publicly-traded companies to calculate a diluted EPS in addition
to their basic EPS for the current year (with a comparative diluted EPS for the
previous year), allowing for the effects of all dilutive potential ordinary shares.
Potential ordinary shares might not dilute the EPS. The diluted EPS calculation
only includes potential ordinary shares that would be dilutive. Note: potential
ordinary shares are dilutive when there might have been a reduction or dilution
in EPS if they had been actual ordinary shares during the financial period.
Diluted EPS is calculated by adjusting the earnings and number of shares figures
used in the basic EPS calculation.
Earnings is adjusted to remove the effect of dividends or interest that have been
recognised during the year for the potential ordinary shares, and for any other
income or expense that would alter as a result of the conversion of the potential
ordinary shares into actual ordinary shares.
The main items of dividend or interest to adjust for are dividends on convertible
preference shares and interest on convertible debentures (convertible bonds).
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The dividend or interest reduces total earnings. However, if they had already
been converted into ordinary shares (and the calculation of diluted EPS is based
on this assumption) the dividends or interest would not have been payable. Total
earnings would therefore have been higher. To calculate the diluted EPS, total
earnings are adjusted to allow for this.
The weighted average number of shares must also be adjusted. The method of
making this adjustment is different for:

convertible bonds or convertible preference shares; and

share options or warrants.

3.3 Diluted EPS: convertible preference shares and convertible bonds

When there are convertible bonds or convertible preference shares, diluted EPS
is calculated as follows, by making adjustments to total earnings and the number
of shares in issue used in the basic EPS calculation.
Total earnings
Total earnings are adjusted because the entity would not have to pay the
dividend or interest on the convertible securities.

For convertible preference shares, add back the preference dividend

paid in the year. Total earnings will be increased by the preference dividend
saved.

For convertible bonds, add back the interest charge on the bonds in the
year less the tax relief relating to that interest. Total earnings will increase
by the interest saved less tax.

Number of shares
The weighted average number of shares is increased, by adding the maximum
number of new shares that would be created if all the potential ordinary shares
were converted into actual ordinary shares.
The additional number of shares is calculated on the assumption that they were
in issue from the beginning of the year or from the date of issue whichever is
later.

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Example: Diluted EPS (convertible bonds)

Company G has 12,000,000 ordinary shares and Rs. 4,000,000 5% convertible
bonds in issue.
As at 31 December Year 2, there have been no new issues of shares or bonds for
several years.
The bonds are convertible into ordinary shares in Year 3 or Year 4, at the
following rates:
At 30 shares for every Rs. 100 of bonds if converted at 31 December Year 3
At 25 shares for every Rs. 100 of bonds if converted at 31 December Year 4
Total earnings for the year to 31 December Year 2 were Rs. 36,000,000.
Tax is payable at a rate of 30% on profits.
The basic EPS and diluted EPS for Year 2 are calculated as follows:
Basic EPS:
Year to 31 December Year 2: Rs. 36,000,000/12 million = Rs. 3 per share
Diluted EPS:
Number of
shares
Basic EPS figures

12,000,000

Earnings (Rs.))
36,000,000

EPS (Rs.))
3

Dilution:
Number of shares

1,200,000

4,000,000 u 30/100
Add back interest:
5% u Rs. 4,000,000

200,000

Less tax at 30%

(60,000)

Adjusted figures

13,200,000

36,140,000

2.74

Diluted EPS: Rs. 36,140,000/13,200,000 = Rs. 2.74 per share

Note: The number of potential shares is calculated using the conversion rate of
30 shares for every Rs. 100 of bonds, because this conversion rate produces
more new shares than the other conversion rate, 25 shares for every Rs. 100 of
bonds. (IAS 33 provides for use of most dilutive option when multiple conversion
options are available).
.

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New issue of convertibles in the year

If new convertibles are issued during the course of the year, the additional
number of shares and the earnings adjustment are included only from the time
that the convertibles were issued.
Example: Diluted EPS (New issue of convertibles in the year)
Company H has 10,000,000 ordinary shares in issue.
There has been no new issue of shares for several years. However, the company
issued Rs. 2,000,000 of convertible 6% bonds on 1 April Year 5.
These are convertible into ordinary shares at the following rates:
On 31 March Year 10

25 shares for every Rs. 100 of bonds

On 31 March Year 11

20 shares for every Rs. 100 of bonds

Tax is at the rate of 30%.

In the financial year to 31 December Year 5 total earnings were Rs. 40,870,000.
The Year 5 basic EPS and diluted EPS are calculated as follows:
Basic EPS
Year 5 = Rs. 40,870,000/10,000,000 = Rs. 4.087 per share
Diluted EPS:
Number of
shares
Basic EPS figures

10,000,000

Earnings (Rs.))
40,870,000

EPS (Rs.)
4.087

Dilution:
Number of shares
2 million u 25/100 u 9/12

375,000

Add back interest:

6% u Rs. 2,000,000 u
9/12

90,000

Less tax at 30%

Adjusted figures

(27,000)
10,375,000

40,933,000

3.94

Diluted EPS: Rs. 40,933,000/10,375,000 = Rs. 3.94 per share

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3.4 Diluted EPS: options and warrants

A different situation applies with share options and share warrants.
Options (warrants) are contracts issued by a company which allow the holder of
the option to buy shares off the company at some time in the future at a preagreed price.
If the option holder exercises this right the number of shares would increase and
the company would receive the cash paid for the shares and this would be
available to invest in the business and in turn this would be expected to boost its
earnings. However, it is impossible to predict how total earnings will be affected
when the cash is eventually received.
This presents a problem. Including the shares in the diluted EPS calculation
without adjusting the earnings would be inconsistent but it is not possible to
adjust the earnings.
IAS 33 solves this problem in quite a neat way. The amount that would be
received on exercise of the options is treated as cash received from selling
shares at full price with the remaining shares having been given away. The
shares sold at full price are not considered to be dilutive as any cash would be
invested to earn the same return as earned in the period. It is only the free
shares that are dilutive.
The following steps must be taken:
Step 1: Calculate the cash that would be received if the options are exercised.
Step 2: Calculate the number of shares that could be sold at (average) full
market price to raise the same amount of cash. (Divide the figure from step 1 by
the average share price in the period).
Step 3: Identify the number of shares that will be issued if all the options are
exercised.
Step 4: Subtract the number of shares in step 2 from the number at step 3.
These shares are treated as having been given away for free and is added to the
existing number of shares in issue, to obtain the total shares for calculating the
diluted EPS.

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Example: Diluted EPS (options)

Company J had total earnings during Year 3 of Rs. 25,000,000.
It has 5,000,000 ordinary shares in issue.
There are outstanding share options on 400,000 shares, which can be exercised
at a future date, at an exercise price of Rs. 25 per share.
The average market price of shares in Company J during Year 3 was Rs. 40.
The diluted EPS for Year 3 may be calculated as follows:
Step 1:

Step 2:

Step 3
Step 4

Cash proceeds from exercise of the

options
400,000 u Rs. 25
Divide by the average share price in the
period

Rs. 10,000,000

Shares issued at full price

Number of shares issued on exercise of
the option

(250,000)

Shares issued for free

150,000

Rs. 40

400,000

Diluted EPS calcullation

Basic EPS figures

Number of
shares

Earnings (Rs.))

5,000,000

25,000,000

25,000,000

4.85

EPS (Rs.)

Dilution:
Number of shares
Adjusted figures

150,000
5,150,000

Diluted EPS: Rs. 25,000,000/5,150,000 = Rs. 4.85 per share

Options are only included in the diluted EPS calculation if the average share
price in the year is greater than the exercise price of the option. If this were not
the case the option would not be exercised. (Nobody would pay an exercise price
of Rs. 100 for something worth only Rs. 80).

When the exercise price of the option is less than the share price they are
said to be in the money.

When the exercise price of the option is more than the share price they are
said to be out of the money.

In the money options are always dilutive. Out of the money options are always
not dilutive (or antidilutive as IAS 33 describes them).

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3.5 Diluted EPS: Employee share options

Employee share options that have vested are treated in exactly the same way as
any other option as explained above.
Unvested options
The situation in respect of unvested options is a little more complicated. When a
company issues options to its employees it recognises an expense for options
over the vesting period in accordance with IFRS 2. This means that the company
will recognise an expense in the future for those options which are unvested at
the reporting date.
This expense represents the service of the employee that will be consumed and
used by the company in the future.
Thus, the company will receive cash when the option is exercised and service
until it vests. IAS 33 requires that the future service received per share be
added to the exercise price for the purpose of calculating the number of dilutive
shares.
The following steps must be taken:
Step 1: Calculate the cash that would be received if the options are exercised
and the future expense that is expected to be charged to profit or loss.
Step 2: Calculate the number of shares that could be sold at full market price to
raise an amount of cash equal to the future benefit identified at step 1. (Divide the
figure from step 1 by the average share price in the period).
Step 3: Identify the number of shares that will be issued if all the options are
exercised.
Step 4: Subtract the number of shares in step 2 from the number at step 3.
These shares are treated as having been given away for free and is added to the
existing number of shares in issue, to obtain the total shares for calculating the
diluted EPS.

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Example: Diluted EPS (employee share options)

Company K had total earnings during Year 5 of Rs. 30,000,000.
It has 6,000,000 ordinary shares in issue.
There are unvested employee share options on 500,000 shares, which can be
exercised at a future date, at an exercise price of Rs. 210 per share.
The future expense that the company expects to recognise in respect of these
options up to the vesting date is Rs. 15,000,000.
The average market price of shares in Company J during Year 5 was Rs. 300.

The diluted EPS for Year 3 may be calculated as follows:

Step 1:

Estimate the future benefit

Cash proceeds from exercise
500,000 u Rs. 210
Future employee service

Rs. 105,000,000
Rs. 15,000,000
Rs. 120,000,000

Step 2:

Step 3
Step 4

Divide by the average share price in the

period

Rs. 300

Shares issued at full price

Number of shares issued on exercise of
the option

400,000

Shares issued for free

100,000

500,000

Diluted EPS calcullation

Basic EPS figures

Number of
shares
6,000,000

Earnings (Rs.))
30,000,000

EPS (Rs.)
5

Dilution:
Number of shares
Adjusted figures

100,000
6,100,000

30,000,000

4.91

Diluted EPS: Rs. 30,000,000/6,100,000 = Rs. 4.91 per share

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3.6 Potential ordinary shares that are not dilutive

Only dilutive potential ordinary shares are included in the dilutive EPS
calculation.
When there are several types of potential ordinary share in issue, they should be
ranked in order of dilution, with the most dilutive potential ordinary shares ranked
first. In order to carry out the ranking the earnings per incremental share is found
for each potential ordinary share. This is the earnings adjustment that would be
necessarily divided by the number of shares that would come into being if the
share were included in the calculation of diluted EPS.
Note that in the money options always rank first as they increase the number of
shares in the calculation without affecting the earnings.
A diluted EPS should then be calculated in stages, taking in one potential
ordinary share at a time, to establish whether any of them are not dilutive.
The following example illustrates the technique.
Example: Order of dilution
The following information relates to Company L for the year ended 31 December
Year 5.
Number of ordinary shares in issue
Reported earnings in the year

5,000,000
Rs. 15,000,000

Average market price of shares during

the year
Potential ordinary shares:
Options
4% convertible bond: Rs. 5,000,000

100,000 7% convertible preference

shares of Rs. 10 each

Rs. 80

600,000 options, with an

exercise price of Rs. 60
Each bond is convertible in Year
10 into ordinary shares at the
rate of 40 new shares for every
Rs. 100 of bonds
Each preference share is
convertible in Year 9 into
ordinary shares at the rate of 1
ordinary share for every 20
preference shares

Tax rate = 30%

Diluted EPS for the year to 31 December Year 5 can be calculated as follows.

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Example (continued): Order of dilution

If all the options are exercised, the cash received will be 600,000 Rs. 60 = Rs.
36,000,000.
This would purchase 450,000 shares (Rs. 36,000,000/Rs. 80) at the average
market price in Year 5.
The dilutive increase in the number of shares would therefore be (600,000
450,000) = 150,000.
Increase
Increase in
number of
in
ea
arnings.
shares
Rs.
Options

150,000

Earnings per
incremental
share
Rs.
0.00

Ranking
1st

Convertible bonds
4% Rs. 5,000,000
less tax 30%

200,000
(60,000)
140,000

Rs. 5,000,000 u
40/100

2,000,000
140,000

2,000,000

0.07

2nd

Preference shares
7% Rs. 1,000,000
100,000 u 1/20

70,000

(7% Rs. 1,000,000)

70,000

5,000
5,000

14.0

3rd

Diluted EPS is calculated as follows (taking these three dilutive potential ordinary
shares in order of their ranking):
Number of
shares
Earnings
EPS
Rs.
Rs.
As reported, basic EPS
15,000,000
5,000,000
3.000
Options
Diluted EPS, options
only
Convertible bonds
Diluted EPS, options
and convertible bonds
Convertible preference
shares
Diluted EPS, options
and all convertibles

150,000

15,000,000

5,150,000

140,000

2,000,000

15,140,000

7,150,000

70,000

5,000

15,210,000

7,155,000

2.913

Dilutive

2.12

Dilutive

2.13

Not
dilutive

The convertible preference shares are not dilutive, and the reported diluted EPS
should be Rs. 2.12 (and not Rs. 2.13).
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3.7 Contingently issuable shares

A company might enter into a contract where it will issue shares on the
occurrence of some future event. Such shares have no effect on the basic EPS
calculation until the condition is actually met.
They are taken into account in the diluted EPS only if the conditions leading to
their issue have been satisfied. For this purpose the reporting date is treated as
the end of the contingency period.
Contingently issuable shares are included in the diluted EPS calculation from the
later of the beginning of the period or the date of the contingently issuable share
agreement.
Example: Contingently issuable shares
Company M has 12,000,000 ordinary shares in issue.
As at 31 December Year 2, there have been no new issues of shares or bonds for
several years.
Company M acquired a new business during Year 1. As part of the purchase
agreement Company M would issue a further 1,000,000 shares to the vendor on
30 June Year 3 if the share price was Rs. 500 at that date.
The share price was Rs. 600 on 31 December Year 2.
Earnings for the year to 31 December Year 2 were Rs. 100,000,000.

Basic EPS:
31 December Year 2: Rs. 100,000,000/12,000,000 = Rs. 8.33 per share
Diluted EPS:

Basic EPS figures

Number of
shares
12,000,000

Earnings (Rs.))
100,000,000

EPS (Rs.))
8.33

100,000,000

7.69

Dilution:
Number of shares
Adjusted figures

1,000,000
13,000,000

Diluted EPS: Rs. 100,000,000/13,000,000 = Rs. 7.69 per share

Shares that are issuable after a period of time are not contingently issuable
shares because passage of time is a certainty. When there is an agreement to
issue shares at a point of time in the future they must be included in the diluted
EPS calculation.

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3.8 Actual conversion during the year

If a conversion right is exercised during the year, interest paid to the holders of
the convertible bond ceases on the date upon which they exercise their right to
the shares and the new shares are included as part of the weighted average
number of shares used in the basic EPS calculation.
When this happens, the new shares issued and the resulting interest saving must
be included in the diluted EPS calculation as an adjustment for the period before
the right was exercised.
Example: Diluted EPS (Conversion right exercised in the year)
Company N has 10,000,000 ordinary shares and Rs. 2,000,000 of convertible 6%
bonds in issue at the start of the year.
The conversion right was exercised on 1 April resulting in the issue 500,000 new
shares.
Tax is at the rate of 30%.
In the financial year to 31 December total earnings were Rs. 40,870,000.
The basic EPS and diluted EPS are calculated as follows:
Basic EPS
Number of
shares
At start of the year

10,000,000

Conversion::
Number of shares
500,000 u 9/12

375,000

Weighted average

10,375,000

Basic EPS: Rs. 40,870,000/10,375,000 = Rs. 3.94 per share

Diluted EPS:
Number of
shares
Basic EPS figures

10,375,000

Earnings (Rs.))
40,870,000

EPS (Rs.)
3.94

Dilution:
Number of shares up to the
date of conversion
500,000 u 3/12

125,000

Add back interest up to the

date of conversion
6% u Rs. 2,000,000 u
3/12

30,000

Less tax at 30%

(9,000)

Adjusted figures

10,500,000

40,891,000

3.89

Diluted EPS: Rs. 40,891,000/10,500,000 = Rs. 3.89 per share

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This is difficult to understand but imagine two identical convertible bonds that
allow conversion at any time over a period.

Bond A is converted during the year.

Bond B is held for a future conversion.

The conversion of Bond A has an impact on the basic EPS from the date of
conversion.
An adjustment is made in respect Bond B for the whole period in the diluted EPS
calculation.
If no further adjustment is made Bond A is shown as being less dilutive than
Bond B because it is only included from the date of conversion. How can actual
shares be less dilutive than potential shares?
In order to correct this anomaly, an adjustment must be made in respect of Bond
A in the diluted EPS calculation for the part of the year before conversion.

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IAS 33: PRESENTATION AND DISCLOSURE REQUIREMENTS

Section overview

Presentation requirements

Disclosure requirements

Alternative measures of earnings per share

4.1 Presentation requirements

An entity should present in the statement of profit or loss:

the basic EPS and

the diluted EPS

for the profit or loss from continuing operations.

For consolidated accounts, this is the EPS and diluted EPS attributable to the
owners of the parent company.
The basic EPS and diluted EPS should be presented with equal prominence for
all the periods presented (the current year and the previous year). These figures
are presented at the end of the statement of profit or loss.
If the entity presents a separate statement of profit or loss:

the EPS and diluted EPS should be shown in this statement, and

not in the statement of comprehensive income.

If there is a discontinued operation, the basic EPS and diluted EPS from
discontinued operation should be shown either on the face of the statement of
profit or loss or in a note to the financial statements.
The basic and the diluted EPS should be presented, even if it is a negative figure
(even if it is a loss per share).

4.2 Disclosure requirements

IAS 33 also requires disclosure in a note to the financial statements of the
following:

The total amounts used as the numerators (total earnings figures) to

calculate the basic EPS and diluted EPS, and a reconciliation of these
numerator figures to the profit or loss for the period

The total amounts used in the denominators (weighted average number of

shares) to calculate the basic EPS and diluted EPS, and a reconciliation of
these two denominator figures to each other.

4.3 Alternative measures of earnings per share

IAS 33 allows an entity to disclose an alternative measure of EPS in addition to
the EPS calculated in accordance with IAS 33. For example, EPS could be
calculated after adjusting earnings for large and unusual items.
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If an alternative EPS figure is presented, IAS 33 states that:

a reconciliation must be shown between the earnings figure used in the

alternative measure and the amounts shown in the statement of profit or
loss

the alternative EPS must use the same weighted average number of
shares as the IAS 33 calculation

basic and diluted EPS should both be disclosed with equal prominence,
and

the alternative figure must only be shown in the notes, not on the face of
the statement of profit or loss.

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EARNINGS PER SHARE AS A PERFORMANCE MEASURE

Section overview

Earnings per share and trends

Limitations of earnings per share

5.1 Earnings per share and trends

Investors and their advisers pay close attention to an entitys net profit for the
period. However, profit for the period can include large and unusual items and
also the results of discontinued operations. This may make it volatile: liable to
fluctuate rapidly up and down. Users can then find it difficult to assess trends in
the profit figure or to use the current years profit to predict an entitys
performance in future years.
The trend (improvement or deterioration) in an entitys published EPS figure can
sometimes be a more reliable indicator of future performance. There are a
number of reasons for this.

The standard version of both basic and diluted EPS is based on profit from
continuing operations. This means that the results of discontinued
operations (which may distort total profit) are excluded.

An entity may also choose to present one or more alternative versions of

EPS. These normally exclude large or unusual items so that EPS is based
on normal recurring earnings.

EPS measures an entitys performance from the viewpoint of investors. It

shows the amount of earnings available to each ordinary shareholder. This
means that EPS takes the effect of preference dividends (if any) into
account. It also takes share issues into account.

Diluted EPS can provide an early warning of any changes to an investors

potential return on their investment due to future share issues.

5.2 Limitations of earnings per share

EPS is probably the single most important indicator of an entitys performance. It
is a very useful measure when it is used as the starting point for a more detailed
analysis of an entitys performance.
However, EPS can have serious limitations:

Not all entities use the same accounting policies. It may not always be
possible to make meaningful comparisons between the EPS of different
entities.

EPS does not take account of inflation, so that growth in EPS over time
might be misleading.

EPS measures an entitys profitability, but this is only part of an entitys

overall performance. An entitys cash flow can be just as important as its

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profit (and more essential to its immediate survival). Changes in the value
of assets (holding gains) can also be an important part of performance for
some entities.

Diluted EPS is often described as an early warning to investors that the

return on their investment may fall sometime in the future. However, diluted
EPS is based on current earnings, not forecast earnings. This means that it
may not be a reliable predictor of future EPS.

One of the main problems with EPS can be the way that it is used by investors
and others. Users often rely on EPS as the main or only measure of an entitys
performance. Management know this and try to make EPS appear as high as
possible. They may attempt to manipulate the figure by using creative
accounting. They may also make decisions which increase EPS in the short term
but which damage the entity in the longer term.

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SOLUTIONS TO PRACTICE QUESTIONS

Solution

1
Number of
shares
9,000,000

Date
1 January to 30 April
New issue on 1 May

Time
factor
4/12

Weighted
average
number
3,000,000

1,200,000

1 May to 30 September
New issue on 1 October

10,200,000
1,800,000

5/12

4,250,000

1 October to 31 December

12,000,000

3/12

3,000,000
10,250,000

EPS = Rs. 36,900,000/10,250,000 = Rs. 3.6

Notes
(1)

The first new share issue is in May, after 4 months. Therefore the number of
shares at the beginning of the year is given a time factor of 4/12.

(2)

There are 5 months between the two share issues. Therefore, the time factor to
apply to the number of shares after the first issue is 5/12.

(3)

The total number of shares in issue from 1 October to the end of the year (three
months) is 12,000,000. These are given a time weighting of 3/12.

Solution

The weighted average number of shares in Year 2 is calculated as follows.

Date
1 January to 31 March
Issue at full price on 31 March

Number of
shares
2,000,000
500,000

Time
factor
3/12

Bonus
fraction
3/2

Weighted
average
number
750,000

1 April to 30 June
Bonus issue on 1 July

2,500,000
1,250,000

3/12

3/2

937,500

1 July to 31 December

3,750,000

6/12

1,875,000
3,562,500

EPS in Year 2 = Rs. 85,500,000/3,562,500 = Rs. 24 per share.

The Year 1 EPS restated as: Rs. 30 2/3 = Rs. 20.

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Solution

After the rights issue, there will be 1 new share for every 2 shares previously in issue
Theoretical ex--rights price
2 existing shares have a cum rights value of
1 new share is issued for

(2 Rs. 50)

3 shares after the issue have a theoretical value of

Rs.
100
20
120

Theoretical ex-rights price = Rs. 120/3 = Rs. 40.

Rights issue bonus fraction:
Actual cum rights price/Theoretical ex rights price = 50/40
Weighted average number of shares
Weighted
average
number of
shares

Date

Number of
shares

Time
factor

1 January to 31 March
Rights issue on 1 April

3,000,000
1,500,000

3/12

1 April to 31 July
Issue at full price on 1 August

4,500,000
400,000

4/12

1,500,000

1 August to 31 December

4,900,000

5/12

2,041,667

Rights
fraction

50/40

937,500

4,479,167
Calculation of EPS
EPS Year 7 = Rs. 17,468,750/4,479,167 = Rs. 3.9 per share
EPS Year 6 = Rs. 3.5 40/50 = Rs. 2.8

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

29

Analysis and interpretation of

financial statements

Contents
1 Purpose of financial ratio analysis
2 Return on capital, profitability and asset turnover
3 Working capital efficiency ratios
4 Liquidity ratios
5 Debt ratios
6 Investor ratios
7 Limitations of interpretation techniques
8 Financial ratios and examination technique

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

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PURPOSE OF FINANCIAL RATIO ANALYSIS

Section overview

Introduction to interpretation

Ratio analysis as a tool

Categories of financial ratios

Users and their information needs

1.1 Introduction to interpretation

Financial statements are used to make decisions. They are used by a number of
different groups including shareholders and investors, and also by lenders, as
well as by management. The financial statements contain a large number of
figures, but the figures themselves do not necessarily have much meaning to a
user of the financial statements. However, the figures can be analysed and
interpreted by calculating financial ratios.
Financial ratios can help the user of the financial statements to assess:

the financial position of the entity; and

its financial performance.

Using ratios: comparisons

Financial ratios can be used to make comparisons:

Comparisons within financial statements. (For example if revenue has

increased by 10% it might be expected that gross profit increase by a
similar amount).

Comparisons over a number of years. By looking at the ratios of a company

over a number of years, it might be possible to detect improvements or
deterioration in the financial performance or financial position of the entity.
Ratios can therefore be used to make comparisons over time, and to
identify changes or trends

Comparisons with the similar ratios of other, similar companies for the
same period.

In some cases, perhaps, comparisons with industry average ratios.

Categories of financial ratios

The main financial ratios can be classified as:

financial performance: return on capital, profitability and use of assets

working capital turnover ratios;

liquidity ratios;

debt ratios;

investor ratios.

This is discussed in far more detail in the following sections

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1.2 Ratio analysis as a tool

It is difficult to assess a companys financial performance by analysing the
financial results for one year. Better information is obtained by making
comparisons with financial performance in the previous year, or perhaps over
several periods (trend analysis).
Ratio analysis is a key tool used for performance analysis, because ratios
summarise financial information, often by relating two or more items to each
other, and they present financial information in a more understandable form.
Ratios also identify significant relationships between different figures in the
financial statements.
Illustration: Good or bad?
For example, knowing that the profit of a company is Rs.50,000 is not particularly
useful information on its own, because the expected amount of profit should be
dependent on the size of the business and the amount of its sales turnover.
If the company generated a profit of Rs.50,000 from Rs.150,000 of sales, then it
has performed well.
However, if a profit of Rs.50,000 has been made from sales of Rs.5 million, then
the profit level is much weaker.
The profit margin (the ratio of profit to sales) is a basic and widely-used ratio for
analysing the strength of a companys financial performance.
A ratio on its own does not provide useful information. Ratios are useful because
they provide a basis for making comparisons. Comparisons might indicate that
performance or the financial position is better or worse than it should be, or is
getting better or worse than in the past.
Illustration: Comparisons
For example, suppose that a company measures its profit margin in the current
year as 20%. Is this good or bad? To evaluate performance, the current year profit
margin of 20% should be interpreted, by comparing it with:
a.

last years profit margin, or the companys profit margin for the past few
years

b.

the budgeted profit margin (available to investors, perhaps, through

company announcements)

c.

the industry average (the average profit margin for companies in the
industry)

d.

the profit margin reported by individual competitors.

For example, if the budgeted profit margin was 25%, an actual profit margin of
20% might suggest that management have under-performed in the period

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Note that a ratio does not explain why any under-performance or outperformance has occurred. Ratios are used to indicate areas of good or weak
performance, but management then have to investigate to identify the cause.
Example: Possible explanations
A company achieved a profit margin of 6% in the year just ended. This was less
than the budgeted profit margin of 10%, and less than the profit margin in the
previous year, which was 8%.
The actual profit margin of 6% indicates disappointing performance, but
management should investigate the cause or causes.
For example, they might find that any of the following reasons might explain the
low profit margin:
a.

Increased competition has forced down sales prices and so reduced profit
margins.

b.

Advances in technology have lowered costs but prices have come down
even more.

c.

Raw material costs have risen and the higher costs could not be passed on
to the customers.

d.

There have been higher employment costs due to pay rises for
manufacturing employees, but these could not be passed on to the
customers.

e.

The company buys most of its supplies from foreign countries, and adverse
movements in exchange rates for its purchases have increased costs and
reduced profit margins.

f.

There has been a change in the companys sales mix, and the company has
sold a larger proportion of cheaper and lower-margin products than
expected.

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1.3 Categories of financial ratios

The basic financial ratios should already be familiar to you. Ratios can be divided
into five categories:
Illustration:
Ratios

Profitability

Financial position

Inventory turnover
Receivables turnover
Payables period

ROCE
ROSF
Gross profit margin
Overheads %

Short-term liquidity

Efficiency

Long-term solvency

Current ratio
Quick ratio

Gearing
Interest

Investor ratios

EPS
PE
Dividend yield
Dividend cover

The main ratios will be considered in more detail. For the purpose of your
examination, you need to know how to calculate each ratio, but you must also
understand why each ratio, or each category of ratios, might be of particular
interest to a specific user group.
An examination question may ask you to provide an analysis of financial
statements for a particular user. It will not tell you which ratios to calculate.
Instead, you will have to decide for yourself which ratios may provide useful
information for that user. Therefore you should learn to identify and select the
appropriate ratios for each user group, and then analyse what the ratio appears
to show, from the point of view of that user.

1.4 Users and their information needs

There are several groups of people who may use financial statements. They
include:

investors and potential investors;

lenders;

employees;

suppliers;

customers;

government and government agencies;

the general public.

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Each user group has different information needs, but as a general rule financial
statements prepared in accordance with IFRSs should provide all user groups
with most of their needs. Each group is interested in financial performance,
financial position and cash flows, but some users are mainly interested in
performance and profitability, while others may be more interested in liquidity and
gearing or other matters.
For example:

A private investor needs to know whether to continue to hold shares or to

sell them. He or she will tend to be most interested in profitability ratios
(such as gross and net profit margin and return on capital employed) and
investor ratios (such as earnings per share, dividend cover and price
earnings ratio).

A potential acquirer needs information about an entitys profitability and

probably also information about whether or not the entity is managed
efficiently. The acquirers management is likely to focus on profit margins,
return on capital employed, asset turnover and working capital ratios.

A bank that has been approached to lend money to an entity needs to know
whether it will receive interest payments when these are due and whether
the money that it lends will eventually be repaid. A bank manager will
normally be most interested in cash flows and liquidity ratios (current ratio,
acid test ratio) gearing and interest cover. A potential lender will also be
interested in predicting future performance as without sales there will be no
cash.

Any analysis should focus on the needs of the user. What do they need to know?
What are they interested in? What decision do they need to make?
The table below lists the user groups, indicates the information that they require
from published reports and accounts, and suggests which items in the financial
statements will be of most interest to each group.
User

Information needs

Items of interest

Investors/
potential
investors

Risks and returns relating to

their investment

Security of dividend
payments

Trend analysis: changes

in revenue, costs and
profits over the past few
years

Information to make
decisions about buying,
selling or holding shares

Dividend cover

Events and
announcements after the
reporting period

Share price

Corporate governance
reports. Narrative
business review.

Net asset value per share

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User

Information needs

Items of interest

Employees

Stability of the company (job

security and job prospects)

Profitability and cash

position

Information about the

companys ability to pay
bonuses or higher salaries.

Increases in salaries (%)

relative to increases in
profit and dividends

Directors remuneration

Whether the entity has

sufficient cash flow to repay
loans

Cash flow

Total borrowing by the

entity: financial gearing

The entitys ability to pay

interest

Interest cover

The adequacy of collateral/

security for loans and bonds

New charges created

over the entitys assets

The entitys ability to settle

its liabilities

Net current assets

Growth record

The entitys ability to survive

and continue as a customer

The entitys ability to survive

and continue as a supplier

Growth record

Cash flow

The entitys contribution to

the economy

Revenue and profit

Market share

Regulation of activities

Taxation

Obtaining government
statistics

Environmental and social

awareness

Environmental and social

reports

Contributions to the local

economy

Directors report

Narrative business review

Lenders
(banks,
bondholders)

Suppliers

Customers

Government

General public

Management are not included as a user group because they should have access
to much more detailed information about the companys financial position and
performance, from internal reports and budgets.

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RETURN ON CAPITAL, PROFITABILITY AND ASSET TURNOVER

Section overview

Return on capital employed

Return on shareholder capital

Return on assets

Analysing return: profitability and asset utilisation

Profit/sales ratio (and cost/sales ratios)

Asset turnover ratio

Percentage annual growth in sales

Dupont analysis

2.1 Return on capital employed

The aim of profitability ratios is to assess the financial performance of a profitmaking entity and the return that it makes on the capital invested.
Profit-making companies should try to make a profit that is large enough in
relation to the amount of money or capital invested in the business. The most
important profitability ratio is probably return on capital employed or ROCE.
For a single company:
Formula:
Profit before interest and taxation
X 100%
ROCE =

(Share capital and reserves + long-term debt capital

+ preference share capital)

Capital employed is the share capital and reserves, plus long-term debt capital
such as bank loans, bonds and loan stock.
Where possible, use the average capital employed during the year. This is
usually the average of the capital employed at the beginning of the year and end
of the year.

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Example: Return on capital employed

The following figures relate to Company X for Year 1.

Share capital
Share premium
Retained earnings
Bank loans

1 January
Year 1
Rs.
200,000
100,000
500,000
200,000

31 December
Year 1
Rs.
200,000
100,000
600,000
500,000

1,000,000

1,400,000

Profit before tax

Income tax expense

Rs.
210,000
(65,000)

Profit after tax

145,000

Interest charges on bank loans were Rs.30,000.

ROCE is calculated as follows:
ROCE = 240,000 (W1)/1,200,000 (W2) u 100 = 20%
W1

Profit before interest and tax

Rs.

Profit before tax

W2

210,000

Add back interest deducted

30,000

Profit before interest and tax

240,000

Capital employed

Rs.

Capital employed at the beginning of the year

1,000,000

Capital employed at the end of the year

1,400,000
2,400,000
2

Average capital employed

1,200,000

This ROCE figure can be compared with the ROCE achieved by the
company in previous years, and with the ROCE achieved by other
companies, particularly competitors.
Groups of companies and ROCE
To calculate the ROCE for a group of companies, it is necessary to decide what
to do with any non-controlling interest (minority interest). Since capital employed
includes all the debt capital in the group, it makes sense to include the noncontrolling interest (minority interest) in the capital employed.
ROCE should therefore be measured as profit before interest and tax as a
proportion of total capital employed, including the non-controlling interest.
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2.2 Return on shareholder capital

Return on shareholder capital (ROSC) measures the return on investment that
the shareholders of the company have made. This ratio normally uses the values
of the shareholders investment as shown in the statement of financial position
(rather than market values of the shares).
Formula: Return on shareholder capital
Profit after taxation and preference dividend
ROSC

=
Share capital and reserves

u 100

The average value of shareholder capital should be used if possible. This is the
average of the shareholder capital at the beginning and the end of the year.
Profit after tax is used as the most suitable measure of return for the
shareholders, since this is a measure of earnings (available for payment as
dividends or for reinvestment in the business).
Example: Return on shareholder capital
The following figures relate to Company X for Year 1.

Share capital
Share premium
Retained earnings
Shareholder capital
Bank loans

1 January
Year 1
Rs.
200,000
100,000
500,000
800,000
200,000

31 December
Year 1
Rs.
200,000
100,000
600,000
900,000
500,000

1,000,000

1,400,000

Profit before tax

Income tax expense

Rs.
210,000
(65,000)

Profit after tax

145,000

Interest charges on bank loans were Rs.30,000.

ROSC is calculated as follows:
ROSC = 145,000/850,000 (W2) u 100 = 17.06%
W1

Shareholder capital

Rs.

Shareholder capital at the beginning of the year

800,000

Shareholder capital at the end of the year

900,000
1,700,000
2

Average shareholder capital

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Groups of companies and ROSC

When calculating the ROSC for a group of companies, the main focus of
attention is normally the return on the investment of the shareholders in the
parent company. The ROSC should therefore be calculated as:
Formula: Return on shareholder capital of a group
Profit after taxation and non-controlling interest
ROSC

Equity attributable to equity holders of the

parent company

u 100

The share capital and reserves should not include the non-controlling interest in
the equity reserves.
Using ROCE or ROSC

It is not necessary to calculate both these ratios. The ratio that you
calculate should be the ratio that is of the greatest interest to the particular
user or user group. For example, management may be most interested in
ROCE, but an equity investor would be interested in ROSC.

ROCE or ROSC could be compared to real interest rates that are currently
available to investors in the market. For example, if a company has a
ROCE of 3% when interest rates of 5% are available in the bond markets, a
shareholder might be advised to consider selling his shares. However, it is
important to remember that bond yields are returns calculated from the
market price of bonds; whereas ROCE and ROSC are calculated from
financial statements and are not market rates of return.

Bank overdrafts might be included as part of capital employed in the ROCE

ratio, because many companies roll over their overdraft facility and use it
as long-term funding. When a bank overdraft is large, the interest cost of
the overdraft might be high, and it would therefore be appropriate to include
the bank overdraft below the line in capital employed, because the
overdraft interest is included above the line in profit before interest and
tax.

A company may be able to manipulate its ROCE or ROSC ratios by using

accounting policies or financing strategies, such as:
x

using operating leases or finance leases

choosing to re-value non-current assets or choosing the historical

cost model

timing the acquisition of non-current assets or the timing of new

financing so as to have the minimal adverse impact on ROCE.

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2.3 Return on assets

Formula: Return on assets
Profit before interest and taxation
X 100%

ROA =

Assets

The normal convention is to use total assets which includes both current and
non-current assets. However, other variations are sometimes used such as noncurrent assets only.

2.4 Analysing return: profitability and asset utilisation

The size of the return on capital employed, or the size of the return on
shareholders capital, depends on two factors:

the profitability of the goods or services that the entity has sold

the volume of sales that the entity has achieved with the capital and assets
it has employed: this is known as asset utilisation or asset turnover.

2.5 Profit/sales ratio (and cost/sales ratios)

The profit/sales ratio is the ratio of the profit that has been achieved for every
Rs.1 of sales.
Formula: Profit/sales ratio
Profit
Profit/sales ratio

=
Sales

u 100

Profit/sales ratios are commonly used by management to assess financial

performance, and a variety of different figures for profit might be used.
The definition of profit can be any of the following:

Profit before interest and tax

Gross profit (sales minus the cost of sales) = gross profit ratio

Net profit (profit after tax) = net profit ratio.

It is important to be consistent in the definition of profit, when comparing

performance from one year to the next.
The gross profit ratio is often useful for comparisons between companies in the
same industry, or for comparison with an industry average.
It is also useful to compare the net profit ratio with the gross profit ratio. A high
gross profit ratio and a low net profit ratio indicate high overhead costs for
administrative expenses and selling and distribution costs.

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Example: Profit to sales ratios

The following figures relate to Company X for Year 1.

Profit before tax

Income tax expense

Rs.
210,000
(65,000)

Profit after tax

145,000

Interest charges on bank loans were Rs.30,000.

Sales during the year were Rs.5,800,000.
Profit to sales ratios are calculated as follows:
a)

If profit is defined as profit before interest and tax:

= 240,000 (W1)/5,800,000 u 100 = 4.14%

b)

If profit is defined as profit after interest and tax:

= 145,000 (W1)/5,800,000 u 100 = 2.5%

W1

Profit before interest and tax

Rs.

Profit before tax

210,000

Add back interest deducted

30,000

Profit before interest and tax

240,000

It is also useful to monitor the ratio of different types of cost to sales. The
following ratios can be useful to highlight an unexpected change in a period or to
indicate a difference between the company and another in a similar industry:

Cost of sales/Sales) 100%

Administration costs/Sales) 100%

Selling and distribution costs/Sales) 100%

2.6 Asset turnover ratio

The asset turnover ratio is the ratio of sales to capital employed.
It measures the amount of sales achieved during the period for each Rs.1 of
investment in assets.
Formula: Asset turnover ratio
Asset
turnover
ratio

Sales
=
Share capital + reserves + long term debt

u 100

It is measured as a multiple (so many times a year).

The asset turnover ratio is also the ratio of sales to (assets current liabilities).
This is because capital employed = total assets minus liabilities excluding longterm debt.

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Example: Asset turnover ratio

The following figures relate to Company X for Year 1.
Average capital employed (as given before)

Rs.1,200,000

Profit before interest and tax = 240,000 (as given before)

Sales during the year were Rs.5,800,000.
ROCE = 240,000 /1,200,000 u 100 = 20% (as given before)
Asset turnover
Asset turnover ratio = Rs.5,800,000/Rs.1,200,000 = 4.83 times.
Note that: ROCE = Profit/sales ratio Asset turnover ratio (where profit is defined
as profit before interest and taxation).
Using the figures shown earlier:
ROCE

Profit/sales

Sales/capital
employed

240,000
1,200,000

240,000
5,800,000

5,800,000
1,200,000

20%

4.14%

4.83 times

2.7 Percentage annual growth in sales

It can be useful to measure the annual growth (or decline) in sales, measured as
a percentage of sales in the previous year.
For example, if sales in the year just ended were Rs.5,800,000 and sales in the
previous year were Rs.5,500,000, the annual growth in sales has been
(Rs.300,000/Rs.5,500,000) 100% = 5.45%.

2.8 Dupont analysis

Another way of interpreting the ROCE is through DuPont analysis.
DuPont Analysis is an expression which breaks ROCE into three parts as follows:
Illustration: Dupont equation
ROCE =
Profit
Sales

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The DuPont equation provides a broader picture of the return the company is
earning on its capital employed. It indicates where a company's strength lies and
where there is a room for improvement.
Example: Dupont analysis
Company A and B operate in the same market and are of the same size. Both
earn a return of 15% on equity.
The following table shows their respective net profit margin, asset turnover and
financial leverage.

Net profit margin

Asset turnover
Financial leverage

Company A

Company B

10%

10%

1.5

10.5

Although both the companies have a return on equity of 15% their

underlying strengths and weaknesses are quite opposite.
Company B is better than company A in using its assets to generate
revenues but it is unable to capitalize this advantage into higher return on
equity due to its lower financial leverage.
Company A can improve by using its total assets more effectively in
generating sales and company B can improve by raising some debt.

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WORKING CAPITAL EFFICIENCY RATIOS

Section overview

Purpose of working capital efficiency ratios

Average time to collect (receivables days or days sales outstanding)

Average time for holding inventory (inventory turnover)

Average time to pay suppliers

Cash operating cycle/working capital cycle

3.1 Purpose of working capital efficiency ratios

Working capital efficiency ratios measure the efficiency with which the entity has
managed its receivables, inventory and trade payables. The ratios are usually
measured in terms of an average number of days.
The working capital ratios are a useful measure of whether the entity has too
much or too little invested in working capital.
Excessive investment in working capital is indicated by a long cash cycle (a
long working capital cycle) that appears to be getting even longer. When too
much is invested in working capital, the return on capital employed and ROSC
will be lower than they should be.
Under-investment in working capital is an indication of possible liquidity
difficulties. When working capital is low in comparison with the industry average,
this might indicate that current assets are being financed to an excessive extent
by current liabilities, particularly trade payables and a bank overdraft.
(The cash cycle, also called the operating cycle and the working capital cycle) is
explained later).

3.2 Average time to collect (receivables days or days sales outstanding)

This ratio estimates the time that it takes on average to collect the payment from
customers after the sale has been made. It could be described as the average
credit period allowed to customers or the average collection period.
Formula: Average time to collect (average collection period or average
receivables days)
Trade receivables
Average time to collect

=
Credit sales

u 365 days

Trade receivables should be the average value of receivables during the year.
This is the average of the receivables at the beginning of the year and the
receivables at the end of the year.
However, the value for receivables at the end of the year is also commonly used.

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Sales are usually taken as total sales for the year. However, if sales are analysed
into credit sales and cash sales, it is probably more appropriate to use the figure
for credit sales only.
The average time to collect money from credit customers should not be too long.
A long average time to collect suggests inefficient collection of amounts due from
receivables.

3.3 Average time for holding inventory (inventory turnover)

This ratio is an estimate of the average time that inventory is held before it is
used or sold.
Formula: Average time for holding inventory (Inventory holding period or average
inventory days)
Inventory
Average inventory days

=
Cost of sales

u 365 days

In theory, inventory should be the average value of inventory during the year.
This is the average of the inventory at the beginning of the year and the inventory
at the end of the year.
However, the value for inventory at the end of the year is also commonly used,
particularly in examinations.

3.4 Average time to pay suppliers

The average time to pay suppliers may be calculated as follows:
Formula: Average time to pay suppliers (Average payables days)
Trade payables
Average time to pay

=
Purchases

u 365 days

Trade payables should be the average value of trade payables during the year.
This is the average of the trade payables at the beginning of the year and the
trade payables at the end of the year.
However, the value for trade payables at the end of the year is also commonly
used
When the cost of purchases is not available, the cost of sales should be used
instead. This figure is obtained from the profit and loss information in the
statement of comprehensive income.

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Example: Working capital efficiency ratios

The following information is available for Company Y for Year 1.
1 January Year 1

31 December Year 1

Rs.
300,000
400,000
150,000

Rs.
360,000
470,000
180,000

Inventory
Trade receivables
Trade payables

Sales in Year 1 totalled Rs.3,000,000 and the cost of sales was Rs.1,800,000.

The Working capital efficiency ratios are calculated as follows:

Efficiency ratios
Average days to collect = [435,000/3,000,000] 365 days = 52.9 days
Inventory turnover period = [330,000/1,800,000] 365 days = 66.9 days
Average time to pay = [165,000/1,800,000] 365 days = 33.5 days.
Workings
Average inventory = [Rs.300,000 + Rs.360,000]/2 = Rs.330,000
Average trade receivables = [Rs.400,000 + Rs.470,000]/2 = Rs.435,000
Average trade payables = [Rs.150,000 + Rs.180,000]/2 = Rs.165,000.

Turnover ratios (multiples)

Turnover ratios can be used as an alternative way of telling the same story as the
efficiency ratios. These show the number of times a balance in the statement of
financial position is turned over in the period.
They are multiples which provide the same insight as the efficiency ratios but in a
different way.
Formulae: Working capital turnover ratios
Credit sales
Receivables turnover

=
Trade receivables
Cost of sales Inventory

Inventory turnover

=
Inventory
Purchases

Payables turnover

=
Trade payables

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3.5 Cash operating cycle/working capital cycle

The cash operating cycle or working capital cycle is the average time of one
cycle of business operations:

from the time that suppliers are paid for the resources they supply

to the time that cash is received from customers for the goods (or services)
that the entity makes (or provides) with those resources and then sells.

A cash cycle or operating cycle is measured as follows.

Illustration: Cash operating cycle
Days/weeks/
months
X

Average inventory holding period

Average trade receivables collection period

X
X

Average period of credit taken from suppliers

(X)

Operating cycle

The working capital ratios and the length of the cash cycle should be monitored
over time. The cycle should not be allowed to become unreasonable in length,
with a risk of over-investment or under-investment in working capital.
A positive working capital cycle balances incoming and outgoing payments to
minimise net working capital and maximise free cash flow. For example, a
company that pays its suppliers in 30 days but takes 60 days to collect its
receivables has a working capital cycle of 30 days. This 30 day cycle usually
needs to be funded through a bank operating line, and the interest on this
financing is a carrying cost that reduces the company's profitability.
Growing businesses require cash, and being able to free up cash by shortening
the working capital cycle is the most inexpensive way to grow. Sophisticated
buyers review closely a target's working capital cycle because it provides them
with an idea of the management's effectiveness at managing their balance sheet
and generating free cash flow.

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Example: Constructing a cash operating cycle

The following figures have been extracted from a companys accounts:
Statement of profit or loss

Rs.

Sales

1,200,000

Cost of sales:
Opening inventory

250,000

Purchases

1,000,000
1,250,000

Closing inventory

(250,000)

Cost of sales

(1,000,000)

Gross profit

200,000

Statement of financial position

Trade receivables

400,000

Trade payables

166,667

Average inventory holding period:

= (Average inventory/Annual cost of sales) u 365
= (250,000/1,000,000) u 365 = 91 days
Average receivables collection period::
= (Average trade receivables/Annual sales) u 365
= (400,000/1,200,000) u 365 = 122 days
Average payables period:
= (Average trade payables/Annual purchases) u 365
= (166,667/1,000,000) u 365 = 61 days

Cash operating cycle:

Days

Average inventory holding period

91

Average trade receivables collection period

122

Average period of credit taken from suppliers

(61)
152

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LIQUIDITY RATIOS
Section overview

The meaning of liquidity

Current ratio

Quick ratio or acid test ratio

Liquidity ratios and consolidated accounts

4.1 The meaning of liquidity

Liquidity means having cash or access to cash readily available to meet
obligations to make payments.
For the purpose of ratio analysis, liquidity is measured on the assumption that the
only sources of cash available are:

cash in hand or in the bank, plus

current assets that will soon be converted into cash during the normal cycle
of trade.

It is also assumed that the only immediate payment obligations faced by the
entity are its current liabilities.
There are two ratios for measuring liquidity:

current ratio

quick ratio, also called the acid test ratio.

The more suitable ratio for use depends on whether inventory is considered a
liquid asset that will soon be used or sold, and converted into cash from sales.

4.2 Current ratio

The current ratio is the ratio of current assets to current liabilities.
Formula: Current ratio
Current ratio

Current assets

Current liabilities

The amounts of current assets and current liabilities in the statement of financial
position at the end of the year may be used. It is not necessary to use average
values for the year.
It is sometimes suggested that there is an ideal current ratio of 2.0 times (2:1).
However, this is not necessarily true and in some industries, much lower current
ratios are normal. It is important to assess the liquidity ratios by considering:

changes in the ratio over time

the liquidity ratios of other companies in the same period

the industry average ratios.

Liquidity should be monitored by looking at changes in the ratio over time.

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4.3 Quick ratio or acid test ratio

The quick ratio or acid test ratio is the ratio of current assets excluding inventory
to current liabilities. Inventory is excluded from current assets on the assumption
that it is not a very liquid item.
Formula: Quick ratio
Current assets excluding inventory
Quick ratio

=
Current liabilities

The amounts of current assets and current liabilities in the statement of financial
position at the end of the year may be used. It is not necessary to use average
values for the year.
This ratio is a better measurement of liquidity than the current ratio when
inventory turnover times are very slow, and inventory is not a liquid asset.
It is sometimes suggested that there is an ideal quick ratio of 1.0 times (1:1).
However, this is not necessarily true and in some industries, much lower quick
ratios are normal. As indicated earlier, it is important to assess liquidity by looking
at changes in the ratio over time and comparisons with other companies and the
industry norm.

4.4 Liquidity ratios and consolidated accounts

Liquidity ratios are more informative when they are calculated for individual
companies. When liquidity ratios are calculated from a consolidated statement of
financial position, they are average measures for all the companies in the group.
The average liquidity ratios for the group might hide the fact that there may be
poor liquidity in some of the subsidiaries in the group.

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DEBT RATIOS
Section overview

Gearing ratio (leverage)

Interest cover ratio

Debt ratios are used to assess whether the total debts of the entity are within control
and are not excessive.

5.1 Gearing ratio (leverage)

Gearing, also called leverage, measures the total long-term debt of a company
as a percentage of either:

the equity capital in the company, or

the total capital of the company.

Formula: Debt to equity ratio

Long term debt
Debt to equity ratio

=
Share capital + reserves

u 100

Alternatively:
Formula: Gearing ratio
Long term debt
Gearing ratio

=
Share capital + reserves + long term debt

u 100

It is usually appropriate to use the figures from the statement of financial position
at the end of the year. However, a gearing ratio can also be calculated from
average values for the year.
When there are preference shares, it is usual to include the preference shares
within debt capital.
A company is said to be high-geared or highly-leveraged when its debt capital
exceeds its share capital and reserves. This means that a company is highgeared when the gearing ratio is above either 50% or 100%, depending on which
method is used to calculate the ratio.
A company is said to be low-geared when the amount of its debt capital is less
than its share capital and reserves. This means that a company is low-geared
when the gearing ratio is less than either 50% or 100%, depending on which
method is used to calculate the ratio.
A high level of gearing may indicate the following:

The entity has a high level of debt, which means that it might be difficult for
the entity to borrow more when it needs to raise new capital.

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High gearing can indicate a risk that the entity will be unable to meet its
payment obligations to lenders, when these obligations are due for
payment.

The gearing ratio can be used to monitor changes in the amount of debt of a
company over time. It can also be used to make comparisons with the gearing
levels of other, similar companies, to judge whether the company has too much
debt, or perhaps too little, in its capital structure.
Gearing and consolidated accounts
The gearing ratio for a group of companies is difficult to interpret, because the
debt will be spread over several entities in the group.
When measuring gearing, the total capital or equity capital (the denominator in
the ratio) should include non-controlling interests (minority interests).

5.2 Interest cover ratio

Interest cover measures the ability of the company to meet its obligations to pay
interest.
Formula: Interest cover
Profit before interest and tax
Interest cover

=
Interest charges in the year

Profit before interest and taxation is calculated by adding the interest charges for
the year to the figure for profit before taxation.
An interest cover ratio of less than 3.0 times is considered very low, suggesting
that the company could be at risk from too much debt in relation to the amount of
profits it is earning.

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Example: Gearing ratios

The following information is available for Company Z for Year 6
At 31 December Year 6
Total assets

Rs.000
5,800

Share capital
Reserves

1,200
2,400
3,600

Long-term liabilities (Bank loans)

1,500

Current liabilities

5,100
700
5,800

For the year to 31 December Year 6

Profit before interest and taxation
Interest

Rs.000
700
(230)
470

Taxation

(140)
330

Profit after taxation

The following ratios can be calculated to shed light on the companys gearing in
Year 6 (compared to previous years or to other companies).
Gearing ratio: 1,500/5,100 u 100 = 29.4%
Debt to equity ratio: 1,500/3,600 u 100 = 41.7%
Interest cover: 700/230 = 3.04 times

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INVESTOR RATIOS
Section overview

Earnings per share (EPS)

Price earnings ratio (P/E ratio)

Dividend yield

Dividend cover

Investor ratios are of interest to investors in shares and bonds and their advisers.
Some of these measure stock market performance. Earnings per share (EPS) and the
price earnings ratio (P/E ratio) were described in an earlier chapter.

6.1 Earnings per share (EPS)

EPS is normally viewed as a key measure of an entitys financial performance. It
measures the profit earned for each equity share of the entity.
Basic EPS is calculated as follows:
Formula: Basic EPS
Net profit (or loss) attributable to ordinary shareholders during a period
weighted average number of shares in issue during the period

6.2 Price-earnings ratio (P/E ratio)

The price/earnings (P/E) ratio measures how expensive or cheap a share is in
relation to its annual earnings. A P/E ratio of 10, for example, means that
investors are prepared to pay a price for the share equal to 10 years of earnings
(at the level of EPS in the previous year). A high P/E ratio is usually a sign of
confidence in an entity, because it suggests that its earnings are expected to
grow in future years. A low P/E ratio usually means that an entitys future
prospects for EPS growth are expected to be poor, so that investors do not put a
high value on the shares.
The P/E ratio is calculated as follows:
Formula: Price earnings ratio
Market value of share
P/E ratio

=
Earnings per share

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6.3 Dividend yield

The dividend yield measures the dividend paid by an entity in relation to its price.
It is calculated as follows:
Formula: Dividend yield
Dividend per share
Dividend yield

=
Current market price per share

u 100

This is a measure of the return that a shareholder can obtain (the dividend
received) in relation to the current value of the investment in the shares (the price
of the shares). A high dividend yield might seem attractive to investors, but in
practice companies with a high dividend yield might have a relatively low share
price.
There are two things to note:

Dividend yield reflects the dividend policy of the entity, not its actual
performance. Management decides on the amount of the dividend and this
may not only depend on earnings, but on the amount that must be retained
for future investment in EPS growth.

The ratio is based on the most recent dividend, but the current share price
may move up and down in response to the markets expectations about
future dividends. This may lead to distortion in the ratio.

6.4 Dividend cover

The dividend cover ratio measures the number of times that an entitys dividends
are covered by profits (how many times an entity could pay the current level of
dividend from its available profits).
It is calculated as follows:
Formula: Dividend cover
Earnings per share
Dividend cover

=
Dividend per share
or
Earnings
=
Dividends

A low dividend cover (for example, less than 2), suggests that dividends may be
cut if there is a fall in profits.

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Example: Dividend yield and dividend cover

The following amounts relate to Entity Q.
The current market price of its equity shares is Rs.5.50 per share.
Profit for the most recent period was Rs.1.4 million and equity dividends paid
were Rs.450,000.
There are 1.2 million Rs.1 equity shares in issue.
Earnings per share =

P/E ratio =

1,400,000
= Rs.1.17.
1,200,000

5.50
= 4.7
1.17

Dividend per share =

450,000
= 0.38c
1,200,000

Dividend yield =

0.38
u 100% = 6.9%
5.50

Dividend cover =

1,400,000
1.17
= 3.1 times or
= 3.1 times
450,000
0.38

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LIMITATIONS OF INTERPRETATION TECHNIQUES

Section overview

Introduction

Differences in accounting policy

Current cost accounts and current purchasing power accounts

Other limitations in the use of financial ratios

Using historical information

Related party relationships and transactions

Using figures from the statement of financial position

Non-financial information

Other information

7.1 Introduction
There are several limitations or weaknesses in the use of interpretation
techniques for analysing the financial position and financial performance of
companies. Some of these are limitations of ratio analysis (the method of
interpretation most often used) and some are limitations of financial statements
and financial information.
Most of the data for calculating financial ratios comes from the financial
statements.

The reliability of ratios is therefore affected by the reliability of the financial

statements themselves.

In addition, when ratios are used to compare different companies, the

comparability is affected if companies use different accounting policies to
prepare their financial statements.

In addition, when comparing a ratio against that of a competitor or the industry

average, it is important to remember that, even within an industry, companies can
have different characteristics. It is very important to remember this when you are
analysing the financial statements of a company, and possibly comparing its
performance and financial position with other companies.

7.2 Differences in accounting policy

One of the uses of financial ratios is to compare the financial position and
performance of one company with those of similar companies for the same
period.
Comparisons between companies might not be reliable, however, when
companies use different accounting policies, or have different judgements in
applying accounting policies or making accounting estimates. For example:

Entities might have different policies about the revaluation of non-current

assets.

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Entities might use different methods of depreciation.

Entities might use different judgements in estimating the expected

profitability on incomplete construction contracts.

Entities might use different judgements in assessing whether a liability

should be treated as a provision or a contingent liability.

IAS 8 states that an entity should not change its accounting policies unless the
change is required by an accounting standard or it will result in more relevant and
reliable information. Therefore changes should not happen often.
Where there has been a change in an accounting policy, IAS 8 also requires
comparative figures to be restated and information to be disclosed. However,
changes in accounting policies and accounting estimates can still make it difficult
to compare the financial statements of an entity over time, particularly if analysis
is based on extracts rather than the full published financial statements.

7.3 Current cost accounts and current purchasing power accounts

Historical cost accounts can also be misleading because they do not accurately
show the effects of inflation over time. They do not take into consideration
changes in the real value of money.
The biggest problem is the valuation of non-current assets. Companies have
different policies towards the revaluation of non-current assets. Some companies
revalue some categories of non-current assets regularly, and in particular land
and buildings. However, not all categories of non-current assets are revalued.
When the rate of inflation is quite high, many non-current assets are probably
under-valued in the financial statements, in comparison with their current net
replacement value.
In addition, when the rate of inflation is high, the reported profit with historical
cost accounting will be higher than it would be using an inflation accounting
system such as current cost accounting (CCA) or current purchasing power
(CPP) accounting.
With CCA and CPP accounting, particularly during a period of high inflation:

The reported profit will be less (or the loss will be higher) than with
historical cost accounting (HCA).

The asset turnover or asset utilisation will be lower, because asset

valuations are higher with CCA and CPP than with historical cost
accounting (even when some non-current assets are re-valued in HCA).

The return on capital employed will be lower, because the reported profit
will be lower and the value of capital employed will be higher.

7.4 Other limitations in the use of financial ratios

There are other problems with the use of financial ratios, particularly where these
are used to compare the performance and position of different entities or of an
entity with an industry average.

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It is possible to calculate the same ratio in different ways. For example,

there are several variations of return on capital employed (ROCE) and
gearing. Comparisons can be misleading if different calculations are used.

Even where two entities operate in the same industry, comparisons can be
misleading. Entities can operate in different markets (for example, high
volume/low margin sales and low volume/high margin sales). The size of an
entity can affect the way it operates and therefore its ratios. For example,
large entities can often negotiate more favourable terms with suppliers than
small ones.

Financial statements are published infrequently. If ratios are used to study

trends and developments over time, they are only useful for trends or
changes over one year or longer, and not changes in the short term.

Ratios can only indicate possible strengths or weaknesses in financial

position and financial performance. They might raise questions about
performance, but do not provide answers. They are not easy to interpret,
and changes in financial ratios over time might not be easy to explain.

It can be argued that financial position and financial performance should be

analysed using market values rather than accounting values. For example, it can
be argued that investment yield is more relevant for the assessment of financial
performance than return on capital employed.

7.5 Using historical information

Financial statements are often used to predict the future performance of an
entity. Where comparative figures are available for several years it may be
possible to extrapolate trends and to base forecasts on these. If comparative
figures are only available for one or two years, predictions may be unreliable.
There may be some limited information about future transactions in the notes to
the financial statements. For example, details of contingent liabilities and nonadjusting events after the reporting period must be disclosed. However,
published financial statements present historical information.
Generally, financial statements do not reflect future transactions or events. They
do not anticipate the effect of significant changes to the entity after the financial
statements have been authorised for issue. These may include events beyond
the control of management (for example, the liquidation of a major customer) or
events that could not possibly have been foreseen at the time the most recent
financial statements were issued.
It should also be remembered that financial statements are not normally
published until several months after the year end. The financial statements are
often out of date by the time that they become available.

7.6 Related party relationships and transactions

A user of financial statements will normally expect the financial statements to
reflect transactions that have taken place on normal commercial terms (at arms
length). The user of the financial statements would want to be informed if:

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transactions have taken place that were not at arms length, or

there are parties that could enforce transactions on the entity that are not
on an arms length basis.

For example, an entity might sell an asset such as a property to another

company owned by one of its directors on more favourable terms than it would
sell to a third party.
In this situation, the financial performance or financial position reported by the
financial statements would be misleading. There is a special relationship between
the parties to the business transactions. This is referred to as a related party
relationship.
Related party relationships and transactions are a normal part of business and
there is nothing wrong with entering into them. However, a related party
relationship can have an effect on the profit or loss, or on the financial position of
an entity, because related parties might enter into transactions with each other on
terms that other entities or individuals (unrelated parties) would not. For example,
where an entity sells goods to a related party, its profits may not be comparable
with those of a similar entity that only trades with third parties on normal
commercial terms.

7.7 Using figures from the statement of financial position

In practice, ratio calculations are often based on figures in the year-end
statement of financial position. These may be very similar to average values for
the period, but this is not always the case.
Some businesses are seasonal and make a high proportion of their sales at a
specific time of year (for example, in the few months before a national holiday
period). Seasonal businesses often arrange their year-ends so that they fall when
inventories and receivables are at their lowest (probably just after the main period
for sales). Where this happens, ratios such as inventory turnover will be lower
than they would be if they were based on the average figure for the year. This
means that ratios may not be strictly comparable with those of other businesses
or with industry averages.
Major purchases of assets can have a significant effect on figures in the
statement of financial position and on ratios if they take place near the end of the
accounting period.

The carrying value of non-current assets is unusually high, because cost

has increased, but a full years depreciation has not been charged.

Return on capital employed and asset turnover are reduced, because

assets have increased but revenue and profits have not. New assets
should generate increased profits, but they have not yet been owned for
long enough to do so.

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7.8 Non-financial information

One of the most serious limitations of traditional financial statements is that they
only reflect the financial effects of transactions. Items are not recognised unless
they can be measured reliably in money terms.
There are two problems here:

Businesses and the transactions that they enter into are becoming
increasingly complex. Much information that is relevant to users cannot be
expressed easily in monetary terms or in numbers.

Businesses increasingly accept that they are not only accountable to

investors and lenders, but to a much wider group of people, or
stakeholders. Stakeholders can include customers, suppliers, employees,
the local community as a whole and (for some large public entities) society
as a whole. These groups are often more interested in the non-financial
effects of an entitys activities, (for example, its effect on the natural
environment), than in its financial performance.

Most large and listed entities now include a Business Review, or an Operating
and Financial Review (sometimes called Management Discussion and Analysis)
in their published financial statements. This is a narrative report which sets out
managements analysis of the business. Such a review is a legal requirement for
many companies within the European Union.
At present entities reporting under IFRSs do not have to publish any non-financial
information of this kind. Recently the IASB issued a non-mandatory Practice
Statement on Management Commentary. It is up to companies or individual
legal jurisdictions to decide whether to follow this guidance.
Useful non-financial information
Useful non-financial information could include the following:

a description of the business, objectives and strategies of the entity

a narrative review of the performance of the business during the period

a description of the main risks and uncertainties facing the entity and the
ways in which these risks are managed

details of any significant factors or events that may have an impact on the
entitys performance in future

details of any significant factors or events that may have an impact on the
entitys cash flows in future

information about key relationships with other entities and transactions with
related parties, including management

a description of the entitys research and development activities (if any) and
of any material intangible assets, including internally generated intangible
assets that have not been recognised in the balance sheet

additional explanations of amounts included in the financial statements,

where appropriate (for example, where these are based on estimates)

information about the entitys policies in relation to environmental matters,

in relation to its employees and on social and community issues.

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7.9 Other information

Size of company
Large companies should be able to benefit from economies of scale and so
should be more profitable than smaller companies in the same industry and
market. Larger companies should also attract better management, so (in theory)
the business should be run more efficiently, and so should achieve higher profit
margins.
Market area
Companies operating in the same industry may achieve very different results
because they operate in different sectors or segments of the market. For
example, two companies selling furniture might have very different profit margins
because they operate in different parts of the market. One company may be
selling antique furniture at high profit margins and the other may be selling selfassembly furniture in larger volumes but with lower profit margins.
Stage in the supply chain
Companies operating in the same industry may operate at different stages in the
supply chain. A supplier of raw materials, a manufacturer and a retailer would be
expected to have very different financial ratios, even though they may operate in
the same industry.
For example, it would be difficult to compare the financial ratios of a timber
supplier, a furniture manufacturer and a furniture retailer.
Timing of transactions
The timing of a key transaction can distort financial ratios. For example, a
company may acquire a subsidiary at the end of the financial year. The
subsidiary would then be consolidated in the group statement of financial position
but its profits would not be included in group profit or loss because they are all
pre-acquisition profits.
Ratios that compare profit figures with items in the statement of financial position
will therefore be distorted, unless a suitable adjustment is made to allow for the
transaction.
Year-end date
In most countries, companies are allowed to decide for themselves what their
financial year-end date should be. The choice of dates can affect the financial
ratios. For example a manufacturer of ski equipment will probably have some
very busy trading months (during the ski-ing holiday season) and some very quiet
months. If it selects the end of the high-selling season as its year-end, its
inventory levels will be abnormally low and its receivables balance may be
abnormally high.
Such distortions in the financial statements can be eliminated by calculating
ratios using a monthly average for any measures taken from the statement of
financial position, such as inventory, receivables and trade payables.

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Management strategy
Financial ratios should be interpreted in the context of all other relevant
information that is available about the company. For example, management may
have decided on a strategy of cutting profit margins in the short term in order to
win market share. This would affect the current profit margin, but in the long run
should result in higher sales and more profits.

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FINANCIAL RATIOS AND EXAMINATION TECHNIQUE

Section overview

Introduction

Approach to questions

Avoiding pitfalls

8.1 Introduction
Examination questions on financial ratio analysis usually require sound
examination technique to construct a good answer. The following guidelines
suggest the approach you should take and indicate the mistakes and pitfalls to
avoid.
At this level, you are unlikely to get a question that simply asks you just to
calculate ratios. You may be asked to consider the accounting treatment of
particular items in the financial statements and the effect that this will have on the
entitys ratios.
For example, if an entity has incorrectly treated a sale and repurchase
transaction as a genuine sale and not as a loan secured on an asset, then there
will be a significant effect on the entitys ratios. For example, the gearing ratio will
not show the true position of the entitys debt as it will exclude the secured loan.
Return on capital employed will also be affected as the incorrect treatment of the
transaction removes the asset from the statement of financial position, thus
increasing ROCE.
Additionally, consider the points below which provide specific guidance on
aspects of the question that you may have to answer.

8.2 Approach to questions

Analyse the requirement
Start by recognising the person or organisation who has asked for the financial
analysis.

Who is the user?

What information is the user interested in? Why has the user requested the
report?

How should the information be presented to the user in the form of a

memo or a more formal report? Dont forget there are presentation marks
available for well-presented reports.

Background information
Establish some of the basic background information.

What industry does the company operate in?

Note the financial year end. This may possibly be significant.

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Is the business seasonal? If so, seasonal trading may distort the year-end
figures in the statement of financial position, particularly for inventory,
receivables, cash and payables.

Have there been any key transactions during the year that may affect
comparisons with previous years? For example, has the company raised a
substantial amount of new finance, or has it acquired a major new
subsidiary, entered a new market with a new product, or disposed of a
business operation?

Review of the financial information

Before calculating any financial ratios, perform a thorough review of the financial
information provided. Look for items that will affect the measurement of key
financial ratios.
Statement of financial position:

Non-current assets.
(1)

Have there been any revaluations? Check the revaluation reserve.

Has it changed since the previous year? (This can also be checked
by looking at the statement of profit or loss and other comprehensive
income.)

(2)

Capital expenditure. Has the company incurred significant capital

expenditure? Look at the increase in non-current assets since the
previous year. How has the expansion been financed? Look at share
capital and reserves, and at levels of debt.

Investments.
(1)

Has the company invested in a new industry?

(2)

Has the company acquired a new subsidiary or invested in a new

associate or joint venture? If so, consider the timing of the acquisition
if an acquisition happened in mid-year the subsidiarys profits will
have been included in profit or loss for only six months but it will be
included in full in the year-end group statement of financial position.

Working capital.
(1)

Has the total working capital increased or decreased in proportion

with the increase or decrease in sales turnover (compared with the
previous year)?

(2)

Look at the amounts of current assets and current liabilities. Does the
company have net current assets or net current liabilities?

Loans.
(1)

Have any loans been repaid in the year? If so, how was the
repayment financed?

Share capital and reserves

(1)

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clear why the new shares were issued? For example, have new
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shares been issued to raise money to repay debt? Or to finance an

expansion of the business?
(2)

Have there been any significant changes in reserves during the year?

Statement of profit or loss

Compare sales growth with profit growth. Are they about the same rates of
growth? If not, you may need to think about reasons for the different growth
rates.

Interest. Is the interest charge high in relation to the amount of debt in the
statement of financial position? If it is high, has any debt been repaid in the
year?

Dividends. Look at the amount of dividend payments, the dividend cover,

and the trend in dividend payments over the past few years.

Did the company make a profit or a loss?

Are there any unusual one-off items in profit or loss? If so, what are they?

You should have an expectation in your mind about the measurements and ratios
that you should expect to find. If the actual measurements or ratios are different
from what you expect, you may need to think about the reasons for the
unexpected results.
For example, you may expect the company to be profitable. If it made a loss, you
will need to look for the reasons.
Calculate financial ratios
Having reviewed the financial information, you should calculate relevant key
ratios.

Present the ratios you have calculated as an appendix to your memo or

report.

Show the formulae and numbers you have used to calculate the ratios. Do
not just write down the ratio by copying it from your calculator. The
examiner will want to see where your figure came from, to make sure that
you understand what you are doing.

Be selective. Only calculate a ratio if it will add to your answer. Do not

simply calculate as many ratios as possible.

Go for variety in the ratios you select.

If the examination question provides some financial ratios, look for ratios
that have not been given. Could any of the missing ratios be significant?

Further information
An examination question might ask for suggestions about what further
information might be helpful. If so, set up your answer as an appendix to your
memo or report, and build your answer as you work through your answer to the
question. Examples of information that might be missing include the following:

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Additional information to calculate further ratios, such as the share price for
calculating the P/E ratio or dividend yield

Segmental analysis

Industry average figures, for making comparisons with similar companies in

the same industry

Changes in management policy (such as changes in the credit terms

offered to customers)

The accounting policies used

Reasons for specific changes not explained by the information given in the
question.

Writing your answer

Make comments that are relevant to the question. Always think about the
requirements of the question when you write your answer. You will not earn
marks for anything that is not relevant.

Make sure you answer all the requirements of the question. If you dont you
will lose marks.

Use short sentences and bullet points.

8.3 Avoiding pitfalls

There are a number of common mistakes in writing answers to an interpretation
question.

Most marks in the exam are likely to be for specific, relevant comments
rather than solely for computations. Do not calculate too many ratios as it
is time-consuming and you will not have time to write your answer. Be
selective and only calculate a ratio if it will add value to your answer.

Good points can be identified by looking at absolute changes in the figures

between one year and the next. For example, if sales have increased 25%,
it would be expected that inventory, receivables and payables should have
increased in line with the increase in sales.

Use all the information. Some valuable information about the company is
usually given in the introductory paragraph in an examination question.
Make sure that you read and use this information.

When making comparisons, make sure that the benchmark you select for
the comparison is suitable. For example, if two companies are being
compared:

Are they the same size?

Do they operate in exactly the same area of the market?

Are their financial statements for the same time period?

When making an observation about differences (such as differences in

comparison with another company, or the previous year), suggest reasons
for the difference. Dont just make an observation without making a

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comment. For example, stating that There has been a fall in non-current
asset has no value on its own. A better answer would be Non-current
assets have decreased despite a rise in sales. You might then go on to
comment that non-current assets are being over-used and are not being
replaced, perhaps because of the poor cash position of the company.

The highest marks will be awarded for linking together the information that
you analyse. For example: Interest charges have remained more or less
the same as in the previous year, despite a decrease in the debt in the
statement of financial position. This may be explained by the company
repaying a large amount of debt shortly before the year end.

Structure your answer around each of the requirements in the question. In

many cases, profitability and long term solvency could be used as main
headings within your answer.

Use the company name in your answer. This will help you to focus your
mind on the circumstances of the company, and avoid writing about
financial ratios in general terms (and so failing to answer the question).

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

30

Sundry standards and interpretations

Contents
1 IAS 2: Inventories
2 IAS 41: Agriculture
3 IFRS 6: Exploration for and evaluation of mineral
resources
4 IFRS 14: Regulatory deferral accounts
5 Service concession arrangements
6 SIC 7: Introduction of the euro

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 6

IFRS 6: Exploration for and evaluation of mineral resources

B (a) 10

IFRS 14: Regulatory deferral accounts

B (a) 12

IAS 2: Inventories

B (a) 32

IAS 41: Agriculture

B (a) 40

IFRIC 12: Service concession arrangements

B (a) 50

SIC 7: Introduction of the euro

B (a) 55

SIC 29: Disclosure service concession arrangements

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IAS 2: INVENTORY
Section overview

Definition of inventory

Measurement rule

Cost formulas

Net realisable value

Disclosure requirements

1.1 Definition of inventory

The nature of inventories varies with the type of business. Inventories are:

Assets held for sale. For a retailer, these are items that the business sells
its stock-in trade. For a manufacturer, assets held for sale are usually
referred to as finished goods

Assets in the process of production for sale (work-in-progress for a

manufacturer)

Assets in the form of materials or supplies to be used in the production

process (raw materials in the case of a manufacturer).

IAS 2: Inventories sets out the requirements to be followed when accounting for
inventory.

1.2 Measurement rule

IAS 2 requires that inventory must be measured in the financial statements at the
lower of:

cost, or

net realisable value (NRV).

The standard gives guidance on the meaning of each of these terms.

Purchase cost
IAS2 states that the cost of inventories shall comprise all costs of purchase,
costs of conversion and other costs incurred in bringing the inventories to their
present location and condition.
The purchase cost of inventory will consist of the following:

the purchase price

plus import duties and other non-recoverable taxes (but excluding

recoverable sales tax)

plus transport, handling and other costs directly attributable to the purchase
(carriage inwards), if these costs are additional to the purchase price.

The purchase price excludes any settlement discounts, and is the cost after
deduction of trade discount.

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Conversion costs
When materials purchased from suppliers are converted into another product in a
manufacturing or assembly operation, there are also conversion costs to add to
the purchase costs of the materials. Conversion costs must be included in the
cost of finished goods and unfinished work in progress.
Conversion costs consist of:

costs directly related to units of production, such as costs of direct labour

(i.e. the cost of the labour employed to perform the conversion work)

fixed and variable production overheads, which must be allocated to costs

of items produced and closing inventories. (Fixed production overheads
must be allocated to costs of finished output and closing inventories on the
basis of the normal production capacity in the period)

other costs incurred in bringing the inventories to their present location and
condition.

Production overheads include:

costs of indirect labour, including the salaries of the factory manager and
factory supervisors

depreciation costs of non-current assets used in production

costs of carriage inwards, if these are not included in the purchase costs of
the materials

Only production overheads are included in costs of finished goods inventories

and work-in-progress. Administrative costs and selling and distribution costs must
not be included in the cost of inventory.
Note that the process of allocating costs to units of production is usually called
absorption. This is usually done by linking the total production overhead to some
production variable, for example, time, wages, materials or simply the number of
units expected to be made.
Normal production capacity
Production overheads must be absorbed based on normal production capacity
even if this is not achieved in a period.
Normal capacity is the production expected to be achieved on average over a
number of periods under normal circumstances, though the actual level of
production may be used if it approximates to normal capacity.
If actual production capacity is unusual in a particular period the overhead might
be under or over absorbed. The amount of fixed overhead allocated to each unit
of production is not increased as a consequence of low production or idle plant.
Unallocated overheads are recognised as an expense in the period in which they
are incurred. In periods of abnormally high production, the amount of fixed
overhead allocated to each unit of production is decreased so that inventories are
not measured above cost.
Variable production overheads are allocated to each unit of production on the
basis of the actual use of the production facilities.

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Example: Normal production capacity

A business plans for production overheads of Rs. 1,000,000 per annum.
The normal level of production is 100,000 units per annum.
Due to supply difficulties the business was only able to make 75,000 units in the
current year.
Other costs per unit were Rs. 126.
The cost per unit is:

Rs.

Other costs

126

Production overhead (Rs. 1,000,000/100,000 units)

Unit cost

10
136

Note:

Rs.

The amount absorbed into inventory is (75,000 u Rs. 10)

Total production overhead

750,000
1,000,000

The amount not absorbed into inventory

250,000

The Rs. 250,000 that has not been included in inventory is expensed (i.e.
recognised in the statement of comprehensive income).

1.3 Cost formulas

With some inventory items, particularly large and expensive items, it might be
possible to recognise the actual cost of each item.
In practice, however, this is unusual because the task of identifying the actual
cost for all inventory items is impossible because of the large numbers of such
items.
A system is therefore needed for measuring the cost of inventory.
The historical cost of inventory is usually measured by one of the following
methods:

First in, first out (FIFO)

Weighted average cost (AVCO)

First-in, first-out method of measurement (FIFO)

With the first-in, first-out method of inventory measurement, it is assumed that
inventory is consumed in the strict order in which it was purchased or
manufactured. The first items that are received into inventory are the first items
that go out.
Since it is assumed that the first items received into inventory are the first units
that are used, it follows that the value of inventory at any time should be the cost
of the most recently-acquired units of inventory.
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Weighted average cost (AVCO) method

With the weighted average cost (AVCO) method of inventory measurement it is
assumed that all units are issued at the current weighted average cost per unit.
A new average cost is calculated whenever more items are purchased and
received into store. The weighted average cost is calculated as follows:
Formula: Calculation of new weighted average after each purchase
Cost of inventory currently in store +
Cost of new items received
= New weighted average
Number of units currently in store +
Number of new units received

Items currently in store are the items in store immediately before the new
delivery is received.
The retail method
The retail method is often used in the retail industry for measuring inventories of
large numbers of rapidly changing items with similar margins for which it is
impracticable to use other costing methods.
Cost is determined by reducing the sales value of the inventory by the
appropriate percentage gross margin.

1.4 Net realisable value

Definition
Net realisable value is the estimated selling price in the ordinary course of
business less the estimated costs of completion and the estimated costs
necessary to make the sale.
Net realisable value is the amount that can be obtained from selling the inventory
in the normal course of business, less any further costs that will be incurred in
getting it ready for sale or disposal.

Net realisable value is usually higher than cost. Inventory is therefore

usually valued at cost.

However, when inventory loses value, perhaps because it has been

damaged or is now obsolete, net realisable value will be lower than cost.

The cost and net realisable value should be compared for each separatelyidentifiable item of inventory, or group of similar inventories, rather than for
inventory in total.
Net realisable value might be lower than cost so that the cost of inventories may
not be recoverable in the following circumstances:

inventories are damaged;

inventories have become wholly or partially obsolete; or,

selling prices have declined.

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Accounting for a write down

When the cost of an item of inventory is less than its net realisable value the cost
must be written down to that amount.

1.5 Disclosure requirements

IAS 2 requires the following disclosures in notes to the financial statements.

The accounting policy adopted for measuring inventories, including the cost
measurement method used.

The total carrying amount of inventories, classified appropriately. (For a

manufacturer, appropriate classifications will be raw materials, work-inprogress and finished goods.)

The amount of inventories carried at net realisable value or NRV.

The amount of inventories written down in value, and so recognised as an

expense during the period.

Details of any circumstances that have led to the write-down of inventories

to NRV.

The amount of any reversal of any write-down that is recognized as a

reduction in the amount of inventories recognized as expense in the period.

The circumstances or events that led to the reversal of a write-down of

inventories.

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IAS 41: AGRICULTURE

Section overview

Scope and definitions

Accounting treatment

Government grants

Disclosure requirements

2.1 Scope and definitions

Scope
IAS 41 Agriculture covers the following agricultural activities:

biological assets, except for bearer plants;

agricultural produce at the point of harvest; and

government grants for agriculture (in certain situations).

IAS 41 does not apply to:

the harvested agricultural product (IAS 2 Inventory applies);

land relating to the agricultural activity (IAS 16 or IAS 40 applies);

bearer plants related to agricultural activity (however, IAS 41 does apply to

the produce on those bearer plants).

intangible assets related to agricultural activity (IAS 38 Intangible assets

applies).

Definitions
The following definitions are relevant to IAS 41:
Definitions
Agricultural activities the management by an entity of the biological
transformation and harvest of biological assets:
a.

for sale; or

b.

into agricultural produce; or

c.

into additional biological assets.

Biological asset a living animal or plant, such as sheep, cows, rice, wheat,
potatoes and so on.
Biological transformation means the processes of growth, production,
degeneration and procreation that cause changes in the quality or the quantity of
a biological asset
Agricultural produce is the harvested product of the entitys biological assets.
Harvest the detachment of produce from a biological asset or the cessation of a
biological assets life.

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Illustration: Definitions
A farmer has a field of lambs (b
biological assets).
As the lambs grow they go through biological transformation.
As sheep they are able to procreate and lambs will be born (additional biological
assets) and the wool from the sheep provides a source of revenue for the farmer
(a
agricultural produce).
Once the wool has been sheared from the sheep (h
harvested), IAS 2 requires that
it be accounted for as regular inventory.

Definitions
A bearer plant is a living plant that:
a.

is used in the production or supply of agricultural produce;

b.

is expected to bear produce for more than one period; and

c.

has a remote likelihood of being sold as agricultural produce, except for

incidental scrap sales.

Illustration: Definitions (further examples)

Biological assets
sheep
trees in a timber plantation
dairy cattle
cotton plants
sugarcane

Agricultural produce
wool
felled trees
milk
harvested cotton
harvested cane

Prroducts that result

from processiong
after harvest
yarn, carpet etc.
logs, lumber
cheese
thread, clothing etc.
sugar

tobacco plants
tea bushes
fruit tress
oil palm
rubber trees

picked leaves
picked leaves
picked fruit
picked fruit
harvested latex

cured tobacco
tea
processed fruit
palm oil
rubber products

Plants such as tea bushes, grape vines, oil palms and rubber trees, usually meet
the definition of a bearer plant and are within the scope of IAS 16 Property, Plant
and equipment. However, the produce growing on bearer plants, for example,
tea leaves, grapes, oil palm fruit and latex, is within the scope of IAS 41.
Note that there is no animal equivalent of a bearer plant. Thus, cows kept for
milk are within the scope of IAS 41.

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2.2 Accounting treatment

Recognition of a biological asset or agricultural produce
An entity should recognise a biological asset or agricultural produce when (and
only when):

the entity controls the asset as a result of past events

it is probable that future benefits will flow from the asset to the entity, and

the fair value or cost of the asset can be measured reliably.

Measurement

A biological asset should be measured initially and subsequently at the

end of each reporting period at its fair value minus ultimate selling costs
(unless the fair value cannot be measured reliably). The gain or loss arising
on initial recognition and subsequent revaluation should be included in
profit or loss for the period in which it arises.

Agricultural produce harvested from an entitys biological assets is

measured at its fair value minus estimated ultimate selling costs. The
gain or loss on initial recognition is included in the profit or loss for that
period. Ultimate selling costs include commissions to brokers and dealers,
levies to regulators, transfer taxes and duties.

Fair value is the quoted price in an active market. It is presumed that fair
values can be measured reliably for biological assets. If this is not so, the
biological asset should be measured at its cost minus any accumulated
depreciation or impairment.

Example: Accounting treatment

Using the earlier example of a sheep farmer, lambs should initially be measured
when they are born at their fair value minus costs to sell.
As they grow and their value changes, this gain or loss should be reflected in the
biological asset value and also in profit and loss.
The sheep may be used for obtaining wool. Once the wool has been sheared from
the sheep, as an agricultural produce the wool should be valued at fair value
minus costs to sell.
If the wool is then turned into yarn or carpet its value is then transferred to
inventory and IAS 2 will provide any further accounting rules.

2.3 Government grants

Agricultural entities (for example, farms) often benefit from government grants in
the form of cash payments. An unconditional grant relating to a biological asset
that is being measured at fair value should be recognised as income when the
grant becomes receivable.
A grant may be dependent on certain conditions being met. For example, the
entity may be asked not to engage in a specific agricultural activity. In such
cases, the grant should be recognised only when the conditions are met.
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If the biological asset has been measured at cost because fair value could not be
measured reliably, then the requirements of IAS 20 Accounting for government
grants should be applied.

2.4 Disclosure requirements

The IAS 41 disclosure requirements include the following:

the aggregate gain or loss arising during the current period on initial
recognition of biological assets and agricultural produce and from the
change in fair value less costs to sell of biological assets.

a description of each group of biological assets;

information about biological assets whose title is restricted or that are

pledged as security

commitments for development or acquisition of biological assets

financial risk management strategies

reconciliation of changes in the carrying amount of biological assets,

showing separately changes in value, purchases, sales, harvesting,
business combinations, and foreign exchange differences;

If fair value cannot be measured reliably, additional required disclosures include:

description of the assets

an explanation of the circumstances

if possible, a range within which fair value is highly likely to lie

depreciation method

useful lives or depreciation rates

gross carrying amount and the accumulated depreciation, beginning and

ending

If the fair value of biological assets previously measured at cost now becomes
available, certain additional disclosures are required.
Disclosures relating to government grants include the nature and extent of
grants, unfulfilled conditions, and significant decreases expected in the level of
grants.

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IFRS 6: EXPLORATION FOR AND EVALUATION OF MINERAL

RESOURCES
Section overview

Background

Selection of accounting policies

Initial recognition and measurement

Subsequent measurement

Presentation

Impairment

Disclosure

3.1 Background
The group accounts of listed entities in the EU had to be prepared according to
IFRS for all accounting periods beginning on or after 1 January 2005. This
regulation applied to some very large energy companies with securities listed on
EU stock markets.
In the run up to conversion, it was noted that there was no IFRS that dealt with
this area, but there were significant entities which engaged in such activities.
There were different views held globally on the accounting solution and this led to
a number of different accounting treatments.
IFRS 6
IFRS 6 specifies the financial reporting for the exploration for and evaluation of
mineral resources. IFRS 6 applies to expenditure incurred on exploration for and
evaluation of mineral resources but not to those expenditures incurred:

before the exploration for and evaluation of mineral resources (e.g.

expenditures incurred before the entity has obtained the legal rights to
explore a specific area); or

after the technical feasibility and commercial viability of extraction are

demonstrable

Definitions
Exploration and evaluation assets are exploration and evaluation expenditures
recognised as assets in accordance with the entitys accounting policy.
Exploration and evaluation expenditures are expenditures incurred by an entity in
connection with the expenditures for and evaluation of mineral resources before
the technical feasibility and commercial viability of extracting a mineral resource
are demonstrable.

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3.2 Selection of accounting policies

IAS 8 sets out criteria which must be applied by a company when needs to
develop an accounting policy for a transaction not covered by a specific IFRS.
IFRS 6 exempts companies from applying these criteria in developing an
accounting policy for the recognition and measurement of exploration and
evaluation assets.
In other words, companies are free to develop an accounting policy (within the
broader guidance of IFRS6) without reference to other parts of IFRS. This is
particularly useful when a company involved in this industry adopts IFRS
because they may be able to carry on using their pre IFRS accounting policy
Changes in accounting policies
An entity is allowed to change accounting policies for exploration and evaluation
expenditures when the change makes information used as a basis of decision
making:

more relevant and no less reliable; or

more reliable and no less relevant

To justify a change, The company must demonstrate that the change brings the
financial statements closer to meeting the IAS 8 criteria but the change need not
achieve full compliance with those criteria

3.3 Initial recognition and measurement

Exploration and evaluation assets are measured at cost. A company must
determine a policy of specifying which expenditures are recognised as
exploration and evaluation assets and apply this policy consistently in doing this.
Expenditures which might be specified include:

acquisition of exploration rights;

topographical, geological, geochemical and geophysical studies;

exploratory drilling;

trenching;

sampling; and

activities in relation to evaluating the technical feasibility and commercial

viability of extracting a mineral resource

Expenditures related to the development of mineral resources must not be

recognised as exploration and evaluation assets. The Conceptual Framework
and IAS 38 Intangible Assets provide guidance on the recognition of assets
arising from development.
IAS 37 applies to the recognition of any obligations for removal and restoration
that are incurred as a consequence of exploration for and evaluation of mineral
resources.

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3.4 Subsequent measurement

A company must apply one of the following to exploration and evaluation assets:

cost model; or

revaluation model

If the revaluation model is applied (IAS 16 or IAS 38 model), it must be consistent

with the classification of the expenditure as tangible or intangible
This means that a revaluation model for expenditure classified as an intangible is
only possible if there is a fair value that can be measured with reference to an
active market

3.5 Presentation
Exploration and evaluation assets must be classified according to the nature of
the assets acquired as:

tangible (e.g. vehicles and drilling rigs); or

intangible (e.g. drilling rights).

The classification must be applied consistently.

An exploration and evaluation asset is reclassified from this category when the
technical feasibility and commercial viability of extracting a mineral resource are
demonstrable. In such cases they must be assessed for impairment before
reclassification.

3.6 Impairment
Exploration and evaluation assets must be:

allocated to cash-generating units (CGUs) or groups of CGUs for the

purpose of assessing such assets for impairment (the CGU; and

assessed for impairment when there are indications that the carrying
amount may exceed recoverable amount

Exploration and evaluation assets are unlikely to generate cash flows

independently from other assets so as such they are similar to goodwill.
Therefore IFRS 6 requires them to be allocated to CGUs groups for the purpose
of impairment testing. They are not tested individually for impairment
Indicators of impairment include (the list is not exhaustive):

expiry of the period of the exploration right without expectation of renewal;

expenditure on further exploration/evaluation in the specific area previously

not budgeted/planned;

non discovery of commercially viable quantities of mineral resources;

a decision to discontinue activities in the specific area;

indication that the carrying amount of the exploration and evaluation asset
is unlikely to be recovered in full from successful development or by sale

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3.7 Disclosure
Entities must disclose information that identifies and explains the amounts
recognised arising from the exploration and evaluation of mineral resources

accounting policies for exploration and evaluation expenditures, and

recognition as assets;

amounts of assets, liabilities, income and expense and operating and

investing cash flows arising from the exploration for and evaluation of
mineral resources

Exploration and evaluation assets must be treated as a separate class of

assets (IAS 16 or IAS 38 disclosures apply depending on classification).

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IFRS 14: REGULATORY DEFERRAL ACCOUNTS

Section overview

Introduction

Overview of requirements

4.1 Introduction
Some countries regulate prices that can be charged for certain goods and
services. Such goods and services are said to be rate regulated.
Definitions
Rate-regulated activities: An entitys activities that are subject to rate regulation.
Rate regulation: A framework for establishing the prices that can be charged to
customers for goods or services and that framework is subject to oversight
and/or approval by a rate regulator.
Regulatory deferral account balance: The balance of any expense (or income)
account that would not be recognised as an asset or a liability in accordance with
other Standards, but that qualifies for deferral because it is included, or is
expected to be included, by the rate regulator in establishing the rate(s) that can
be charged to customers.
In the absence of an accounting standard on a topic, entities that adopt IFRS
must formulate an accounting policy in accordance with guidance given in IAS 8.
This has led to divergence in practice.
The IASB are engaged in a project on this area but in the meantime have issued
IFRS 14 as an interim measure.

4.2 Overview of requirements

IFRS 14 permits a first-time adopter within its scope to continue to account for
regulatory deferral account balances in its first IFRS financial statements in
accordance with its previous GAAP when it adopts IFRS.
However, IFRS 14 introduces limited changes to some previous GAAP
accounting practices for regulatory deferral account balances, which are primarily
related to the presentation of these accounts. It requires entities to present
regulatory deferral account balances as separate line items in the statement of
financial position and to present movements in those account balances as
separate line items in the statement of profit or loss and other comprehensive
income.
IFRS 14 also requires specific disclosures to identify the nature of, and risks
associated with, the rate regulation that has resulted in the recognition of
regulatory deferral account balances.

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Chapter 30: Sundry standards and interpretations

SERVICE CONCESSION ARRANGEMENTS

Section overview

IFRIC 12: Service concession arrangements

Recognition of a financial asset

Recognition of an intangible asset

SIC 29: Service concession arrangements: disclosures

5.1 IFRIC 12: Service concession arrangements

Background
Some governments have introduced schemes to attract private sector
participation in public service infrastructure (roads, bridges, tunnels etc.).
For example, an entity in the private sector might construct a facility and then run
it for the government.
Typically an arrangement within the scope of IFRIC 12 involves a private sector
entity (an operator):

constructing (or upgrading) infrastructure used to provide a public service;

operating and maintaining that infrastructure for a specified period of time;

and

being paid for its services over the period of the arrangement

Terminology
Grantor government body that contract with an operator.
Operator private sector participant in a service concession arrangement
An important feature of service concession arrangements is that the operator has
a contractual obligation to provide services to the public on behalf of the public
sector entity.
This interpretation gives guidance to operators on how they must account for
public-to-private service concession arrangements (also known as build-operatetransfer (BOT) arrangements, and rehabilitate-operate-transfer (ROT)). It does
not give guidance on grantor accounting.
Scope
Service concession arrangements are in the scope of IFRIC 12 if:

the grantor controls (or regulates):

x

what services must be provided by the operator;

to whom the services are provided; and

at what price; and

the grantor controls the significant residual interest in the infrastructure at

the end of the term of the arrangement (if any)

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Other common features of service concession arrangements include the

following:

The contract sets out initial prices to be levied by the operator and
regulates price revisions

The operator is obliged to hand over the infrastructure to the grantor in a

specified condition at the end of the arrangement

IFRIC 12 applies to both:

infrastructure that the operator constructs or acquires from a third party for
the purpose of the service arrangement; and

existing infrastructure to which the grantor gives the operator access for the
purpose of the service arrangement

The issue
IFRIC 12 gives guidance to operators on how they must account for service
concession arrangements. Specifically it provides rules on:

how the operator should account for:

x

its rights over the infrastructure asset;

any other assets provided to the operator by the grantor;

consideration under the arrangement;

construction or upgrade services;

operation services;

borrowing costs; and

subsequent accounting treatment of any financial asset and/or intangible

asset arising under the arrangement

Consensus
The infrastructure asset must not be recognised as PP&E by the operator. The
operator does not control the asset but merely operates it.
The operator has access to operate the asset in order to provide the public
service on behalf of the grantor.
A grantor might transfer other assets to an operator to be kept or dealt with as it
wishes.

Such assets are not government grants (IAS 20) if they are part of the
consideration for the arrangement.

The assets are recognised as operators assets (measured at fair value on

initial recognition).

The operator must recognise a liability for any obligations assumed in

exchange for the assets.

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Consensus: Consideration for construction (upgrade) is recognised at its fair value

Consideration may be rights to:

a financial asset; or

an intangible asset

5.2 Recognition of a financial asset

A financial asset must be recognised when the operator has an unconditional
contractual right to receive cash or another financial asset from or at the direction
of the grantor.
Such an unconditional contractual right exists where the grantor contractually
guarantees to pay the operator:

specified or determinable amounts; or

any shortfall between amounts received from users of the public service
and specified or determinable amounts

IAS 32 and IAS 39 (IFRS 9) and IFRS 7 apply.

Example: Service concession arrangement resulting in recognition of a financial
asset
X Limited is an operator in a service concession arrangement.
Terms
X Limited will construct a road (completed in 2 years).
X Limited to maintain and operate the road for 8 years (i.e. years 310).
X Limited to resurface the road at the end of year 8.
The government is to pay X Limited Rs. 200 million per year in years 310. (The
right to receive cash flows is a financial asset).
Further information:
All cash flows take place at the end of the year
X Limiteds cost of borrowing is 6.7%
The fair values of the consideration received are as follows:

12
3 to 10
8

Construction services
Operation services
Resurfacing

Forecast
costs
500 pa
10 pa
100

Mark--up
5%
20%
10%

Fair value of
consideration
525 pa
12 pa
110

The total fair values of consideration provided are:

Construction services (2 u 525)
Operation services (8 u 12)
Resurfacing

Rs. m
1,100
96
110
1,306

Total cash to be received (8 u 200)

Interest

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The effective interest rate calculated as the IRR of amounts recognised as

consideration and the cash flows from the government for the financial
asset is 6.18%.
The above information can be used to construct the following amortisation table
for the financial asset (all figures are in Rs. millions).
Amortised
cost b/f

Interest
@
6.18%

Income
recognised
in year

525

525

525

32

525

1,082

1,082

67

12

(200)

961

961

59

12

(200)

833

833

51

12

(200)

696

696

43

12

(200)

551

551

34

12

(200)

397

397

25

122

(200)

344

344

21

12

(200)

177

10

177

11

12

(200)

Year

Amortised
cost c/f

Cash

The interest income (at 6.18%) is recognised in profit or loss together with
the other elements of income.
The amortised cost at each year end is recognised as a financial asset.
The following table shows the movement in the cash balances over the
duration of the agreement (all figures are in Rs. millions).
Year

Cash b/f

Interest
at 6.7%

Cash out

Cash in

Net cash
flow

Cash c/f

(500)

(500)

(500)

(500)

(34)

(500)

(534)

(1,034)

(1,034)

(69)

(10)

200

121

(913)

(913)

(61)

(10)

200

129

(784)

(784)

(53)

(10)

200

137

(646)

(646)

(43)

(10)

200

147

(500)

(500)

(33)

(10)

200

157

(343)

(343)

(23)

(110)

200

67

(276)

(276)

(19)

(10)

200

171

(105)

10

(105)

(7)

(10)

200

183

78

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Example (continued): Service concession arrangement resulting in recognition of

a financial asset
The financial asset amortisation table and the cash table showing the net cash
balances reflect the following double entries (only the first three years are shown.
Debit

Year 1
Financial asset

Credit

525

Revenue (P&L)

525

Costs (P&L)

500

Cash

500
Debit

Year 2
Financial asset (525 + 32)

Credit

557

Revenue (P&L)

525

Interest income (P&L)

32

Costs (P&L)

500

Interest expense (P&L)

34

Cash

534
Debit

Year 3

Credit

Financial asset (67 + 12 200)

121

Revenue (P&L)

12

Interest income (P&L)

67

Costs (P&L)

10

Interest expense (P&L)

69

Cash

121

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5.3 Recognition of an intangible asset

An intangible asset is recognised to the extent that the operator receives a right
(a licence) to charge users of the public service. A right to charge users of the
public service is not an unconditional right to receive cash because the amounts
are contingent on the extent that the public uses the service
Example: Service concession arrangement resulting in recognition of an
intangible asset
X Limited is an operator in a service concession arrangement.
Terms
X Limited will construct a road (completed in 2 years).
X Limited to maintain and operate the road for 8 years (i.e. years 310) and
charge a toll to road users. It is estimated that the toll will be Rs 200 million per
annum and that operating costs will be Rs. 10 million per annum.
The right to charge a toll is an intangible asset.
Analysis
X Limited is providing a construction service to the grantor in exchange for a right
to collect tolls from road users in years 310.
This right is an intangible asset paid for by providing construction services. It must
be recognised at cost (fair value of consideration received or receivable for the
construction services delivered.
X Limited recognises toll revenue when it collects tolls in years 3 to 10. The
intangible asset recognised over years 1 and 2 must be amortised over years 3 to
10
Further information:
All cash flows take place at the end of the year
X Limited estimates the fair value of consideration received as equal to the
forecast construction costs plus 5%. Construction revenue of Rs. 525 million and
construction costs of Rs. 500 million is recognised in each of years 1 and 2.
X Limited capitalises the borrowing cost in the construction phase. X Limiteds
cost of borrowing is 6.7%.

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Example (continued): Service concession arrangement resulting in recognition of

an intangible asset
The following table shows the movement in the cash balances over the duration
of the agreement (all figures are in Rs. millions).

Year

Cash b/f

Interest
at 6.7%

Cash out

Cash in

Net cash
flow

Cash c/f

(500)

(500)

(500)

(500)

(34)

(500)

(534)

(1,034)

(1,034)

(69)

(10)

200

121

(913)

(913)

(61)

(10)

200

129

(784)

(784)

(53)

(10)

200

137

(646)

(646)

(43)

(10)

200

147

(500)

(500)

(33)

(10)

200

157

(343)

(343)

(23)

(10)

200

167

(176)

(176)

(19)

(10)

200

171

(5)

(5)

(7)

(10)

200

183

178

10

The intangible asset on initial recognition is as follows:

Rs. m
Year 1: Construction services

525

Year 2: Construction services

525

Year 2: Capitalised interest

34

Intangible asset on initial recognition

1,084

Useful life (years 3 to 10)

8 years

Annual amortisation charge (years 3 to 10)

135

Note that interest incurred after the intangible asset is brought into use
must be expensed to profit or loss.

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Example (continued): Service concession arrangement resulting in recognition of

an intangible asset
The double entries over the first three years are as follows:
Debit

Year 1
Intangible asset

Credit

525

Revenue (P&L)

525

Costs (P&L)

500

Cash

500
Debit

Year 2
Intangible asset (525 + 34)

Credit

559

Revenue (P&L)

525

Costs (P&L)

500

Cash (500 + 34)

534
Debit

Year 3

Credit

Intangible asset

135

Revenue (P&L)

200

Costs (P&L) (10 + 135)

145

Interest expense (P&L)

69

Cash (200 69 10)

121

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Consensus: Sundry issues

Contractual obligations to restore the infrastructure to a specified level of
serviceability before it is handed over to the grantor at the end of the service
arrangement are recognised and measured in accordance with IAS 37.
Borrowing costs are recognised and measured in accordance with IAS 23 might
lead to capitalisation of borrowing costs in the construction phase when the
operator has a contractual right to receive an intangible asset.

5.4 SIC 29: Service concession arrangements: disclosures

IFRIC 12 does not contain any disclosure requirements. Disclosures for service
concession arrangements are specified by SIC 29
An operator and a grantor must disclose:

a description of the arrangement;

significant terms that may affect the amount, timing and certainty of future
cash flows;

the nature and extent of:

x

rights to use specified assets;

obligations to provide or rights to expect provision of services;

obligations to acquire or build items of property, plant and equipment;

obligations to deliver or rights to receive specified assets at the end of

the concession period;

renewal and termination options; and

other rights and obligations (e.g., major overhauls);

changes in the arrangement occurring during the period; and

how the service arrangement has been classified.

An operator must disclose revenue and profits (losses) recognised in the period
on exchanging construction services for a financial asset or an intangible asset.

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SIC 7: INTRODUCTION OF THE EURO

Section overview

SIC 7: Introduction of the euro

6.1 SIC 7: Introduction of the euro

The issue
The euro was introduced on 1 January 1999.
The conversion rates between the euro and the first participating national
currencies were irrevocably fixed at this date thus eliminating the risk of
subsequent exchange differences related to these currencies from this date.
SIC 7 gives guidance on how IAS 21 should be applied at the date of changeover
from a national currency to the euro.
These rules might seem to be a little irrelevant but they would also apply when
any new country adopts the euro in the future. Furthermore, similar rules would
also apply to any future monetary union that might occur.
Consensus
The requirements of IAS 21 regarding the translation of foreign currency
transactions and financial statements of foreign operations should be strictly
applied to a changeover.
This means that, in particular:

foreign currency monetary assets and liabilities resulting from transactions

must continue to be translated into the functional currency at the closing
rate with any resultant exchange differences recognised as income or
expense immediately;

the exchange differences relating to the translation of financial statements

of foreign operations, recognised in other comprehensive income, must be
accumulated in equity and reclassified from equity to profit or loss only on
the disposal or part disposal of investment.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

31

IFRS 1: First time adoption of IFRS

Contents
1 Accounting for the transition to IFRS
2 Presentation and disclosure

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with the international

pronouncements and under the Companies Ordinance, 1984.

LO 2

Evaluate and analyse financial data in order to arrive at firm decisions

on the accounting treatment and reporting of the same.

FINANCIAL REPORTING AND ETHICS

Financial reporting
B (a) 2

IFRS 1: First-time adoption of international financial reporting standards

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ACCOUNTING FOR THE TRANSITION TO IFRS

Section overview

Introduction and terminology

Opening IFRS statement of financial position

Full retrospective application of IFRS

Permitted exceptions to full retrospective application of IFRS

Mandatory exceptions to full retrospective application of IFRS

1.1 Introduction and terminology

Changing from one GAAP to another is a major undertaking which has wide
reaching implications for the company undertaking this step.
IFRS 1 First Time Adoption of International Financial Reporting Standards
explains how the transition to IFRS should be accounted for.
Definitions
First time adopter: An entity that presents its first IFRS financial statements
First IFRS financial statements: The first annual financial statements in which an
entity adopts IFRS by an explicit and unreserved statement of compliance with
IFRS.
The first IFRS financial statements will include the current year, which is the first
period published entirely according to IFRS and comparatives, which were
originally published under previous GAAP, and have been restated into IFRS
A first-time adopter must prepare an opening statement of financial position
according to IFRS as at the date of transition to IFRS.
Definitions
Date of transition to IFRSs: The beginning of the earliest comparative period for
which an entity presents full comparative information under IFRS in its first IFRS
financial statements.
Opening IFRS statement of financial position: An entitys statement of financial
position at the date of transition to IFRSs.
The opening IFRS statement of financial position is prepared by full retrospective
application of all IFRS extant at the end of first IFRS reporting period.
Definition
First IFRS reporting period: The latest reporting period covered by the entitys first
IFRS financial statements.

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Example: Terminology
A company is preparing its first IFRS financial statements for the year ending 31
December 2016.
The company operates in a regime that requires a single period of comparative
information.
First IFRS reporting period

Year ended 31 December 2016

First IFRS financial statements:

Financial statements prepared to

the above year-end
All IFRSs extant at this date are
applied retrospectively (subject to
permitted exemptions and
mandatory exceptions).

Date of transition to IFRSs

1 January 2015 (the start of the

comparative period)

Opening IFRS statement of

financial position:

An IFRS statement of financial

position prepared as at the above
date. (1 January 2015)

1.2 Opening IFRS statement of financial position

As stated above, the opening IFRS statement of financial position is prepared by
full retrospective application (subject to permitted exemptions and mandatory
exceptions) of all IFRS extant at the first IFRS reporting date. The standards
extant at the reporting date are used to reconstruct the statement of financial
position as at the date of transition. This means that if a rule in existence at the
date of transition was changed by the first IFRS reporting date, it is the new rule
that is applied in building the opening IFRS statement of financial position.
The opening IFRS statement of financial position becomes the basis for
accounting moving forward. It is constructed at the start of the comparative
period. The company will already have prepared and filed financial statements for
this period under its previous GAAP. These have to be restated to IFRS to
become the IFRS comparatives to the first IFRS financial statements.
Example: Terminology
A company is preparing its first IFRS financial statements for the year ending 31
December 2016.
The company operates in a regime that requires a single period of comparative
information.
The company drafts its opening IFRS statement of financial position as at 1
January 2015.
It will have published financial statements under its previous GAAP to cover the
year end 31 December 2015.
These are restated to become comparatives in the first IFRS financial statements.

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1.3 Full retrospective application of IFRS

Full retrospective restatement means that all of the figures from the previous
GAAP statement of financial position should be restated to what they would have
been if IFRS had always been applied.
This means that in the opening IFRS statement of financial position, a first-time
adopter must:

recognise all assets and liabilities whose recognition is required by IFRSs;

not recognise assets or liabilities if IFRSs do not permit such recognition;

re-classify items recognised under the previous GAAP as one type of

asset, liability or component of equity if IFRSs require that they should be
classified differently; and

apply IFRSs in measuring all assets and liabilities.

These adjustments are made at the date of transition and lead to restructuring of
the comparative statement of financial position
Full retrospective restatement is a difficult task. IFRS must be applied in its
entirety from the date of transition but there are two categories of exception to full
retrospective restatement before this. These are:

exemptions which are permitted; and

exceptions which are mandatory.

1.4 Permitted exceptions to full retrospective application of IFRS

A first-time adopter may elect to use one or more available exemptions from the
application of IFRSs.
There are possible exemptions to full retrospective application in a number of
areas including the following:

business combinations;

cost of non-current assets (deemed cost);

cumulative translation differences;

investments in subsidiaries, associates and jointly controlled entities (IAS

27); and

designation of previously recognised financial instruments.

Business combinations
The business combination exemption is actually a series of exemptions relating
to:

IFRS 3: Business combinations;

Consolidation, equity accounting and joint arrangements (IFRS 10, IFRS 11

and IAS 28);

IAS 21: The effects of Changes in Foreign Exchange Rates

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The rules on business combinations must be applied to all transactions arising

after the date of transition but do not have to be applied retrospectively.
However, IFRS 1 allows the rules to apply from any date before the date of
transition. In effect, this means that a company could pick any date before the
date of transition from which to start applying IFRS and if this is the case both
IFRS 3 and IFRS 10 must be applied to all subsequent combinations.
Alternative rules apply if IFRS 3 is not applied retrospectively (Appendix C to
IFRS 1). These include:

assets and liabilities recognised under previous GAAP forms the basis for
the recognition of assets and liabilities under IFRS at the date of transition
(subject to adjustments);

the carrying amount of assets and liabilities under previous GAAP is

deemed cost for IFRS;

goodwill written off is not reinstated;

goodwill at transition is subject to impairment test.

IAS 21 requires that goodwill and fair value adjustments arising on acquisition of
a foreign operation are retranslated at each reporting date. IFRS 1 allows that
this requirement does not have to be applied to business combinations before the
date of transition.
Deemed cost
This exemption applies to:

Property, plant and equipment;

Intangible assets (conditions apply);

Investment property; and

Exploration and evaluation assets for oil and gas under IFRS 6, and assets
recorded in respect of rate-regulated activities

It might be difficult to retrospectively construct the IFRS cost of non-current

assets at the date of transition.
IFRS 1 allows the use of one of the following to establish the IFRS cost of an
asset at the date of transition:

fair value;

cost adjusted by changes in an inflation index;

a fair value established at a date before the date of transition in accordance

with previous GAAP;

cost as determined under previous GAAP (oil and gas, rate-regulated

activities).

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Cumulative translation differences

IAS 21 requires cumulative translation differences (CTDs) arising on translation
of foreign operations to be classified as a separate component of equity and
recycled through the statement of profit or loss on disposal of the subsidiary.
A first time adopter does not have to identify CTDs that arose before the date of
transition
Investments in subsidiaries, jointly controlled entities and associates
If an entity prepares separate financial statements IAS 27 Separate Financial
Statements requires it to account for investments in subsidiaries, jointly ventures
and associates either:

at cost;

in accordance with IAS 39 (IFRS 9);or

using the equity method as described in IAS 28

IFRS 1 allows one of the following amounts to be used to establish a cost for
IFRS in the separate opening IFRS financial statements:

cost determined in accordance with IAS 27; or

deemed cost:

fair value (determined in accordance with IAS 39) at the date of transition;
or

previous GAAP carrying amount at that date

Designation of previously recognised financial instruments

IAS 39 Financial Instruments: Recognition and Measurement allows classification
on initial recognition of:

a financial asset as fair value through profit or loss (conditions) or as

available for sale; and

a financial liability as fair value through profit or loss (conditions)

IFRS 1 allows such designation to be made at the date of transition

1.5 Mandatory exceptions to full retrospective application of IFRS

IFRS 1 prohibits the retrospective application of some IFRSs for the opening
IFRS statement of financial position.
Exceptions that must be used concern the following:

estimates;

derecognition of financial assets and liabilities;

hedge accounting;

non-controlling interests;

embedded derivatives; and

government loans

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Estimates
An entity must not apply hindsight to estimates at the date of transition (unless
there is evidence that they were wrong)
The statement of financial position at the date of transition and restated
comparatives must be constructed using estimates current as at those dates
Estimates might include:

market values;

exchange rates;

interest rates;

Example: Estimates
A company is preparing its first IFRS financial statements for the year ending 31
December 2015.
The company operates in a regime that requires a single period of comparative
information. This means that its date of transition is 1 January 2014.
The company had recognised a warranty provision in its previous GAAP financial
statements for the year ended 31 December 2013.
This provision was based on an expectation that 5% of products would be
returned.
During 2014 and 2015 7% of products were returned.
The opening IFRS statement of financial position includes a provision recognised
and measured in accordance with IAS 37. This provision is based on estimated
returns of 5% as this was the estimate current at that date.
The company is not allowed to base the measurement of the provision on 7%
returns.
Derecognition
If an asset was derecognised under previous GAAP but would not have been
under IFRS, full retrospective application would bring it back onto the statement
of financial position. This is not allowed by IFRS 1.
The IAS 39/IFRS 9 derecognition rules must be applied prospectively for
transactions occurring on or after the date of transition to IFRSs.

non-derivative financial assets and liabilities derecognised in a period

beginning before transition are not re-recognised; however

an entity may apply the rules retrospectively from any date of its choosing
but only if the information needed to apply IAS 39 was obtained at the date
of the transaction.

Note that some financial assets that were derecognised before the date of
transition might still be brought back onto the opening IFRS statement of financial
position due to the rules requiring consolidation of special purpose vehicles. If a
financial asset had been derecognised in a sale or transfer to an entity which
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would be defined as a subsidiary under IFRS, that financial asset would be

brought back into the opening IFRS statement of financial position by
consolidation.
Hedge accounting
Hedge accounting relationships cannot be designated retrospectively
At transition;

all derivatives are measured at fair value;

deferred gains/losses previously reported as assets and liabilities are

eliminated;

hedge accounting can only be used if the hedge qualifies under rules in
IFRS.

Non-controlling interests
IFRS 10 contains rules:

on accounting for changes in ownership of a subsidiary that do and do not

result in a loss of control; and

that require total comprehensive income to be attributed to the parent and

to the non-controlling interests even if this results in the non-controlling
interests having a deficit balance;

These rules must be applied prospectively from the date of transition

If a first-time adopter elects to apply IFRS 3 retrospectively to past business
combinations, it must also apply IFRS 10 from the same date

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PRESENTATION AND DISCLOSURE

Section overview

Presentation by a first time adopter

Disclosure by a first time adopter

2.1 Presentation by a first time adopter

IFRS 1 requires that a first-time adopter must include at least one year of
comparative information in its first IFRS financial statements. (This is why the
date of transition to IFRS cannot be later than the beginning of the previous
financial year).
Presentation
To comply with IAS 1 the first IFRS financial statements must include at least:

3 statements of financial position:

x

Current year (the date to which the first IFRS financial statements are
prepared);

Last year (the comparatives to the first IFRS financial statements which
were originally published under the previous GAAP);

Start of last year (date of transition).

2 statements of profit and loss and other comprehensive income (current

year with comparatives);

2 statements of cash flows (current year with comparatives);

2 statements of changes in equity (current year with comparatives); and

2 sets of related notes to the financial statements (current year with

comparatives).

2.2 Disclosure by a first-time adopter

The company must explain how the transition to IFRS affected its reported:

financial position;

financial performance; and

cash flows.

IFRS 1 requires that a company publish reconciliations of amounts in the

previous GAAP financial statements to those in the IFRS financial statements.
The first IFRS financial statements must include:

reconciliations of equity (net assets):

x

at the date of transition; and

at the end of latest period presented under previous GAAP;

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a reconciliation of the profit or loss for the latest period presented under
previous GAAP

Illustration: Reconciliations

SofFP = Statement of financial position

Total CI = Total comprehensive income
IFRS 1 provides an illustrative example in columnar form.
The adjustment to each previous GAAP figure must be explained in notes to the
financial statements.
A simple example follows to show the presentation for the reconciliation of net
equity.

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Example: Reconciliation of equity

A simplified example of a reconciliation of equity is shown below.
Previous
GAAP
Rs.

IFRS
adjustments
Rs.

IFRSs
Rs.

Property, plant and equipment

Intangible assets

2,000
400

300
(50)

2,300
350

Total non-current assets

2,400

250

2,650

Trade and other receivables

Inventory
Cash

1,200
800
50

0
(70)
0

1,200
730
50

Total current assets

2,050

(70)

1,980

Total assets

4,450

180

4,630

800
415
30
25

0
0
0
220

800
415
30
245

Total liabilities

1,270

220

1,490

Total assets less total

liabilities

3,180

(40)

3,140

Issued capital
Revaluation reserve
Retained earnings (balance)

1,000
0
2,180

0
190
(230)

1,000
190
1,950

Total equity

3,180

(40)

3,140

Loans
Trade payables
Current tax liability
Deferred tax liability

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

32

Specialised financial statements

Contents
1 IFRS for small and medium sized entities (SMEs)
2 IFRS 4: Insurance contracts
3 Insurance companies
4 Banks
5 Mutual funds
6 IAS 26: Retirement benefit plans

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 4

Prepare financial statements of specialised entities (including small and

medium sized entities in accordance with the Companies Ordinance,
1984 and the applicable reporting framework, retirement benefit funds in
accordance with international pronouncements) and be able to
demonstrate an understanding of reporting requirements under the laws
specific to insurance, banking companies and mutual funds.

SPECIALISED FINANCIAL STATEMENTS

C1

Small and medium sized entities

C2

Banks

C3

Mutual funds

C4

Insurance companies

C5

IAS 26: Accounting and reporting by retirement benefit plans

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IFRS FOR SMALL AND MEDIUM-SIZED ENTITIES (SMES)

Section overview

Introduction

IFRS for SMEs

IFRS for SMEs section by section

Comprehensive review of the IFRS for SMEs

1.1 Introduction
International accounting standards are written to meet the needs of investors in
international capital markets. Most companies adopting IFRSs are large listed
entities. The IASB has not stated that IFRSs are only aimed at quoted
companies, but certainly the majority of adopters are large entities. In many
countries IFRSs are used as national GAAP which means that unquoted small
and medium-sized entities (SMEs) have to apply them.
There is an argument that all entities should apply the same accounting
standards in order to give a fair presentation of the affairs of the entity. However
in some cases, many of the IFRSs are complex and can be difficult for SMEs to
apply, particularly in areas such as financial instruments. Additionally, not all the
information required by IFRSs for disclosure is needed by the users of the SMEs
financial statements.
Some commentators therefore suggest that SMEs and public entities should be
allowed to use simplified or differing standards as the nature of their business is
different from large quoted entities.
The users of financial statements of SMEs are different from the users of the
financial statements of quoted companies. The only user groups that use the
financial statements of an SME are normally:

its shareholders/owners;

lenders;

senior management; and

possibly, government departments and agencies.

A SME is often owned and managed by a small number of entrepreneurs, and

may be a family-owned and family-run business. Large companies, in contrast,
are run by professional boards of directors, who must be held accountable to
their shareholders.
Because there are big differences between SMEs and large quoted companies, it
is not clear whether there is any reason why SMEs should comply with IFRSs.
There are arguments in favour of using IFRSs for SMEs, and arguments against.

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Arguments against the use of IFRSs by SMEs

There are several reasons why SMEs should not adopt IFRSs for the
preparation of their financial statements.

Some IFRSs deal with subjects that are of little or no relevance to SMEs,
such as accounting standards on consolidation, associates, joint ventures,
deferred tax, construction contracts and standards that deal with complex
issues of fair value measurement.

The costs of complying with IFRSs can be high. Large companies are able
to bear the cost, which might not be significant relative to their size. For
SMEs, the cost is proportionately much higher, and it is doubtful whether
the benefits of complying with IFRSs would justify the costs.

There are not many users of financial statements of SMEs, and they use
the financial statements for a smaller range of decisions, compared to
investors in international capital markets. So would it be a waste of time (as
well as cost) to comply with IFRSs?

Arguments in favour of the use of IFRSs by SMEs

There are also reasons why SMEs should adopt IFRSs for the preparation of
their financial statements.

If SMEs use different accounting rules and requirements to prepare their

financial statements, there will be a two-tier system of accounting. This
could make it difficult to compare results of larger and smaller companies,
should the need arise. Confidence in the quality of financial reporting might
be affected adversely.

If SMEs prepared financial statements in accordance with their national

GAAP, it will be impossible to compare financial statements of companies
in different countries. If SMEs grow in size and eventually obtain a stock
market quotation, they will have some difficulty in the transition from
national GAAP to IFRSs.

It has also been argued that full statutory accounts for SMEs would be in
the public interest, and might help to protect other stakeholders in the
company (such as suppliers, customers, lenders and employees).

Considerations in developing standards for SMEs

The aim of developing a set of accounting standards for SMEs is that they allow
information to be presented that is relevant, reliable, comparable and
understandable. The information presented should be suitable for the uses of the
managers and directors and any other interested parties of the SME.
Additionally, many of the detailed disclosures within full IFRSs are not relevant
and the accounting standards should be modified for this. The difficulty is getting
the right balance of modification, too much and the financial statements will lose
their focus and will not be helpful to users.

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1.2 IFRS for SMEs

The standard consists of 230 pages of text, arranged into 35 sections that cover
all of the recognition, measurement, presentation and disclosure requirements for
SMEs. There is no cross reference to other IFRS (with one exception relating to
financial instruments).
The IFRS for SMEs imposes a lesser burden on SMEs due to:

some topics in IFRSs being omitted because they are not relevant to typical
SMEs

the simplification of many of the recognition and measurement

requirements available in full IFRSs

substantially fewer disclosures.

The IFRS for SMEs does not address the following topics:

earnings per share (i.e. there is no equivalent to IAS 33);

interim accounting (i.e. there is no equivalent to IAS 34);

segment reporting (i.e. there is no equivalent to IFRS 8);

special accounting for assets held for sale (i.e. there is no equivalent to
IFRS 5).

The omission of equivalent rules to those in IAS 33, IAS 34 and IFRS 8 is not
surprising as they are relevant to listed entities. As the next section explains,
such entities cannot be SMEs.
Stand-alone document
The IFRS for SMEs is a stand-alone document. This means that it contains all of
the rules to be followed by SMEs without referring to other IFRSs. For example it
sets out rules for property, plant and equipment without specifying that the rules
are similar or dissimilar to those found in IAS 16.
In the following pages we provide an overview of the sections of the IFRS for
SMEs and often refer to similarity or difference to equivalent other IFRSs. This is
not what the IFRS for SMEs does but we adopt the approach to make it easier for
you to gain an understanding of the main features of the standard.
The IFRS for SMEs is derived from rules in other IFRS. You will note that it uses
the same terminology and that many of the rules are identical. However, in
several cases the rules in other IFRSs from which the IFRS for SMEs derives
have been changed whereas the equivalent rules in this standard have not been
changed. For example the rules on joint ventures are based on the standard (IAS
31) that preceded IFRS 11 which you covered earlier. You should not interpret
this as meaning that the standard is out of date. It simply means that there is a
difference between the rules for SMEs and those followed by other entities.
Changes to the main body of standards will not necessarily result in a revision to
the IFRS for SMEs.

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1.3 IFRS for SMEs section by section

Section 1: Small and medium-sized entities
Definition
Small and medium-sized entities are entities that:
a.

do not have public accountability, and

b.

publish general purpose financial statements for external users. Examples of

external users include owners who are not involved in managing the
business, existing and potential creditors, and credit rating agencies.

An entity has public accountability if:

a.

its debt or equity instruments are traded in a public market or it is in the

process of issuing such instruments; or

b.

it holds assets in a fiduciary capacity for a broad group of outsiders as one of

its primary businesses (e.g. banks and insurance companies).

The decision as to which entities are required or permitted to apply the standard
will lie with the regulatory and legislative authorities in each jurisdiction.
Section 2: Concepts and pervasive principles
This section is drawn from the IASB Framework for the preparation and
presentation of financial statements. This was the document that preceded the
IASB Conceptual Framework with which you are already familiar.
The section states that the objective of financial statements of a small or
medium-sized entity is to provide information about the financial position,
performance and cash flows of the entity that is useful for economic decisionmaking by a broad range of users who are not in a position to demand reports
tailored to meet their particular information needs. Financial statements also
show the results of the stewardship of management (the accountability of
management for the resources entrusted to it).
The section lists the following qualitative characteristics of information in financial
statements:

understandability;

relevance;

materiality;

reliability;

substance over form;

prudence;

completeness;

comparability; and

timeliness.

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The section contains guidance on financial position (including the definitions of

assets, liabilities and equity) and on financial performance (including the
definitions of income and expenses) which is the same as in the conceptual
framework. The recognition criteria are also the same.
The IFRS for SMEs contains guidance on measurement that is not found in either
the original or the new frameworks.
An entity must measure assets and liabilities at historical cost unless another
section in the IFRS for SMEs requires initial measurement on another basis such
as fair value.
Most non-financial assets that an entity initially recognised at historical cost are
subsequently measured on other measurement bases. For example:

property, plant and equipment is measured at the lower of depreciated cost

and recoverable amount;

inventories are measured at the lower of cost and selling price less costs to
complete and sell; and

an entity recognises an impairment loss relating to non-financial assets that

are in use or held for sale.

This guidance is intended to ensure that an asset is not measured at an amount

greater than the entity expects to recover from the sale or use of that asset.
Most liabilities other than financial liabilities are measured at the best estimate of
the amount that would be required to settle the obligation at the reporting date.
Assets and liabilities, or income and expenses, must not be offset unless
required or permitted by another section in the IFRS for SMEs.
Section 3: Financial statement presentation
Financial statements must present fairly the financial position, financial
performance and cash flows of an entity. Fair presentation requires the 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 Section 2 Concepts and Pervasive Principles.
The application of the IFRS for SMEs, with additional disclosure when necessary,
is presumed to result in financial statements that achieve a fair presentation of
the financial position, financial performance and cash flows of SMEs.
Application of the IFRS for SMEs by an entity with public accountability cannot
result in a fair presentation in accordance with this IFRS.
An entity whose financial statements comply with the IFRS for SMEs must make
an explicit and unreserved statement of such compliance in the notes. Financial
statements must not be described as complying with the IFRS for SMEs unless
they comply with all the requirements of this IFRS.
A complete set of financial statements of an entity reporting under the IFRS for
SMEs is similar to that required by full IFRS and comprises:

a statement of financial position;

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either a single statement of profit or loss and other comprehensive income,

or a separate statement of profit or loss and a separate statement of other
comprehensive income;

a statement of changes in equity (or a statement of income and retained

earnings);

a statement of cash flows;

notes including a summary of significant accounting policies; and

comparative information.

Section 4: Statement of financial position

The rules in IFRS for SMEs on statements of financial position are very similar to
those found in IAS 1.
One difference is that line items required for assets held for sale or liabilities of
disposal groups held for sale are not required.
Section 5: Statement of comprehensive income and income statement
The rules in IFRS for SMEs on statements of financial performance are very
similar to those found in IAS 1.
An entity must present its total comprehensive income either:

in a single statement; or

in two statements

An entity must present its total comprehensive income for a period either:

in a single statement of comprehensive income, in which case the

statement of comprehensive income presents all items of income and
expense recognised in the period, or

in two statements (an income statement and a statement of comprehensive

income) in which case the income statement presents all items of income
and expense recognised in the period except the following three categories
of gain or loss that must be recognised in total comprehensive income in
accordance with the IFRS for SMEs:
x

gains and losses arising on translating the financial statements of a

foreign operation (Section 30: Foreign currency translation).

some actuarial gains and losses (Section 28: Employee benefits).

some changes in fair values of hedging instruments (Section 12:

Other financial instruments).

An income statement is what the IFRS for SMEs calls a statement of profit or
loss.

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Section 6: Statement of changes in equity and statement of income and retained

earnings
An SME must present either:

a statement of changes in equity (SOCIE); or

a statement of income and retained earnings (if the only changes in equity
in the period arise from profit or loss, dividends paid, corrections of errors
and changes in accounting policy).

The statement of income and retained earnings is an income statement with a

closing section which shows the following:

retained earnings at the beginning of the reporting period;

dividends declared and paid or payable during the period;

restatements of retained earnings for corrections of prior period errors;

restatements of retained earnings for changes in accounting policy; and

retained earnings at the end of the reporting period.

Section 7: Statement of cash flows

There are no significant differences between the rules in section 7 and those in
IAS 7.
Section 8: Notes to the financial statements
There are no significant differences between the IFRS for SMEs rules on notes to
the financial statements and those found in IAS 1.
Section 9: Consolidated and separate financial statements
This section derives from the standards that were replaced by the project that led
to the publication of IFRS 10. However, there are no significant, practical
differences between the IFRS for SMEs rules on subsidiaries and consolidation
and those found in the other IFRS.
Each set of rules would result in the recognition of the same entities as
subsidiaries and result in the same consolidated financial statements in most (but
not all) cases. It is possible that the more detailed guidance on control in IFRS 10
would lead to the consolidation of some entities that might not be considered as
subsidiaries according to the IFRS for SMEs rules. However, most SMEs are
unlikely to be involved in the sort of investment that IFRS 10 would further
identify.
Section 10: Accounting policies, estimates and errors
The rules in IFRS for SMEs on accounting policies, estimates and errors are very
similar to those found in IAS 8. However, there is no requirement to disclose the
impact of a new standard in issue but not yet effective.
Sections 11 and 12: Introduction to IFRS for SMEs in respect of financial
instruments
Section 11 and Section 12 together deal with recognising, derecognising,
measuring and disclosing financial instruments (financial assets and financial
liabilities).
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Section 11 applies to basic financial instruments and is relevant to all entities.

Section 12 applies to other, more complex financial instruments and transactions.
An entity must apply either:

the provisions of both Section 11 and Section 12 in full, or

the recognition and measurement provisions of IAS 39 (now IFRS 9).

Section 11: Basic financial instruments

This section applies to all entities.
A financial instrument is a contract that gives rise to a financial asset of one entity
and a financial liability or equity instrument of another entity.
An entity must recognise a financial asset or a financial liability only when the
entity becomes a party to the contractual provisions of the instrument.
Measurement of financial assets and liabilities on initial recognition is at the
transaction price (including transaction costs) with the following exceptions:

financial assets and liabilities that are measured at fair value through profit
or loss) are measured at their fair value (which is usually the transaction
price) with transaction costs expensed to profit or loss;

financing transactions (for example in connection with the sale of goods if

payment is deferred beyond normal business terms or is financed at a rate
of interest that is not a market rate) where the financial asset or financial
liability is measured at the present value of the future payments.

Subsequent measurement at the end of each reporting period is as follows:

Debt instruments are measured at amortised cost using the effective

interest method with the following exceptions:
x

Debt instruments that are classified as current assets or current

liabilities are measured at the undiscounted amount;

If an arrangement constitutes a financing transaction, the debt

instrument is measured at the present value of the future payments.

Investments in shares must be measured at fair value with all gains and
losses recognised through profit or loss.

Section 12: Other financial instruments issues

This section applies to only to those entities which have complex financial
instruments. This includes derivatives and any instrument with an embedded
derivative.
An entity must recognise a financial asset or a financial liability only when the
entity becomes a party to the contractual provisions of the instrument.
When a financial asset or financial liability is recognised initially, an entity must
measure it at its fair value, which is normally the transaction price.

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At the end of each reporting period, an entity must measure all financial
instruments within the scope of Section 12 at fair value and recognise changes in
fair value in profit or loss.
This section includes a simplified hedge accounting regime which can only be
used to account for hedges of the following risks:

interest rate risk of a debt instrument measured at amortised cost;

foreign exchange or interest rate risk in a firm commitment or a highly

probable forecast transaction;

price risk of a commodity that it holds or in a firm commitment or highly

probable forecast transaction to purchase or sell a commodity;

foreign exchange risk in a net investment in a foreign operation.

Section 13: Inventories

There are no significant differences between the IFRS for SMEs rules on
accounting for inventory and those found in IAS 2.
Section 14: Investments in associates
The section 14 rules on identifying investments in associates are very similar to
those found in IAS 28.
Section 14 allows an entity to account for all of its associates using one of the
following:

cost model;

equity method; or

fair value model.

Section 15: Investments in joint ventures

Definition
A joint venture is a contractual arrangement whereby two or more parties
undertake an economic activity that is subject to joint control.
Joint control is the contractually agreed sharing of control over an economic
entity.
Joint control only exists when the strategic financial and operating decisions
relating to the economic activity require the unanimous consent of the entities
sharing control (the joint venturers).
Joint control is the key factor in deciding whether a joint venture exists. The
following characteristics are common to all types of joint venture:

two or more joint venturers are bound by a contractual arrangement

(usually in writing); and

the contractual arrangement establishes joint control.

The IFRS for SMEs identifies three broad types of joint venture:

jointly-controlled operations

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jointly-controlled assets

jointly-controlled entities.

An entity with a jointly-controlled operation must recognise:

the assets that it controls and the liabilities that it incurs, and

the expenses that it incurs and its share of the income that it earns from the
sale of goods or services by the joint venture.

An entity with an interest in jointly-controlled assets must recognise:

its share of the jointly controlled assets, classified according to the nature of
the assets;

any liabilities that it has incurred;

its share of any liabilities incurred jointly with the other venturers in relation
to the joint venture;

any income from the sale or use of its share of the output of the joint
venture, together with its share of any expenses incurred by the joint
venture; and

any expenses that it has incurred in respect of its interest in the joint
venture.

An entity with an interest in jointly-controlled entity must account for all of its
jointly-controlled entities using one of the following:

cost model;

equity method; or

fair value model.

Section 16: Investment property

The section 14 rules on identifying investment properties are very similar to those
found in IAS 40.
Section 14 requires that investment properties must be measured at fair value
(cost model not allowed, unless fair value cannot be measured reliably without
undue cost or effort).
Section 17: Property, plant and equipment
This section applies to accounting for property, plant and equipment and
investment property whose fair value cannot be measured reliably without undue
cost or effort.
Most of the section 17 rules are similar to the IAS 16 rules. However, there are
some differences.

All assets within the scope of this section must be measured subsequently
using the cost model. Revaluation is not allowed.

Residual value, useful life and depreciation need to be reviewed only if

there is an indication they may have changed since the most recent annual
reporting date. (IAS 16 requires an annual review).

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Section 18: Intangible assets other than goodwill

The section 18 rules on accounting for intangible assets are similar to the IAS 38
rules. However, there are some differences.

All assets within the scope of this section must be measured subsequently
using the cost model. Revaluation is not allowed.

All research and development costs must be expensed as incurred. There

is no capitalisation of internally generated intangible assets.

All intangible assets must be amortised over their estimated useful lives. If this
cannot be estimated a useful life of 10 years is assumed. This means that there
is no requirement to test unamortised intangibles for impairment on an annual
basis.
Section 19: Business combinations and goodwill
The section 19 rules on accounting for business combinations and goodwill are
similar to the IFRS 3 rules. However, there are some differences.

Acquisition costs are capitalised under this standard whereas they must be
expensed under IFRS 3.

Goodwill is amortised over its estimated useful life. If this cannot be

estimated a useful life of 10 years is assumed. This means that there is no
requirement to test goodwill for impairment on an annual basis.

Section 20: Leases

There are no significant differences between the IFRS for SMEs rules on leases
and those found in IAS 17.
Section 21: Provisions and contingencies
There are no significant differences between the IFRS for SMEs rules on
provisions and contingencies and those found in IAS 37.
Section 22: Liabilities and equity
The section 22 rules on equity and liabilities are similar to the IAS 32 rules
though IAS 32 does envisage more complex scenarios. Both sets of rules would
lead to the same classification of an instrument as debt or equity and both sets of
rules require split accounting (into debt and equity components) on the initial
recognition of an issue of convertible debt.
Both sets of rules require that any gain or loss on transactions involving an
entitys own equity must be recognised as a movement in equity. Section 22
applies the same rational to transactions involving a parents controlling interest
in a subsidiary that do not result in a loss of control. The carrying amount of the
non-controlling interest is adjusted to reflect the change in the parents interest in
the subsidiarys net assets. Any difference between the amount by which the
non-controlling interest is so adjusted and the fair value of the consideration paid
or received, if any, shall be recognised directly in equity and attributed to equity
holders of the parent.

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Section 23: Revenue

This section is based closely on IAS 18, IAS 11. There are no significant
differences between the section 23 rules and the rules in those standards.
Section 24: Government grants
The section 24 rules on accounting for government grants are similar to the IAS
20 rules. However, section 24 does not seem to allow deduction of a capital grant
from the asset to which it relates.
Section 25: Borrowing costs
Borrowing costs must be recognised as expenses and cannot be capitalised as
required by IAS 23.
Section 26: Share-based payment
The section 26 rules on accounting for share-based payment are similar to the
IFRS 2 rules.
One difference is that section 26 allows the directors to make an estimate of the
fair value of equity instruments granted when there is no observable market price
and a reliable measure of fair value is impracticable.
Section 27: Impairment of assets
The section 27 rules on impairment of assets are similar to those in IAS 2 for
inventories and those in IAS 36 for impairment of other non-financial assets.
Section 28: Employee benefits
The section 28 rules on accounting for employee benefits are very similar to
those found in IAS 19 with no significant differences worth mentioning.
Section 29: Income tax
This is one area where there are significant differences.
There was an ED proposing major changes to IAS 12 in issue when the IFRS for
SMEs was published. The tax rules in this section were based on those in the
ED. The ED was subsequently withdrawn and IAS 12 was not revised. This
means that the rules in section 29 are based on concepts which the IASB chose
not to follow in IAS 12 and are more complex than those in IAS 12.
These rules are not explained further in this text.
Section 30: Foreign currency translation
The section 30 rules on foreign currency translation are similar to the IAS 21
rules.
One difference is that section 30 does not permit recycling of the cumulative
translation difference in respect of an investment in a foreign entity when that
entity is disposed of.
Section 31: Hyperinflation
The section 31 rules on hyperinflation are very similar to the IAS 21 rules.
This is not relevant to Pakistani companies.

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Section 32: Events after the end of the reporting period

There are no significant differences between the IFRS for SMEs rules on events
after the end of the reporting period and those found in IAS 10.
Section 33: Related party disclosures
There are no significant differences between the IFRS for SMEs rules for related
parties and those found in IAS 24.
Section 34: Specialised activities
IFRS for SMEs provides guidance on:

Agriculture (drawn from IAS 41);

Extractive industries (refers back to the property, plant and equipment,

intangibles other than goodwill, and provisions sections of the IFRS);

Service concession arrangements (drawn from, but much simplified, IFRIC

12).

Section 35: Transition to the IFRS for SMEs

This section applies to a first-time adopter of IFRS for SMEs. This could be a
company changing from local accounting rules or from full IFRS.
The guidance is similar to that provided by IFRS 1 for first time adoption of full
IFRS.
These rules are not described further in this chapter.

1.4 Comprehensive review of the IFRS for SMEs

The IFRS for SMEs was issued in July 2009. At that time the IASB stated its plan
to undertake an initial comprehensive review of the IFRS for SMEs to assess the
first two years experience that entities would have had in implementing it and to
consider whether there is a need for any amendments.
Companies started using the IFRS for SMEs in many jurisdictions in 2010.
Consequently, the IASB commenced its initial comprehensive review in 2012.
This review led to the publication of an exposure draft of proposed amendments
to the IFRS for SMEs (ED/2013/9) in October 2013.
The ED proposes 57 amendments which affect IFRS for SMEs. Further minor
editorial amendments which have no effect on IFRS for SMEs were also
proposed. These were made largely to ensure consistency of terminology and
wording throughout the IFRS for SMEs.
The 57 amendments fall into several broad categories:

amendments to incorporate new and revised IFRSs:

amendments that change the IFRS for SMEs;

new guidance;

new exemptions;

disclosure simplifications; and

minor clarifications.

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Note that there were no changes proposed resulting from the issue of IFRS 10,
IFRS 11, IFRS 12, IFRS 13 and IFRS 9. This implies that the IASB are content
with the IFRS for SMEs in this area and see no need to align the rules in the light
of changes to the other standards.
One major change proposed is the alignment of section 29 on income tax with
IAS 12. The reason for the difference was explained in the previous section.

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IFRS4: INSURANCE CONTRACTS

Section overview

Background

Insurance risk

Objective of IFRS 4

Selection of accounting policies

2.1 Background
The group accounts of listed entities in the EU had to be prepared according to
IFRS for all accounting periods beginning on or after 1 January 2005. This
regulation applied to some very large insurance companies in the EU.
In the run up to conversion, the insurance industry identified a problem. IFRS
contained no rules on accounting for insurance contracts. IAS 8 specifies criteria
for an entity to use in developing an accounting policy if no IFRS applies
specifically to an item. The industry believed that this would lead to difficulties
and divergent accounting across the industry.
The IASB launched the insurance contract project, intending that this would be
completed in two phases.
Phase 1 was intended as a temporary solution to the problem faced by insurers
and this resulted in the publication of IFRS 4 in 2004. Phase 2 was expected to
be completed in 2005/6 but this has not happened yet. The project team has
been working assiduously on this for many years. Their failure to complete the
project to date is a reflection on how complex insurance issues can be and also
the need for US GAAP and IFRS to converge in this area.

2.2 Insurance risk

Definition
Insurance contract: A contract under which one party (the insurer) accepts
significant insurance risk from another party (the policyholder) by agreeing to
compensate the policyholder if a specified uncertain future event (the insured
event) adversely affects the policyholder. (See Appendix B for guidance on this
definition.)
Insurance risk: Risk, other than financial risk, transferred from the holder of a
contract to the issuer.
Financial risk: The risk of a possible future change in one or more of 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.
Note that if a product does not fall into this definition then IAS 39 (IFRS 9) would
probably apply to it.

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2.3 Objective of IFRS 4

IFRS4 was published to introduce:

limited improvements to accounting practices for insurance contracts prior

to Phase 2 of the project; and

requirements for disclosure of information that identifies and explains

amounts in the financial statements arising from insurance contracts, and
helps users to understand the amount, timing and uncertainty of future cash
flows under such contracts.

IFRS 4 applies to insurers and must be followed in accounting for:

insurance contracts issued; and

reinsurance contracts issued and held.

Definition
Reinsurance contract: An insurance contract issued by one insurer (the reinsurer)
to compensate another insurer (the cedant) for losses on one or more contracts
issued by the cedant.

2.4 Selection of accounting policies

IAS 8 specifies criteria for an entity to use in developing an accounting policy if
no IFRS applies specifically to an item. However, IFRS 4 exempts an insurer
from applying those criteria to its accounting policies for:

insurance contracts that it issues; and

reinsurance contracts that it holds.

However, IFRS 4 does not exempt insurers from certain implications of the IAS 8
criteria. Specifically, an insurer:

must not:
x

recognise a liability for catastrophe provisions or equalisation

provisions relating to future claims that are not in existence at the
reporting date;

offset reinsurance assets and related insurance liabilities; or

offset income/expense from reinsurance contracts against the

expense/income from the related insurance contracts; but

must:
x

remove an insurance liability when, and only when, it is extinguished,

discharged, cancelled or expired;

carry out a liability adequacy test; and

consider whether its reinsurance assets are impaired

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Changes in accounting policies

An insurer is allowed to change accounting policies for insurance contracts when
the change makes information used as a basis of decision making:

more relevant and no less reliable; or

more reliable and no less relevant

In particular an insurer cannot introduce any of the following practices, although it

may continue using accounting policies that involve them:

measuring insurance liabilities on an undiscounted basis

measuring contractual rights to future investment management fees at an

amount that exceeds their fair value as implied by a comparison with
current market-based fees for similar services

using non-uniform accounting policies for the insurance liabilities of

subsidiaries.

Prudence
An insurer need not change accounting policies for insurance contracts to
eliminate excessive prudence.
If an insurer already measures its insurance contracts with sufficient prudence, it
must not introduce additional prudence.

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INSURANCE COMPANIES
Section overview

Introduction to accounting by insurance companies

Financial statements of insurance companies

Other statements and disclosures

3.1 Introduction to accounting by insurance companies

Insurance companies, in Pakistan, are subject to the Insurance Ordinance, 2000
which requires all insurance companies to prepare the following statutory
accounts at each year-end:

in the case of a life insurer,x

a statement of assets and liabilities for each statutory fund operated

by the life insurer and the shareholders fund;

a statement of profits and losses for the shareholders fund;

a statement of cash flows for each statutory fund operated by the life
insurer and the shareholders fund;

a revenue account for each statutory fund operated by the life insurer;

a statement of premiums for each statutory fund operated by the life

insurer;

a statement of claims for each statutory fund operated by the life

insurer;

a statement of expenses for each statutory fund operated by the life

insurer; and

a statement of investment income for each statutory fund operated by

the life insurer.

in the case of a non-life insurer,

x

a statement of assets and liabilities;

a statement of profits and losses;

a statement of cash flows;

a statement of premiums;

a statement of claims;

a statement of expenses;

a statement of investment income; and

a statement of claims analysis

Insurance companies must also pay regard to the requirements of the

Companies Ordinance 1984 in so far as they are not inconsistent with the
Insurance Ordinance, 2000. Therefore, insurance companies must prepare
financial statements in accordance with IFRS just like any other type of company.

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Summary
All insurance companies operating in Pakistan must prepare their accounts in
accordance with the following:

the Companies Ordinance, 1984;

the Insurance Ordinance, 2000;

SEC (Insurance) Rules, 2002; and

IFRS as notified in the official Gazette by the Securities and Exchange

Commission of Pakistan for listed companies under section 234(3)(i) of the
Companies Ordinance 1984.

3.2 Financial statements of insurance companies

Insurance companies: Statement of financial performance
Illustration: Statement of comprehensive income format for an insurance company
Statement of comprehensive income for the year ended XX/XX/XXXX
Property

Health

Motor

Rs. m

Net premium revenue

Net claims

(X)

(X)

(X)

(X)

Expenses

(X)

(X)

(X)

(X)

Net commission

Underwriting result

Investment income

Other income

General and administration expenses

(X)
X

Profit before tax

Taxation

(X)

Profit after tax

Other comprehensive income

X
X

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Insurance companies: Statement of financial position

Illustration: Statement of financial position format for an insurance company
Statement of financial position as at XX/XX/XXXX
Rs. m
Share capital and reseves
Share capital
Retained profits
Reserves

X
X
X
X

Underwriting provisions
Provision for outstanding claims
Provision for unearned premium
Commision income unearned
Total underwriting provisons
Deferred liabilites
Staff retirement benefit
Creditors and accruals
Premium received in advance
Amounts due to other insurers/reinsurers
Accrued expenses
Other creditors and accruals

X
X
X
X
X

Other liabilities

X
X
X
X
X
X

TOTAL EQUITY AND LIABILITIES

ASSETS
Cash and bank balances
Investments
Other assets
Premiums due but unpaid
Amounts due from other insurers/reinsurers
Accrued investment income
Reinsurance recoveries against outstanding claims
Deferred commission expense
Prepayments
Sundry receivables
Fixed assets (non--current assets)

X
X
X
X
X
X
X
X
X
X
X
X
X

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3.3 Other statements and disclosures

The following examples have been partially populated with numbers to show the
summation logic in the notes.
Statement of premiums
Illustration: Statement of premiums

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Statement of expenses
Illustration: Statement of expenses

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Statement of claims
Illustration: Statement of claims

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BANKS
Section overview

Introduction to accounting by banks

Banks: Statement of financial performance

Banks: Statement of financial position

Other statements and disclosures

4.1 Introduction to accounting by banks

Section 34 of the Banking Companies Ordinance 1962 requires that every bank
incorporated in Pakistan must prepare financial statements in accordance with
the second schedule of the act.
The second schedule requirements are now published as in BSD (Banking
Supervision Department) circular No. 36 issued by the State Bank of Pakistan.
This also applies to banks incorporated overseas in respect of all business
transacted through branches in Pakistan.
Banks must also pay regard to the requirements of the Companies Ordinance
1984 in so far as they are not inconsistent with the Banking Companies
Ordinance 1962. Therefore, banks must prepare financial statements in
accordance with IFRS just like any other type of company.
Summary
All banks operating in Pakistan must prepare their accounts in accordance with
the following:

directives issued by the State Bank of Pakistan;

the Banking Companies Ordinance 1962;

IFRS as notified in the official Gazette by the Securities and Exchange

Commission of Pakistan for listed companies under section 234(3)(i) of the
Companies Ordinance 1984.

This is the case whether the bank is incorporated in Pakistan or outside Pakistan
and whether it listed or no.
BSD circular No. 36
BSD circular No. 36 contains formats that must be used when preparing financial
statements. The formats for the statement of financial performance (profit and
loss account) and statement of financial position (balance sheet) are shown in
the following sections.

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4.2 Bank: Statement of financial performance

Illustration: Statement of comprehensive income format for a bank
Statement of comprehensive income for the year ended XX/XX/XXXX
Rs. m

MARK-UP/INTEREST INCOME
Mark-up/return/interest earned

Mark-up/return/interest expensed

(X)

Net mark-up/ interest income

Provision against non-performing loans and advances

(X)

Provision for diminution in the value of investments

(X)

Bad debts written off directly

(X)
(X)

Net mark-up/ interest income after provisions and write offs

NON MARK-UP/INTEREST INCOME

Fee, commission and brokerage income

Dividend income
Income from dealing in foreign currencies

Gain / (Loss) on sale of securities

Unrealised gain / (loss) on revalution of investments classified

as held for trading
Other income

Total non-markup/interest Income

X
X

NON MARK-UP/INTEREST EXPENSES

Administrative expenses
Other provisions/write offs (to be specified)

X
X

Other charges

Total non-markup/interest expenses

(X)
X

Extraordinary/unusual items (to be specified)

PROFIT/(LOSS) BEFORE TAXATION

Taxation

X
(X)

PROFIT/(LOSS) AFTER TAXATION

Unappropriated/unremitted profit/(loss) brought forward

Profit available for appropriation/unremitted profit/(loss)

X
X

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4.3 Bank: Statement of financial position

Illustration: Statement of financial position format for a bank
Statement of financial position as at XX/XX/XXXX
Rs. m
ASSETS
Non--current assets
Cash and balances with treasury banks
Balances with other banks
Lendings to financial institutions
Investments
Advances
Operating fixed assets
Deferred tax assets
Other assets

X
X
X
X
X
X
X
X
X

LIABILITIES
Bills payable
Borrowings
Deposits and other accounts
Sub-ordinated loans
Liabilities against assets subject to finance lease
Deferred tax liabilities
Other liabilities

X
X
X
X
X
X
X
X

NET ASSETS

REPRESENTED BY
Share capital/ Head office capital account
Reserves
Unappropriated/ Unremitted profit

X
X
X

Surplus/ (Deficit) on revaluation of assets

X
X
X

4.4 Other statements and disclosures

Banks are subject to disclosure requirements that require them to provide
information on accounting issues specific to banks including notes on

non-performing advances;

cash balances with treasury banks;

balances with other banks

investments (by type and by segment; and

deposits and other accounts.

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Non performing advances

Illustration: Non performing advances
Particulars of non-p
performing advances
Advances include Rs. XX million which, as detailed below, have been placed
under non-performing status:
Category

Other assets
especially
mentioned
Sub-standard
Doubtful
Loss

Amount outstanding

Provision required and held

Domestic

Overseas

Total

Domestic

Overseas

Total

Rs. m

Rs. m

Rs. m

Rs. m

Rs. m

Rs. m

50
200
335
400

10
15
30
400

985

455

50
200
300
400
950

35
35

10
15
35
400

5
5

460

Provision
ns against non-p
performing advances

Opening balance
Charge for the year
Amounts written off
Reversals
Closing balance

Specific

General

Total

Rs. m

Rs. m

Rs. m

400
150
(20)
(70)
460

100
20

500
170
(20)
(70)
580

120

Illustration: Cash and balances with treasury banks

In hand

Rs. m

 local currency
 foreign currencies

X
X
X

With State Bank of Pakistan

 local currency current account
 local currency deposit account
 foreign currency current accounts
 foreign currency deposit accounts
With National Bank of Pakistan
 local currency current account
 local currency deposit account

X
X
X
X
X
X
X
X
X

The local currency account is maintained with the State Bank of

Pakistan (SBP) as per the requirements of Section 36 of the State Bank
of Pakistan Act, 1956, which requires banking companies to maintain a
local currency cash reserve in a current account opened with the SBP at
a sum not less than its demand laibilities as prescribed by the SBP.

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Balances with other banks

Illustration: Balances with other banks
In Pakistan

Rs. m

 current accounts

 deposit accounts

X
X

Outside Pakistan
 current accounts

 deposit accounts

X
X
X

Investments
Disclosures must show investments by type (meaning how they are classified in
the financial statements) and by segment (meaning the market segment that has
been invested in.
The balances on both should agree.
Illustration: Investments
Investments by type
Available--for--sale securities

Rs. m

Fully paid shares of listed companies

Fully paid shares of cooperative instituions

X
X

Held to maturity investmentss

Market treausry bills
Pakistan investment bonds

Non-banking financial institutions

X
X

Less: Provision for dimunition on value of investment

(X)

Investments net of provisions

Surplus on revaluation of available-for-sale securities

Total investments

Investments by segment
Federal government securities

Rs. m

Market treasury bills

Pakistan investment bonds

X
X

Investment with other financial institutions

Non-banking financial institutions

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Fully paid up shares

Listed companies

Unlisted companies

X
X
X

Less: Provision for dimunition on value of investment

(X)

Investments net of provisions

Surplus on revaluation of available-for-sale securities

Total investments

Deposits and other accounts

Illustration: Deposits and other accounts

Customers

Rs. m

Fixed deposits

Savings deposits
Current accounts non-remunerative

X
X

Margin deposits
X
Financial institutions
Remunerative deposits

Non-remunerative deposits

X
X
X

Particulars of deposits
In local currencies

In foreign currencies

X
X

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MUTUAL FUNDS
Section overview

Introduction to mutual funds

Accounting issues

Financial statements of mutual funds

Other statements and disclosures

5.1 Introduction to mutual funds

The mutual funds industry is regulated by The Securities and Exchange
Commission of Pakistan (SECP).
A mutual fund is a collective investment scheme, which specialises in investing a
pool of money collected from investors for the purpose of investing in shares,
bonds and other securities. This gives small investors access to professionally
managed, diversified portfolios of equities, debt instruments etc. that they would
otherwise not be able to achieve.
Mutual funds are operated by asset management companies (AMCs). An AMC is
a public limited company registered under Companies Ordinance, 1984.
Investors purchase units (shares) and receive a share of income based on the
number of units (shares) which they own. The value of the units (shares)
changes on an ongoing basis so the holders are exposed to capital gain or loss.
The value of a unit (share) is based on the net asset value at the date of the
valuation and the number of units available.
Formula: Unit price
Current market value of all assets - liabilities
Unit price

=
Total number of units outstanding

Types of mutual funds

There are basically two types of mutual funds:

Open-ended mutual funds:

x

Open-ended mutual funds (also called unit trusts) are funds which
continually issue or redeem new units on demand.

Units may be purchased or redeemed at the prevailing net asset

value.

Trading is through a management company which announces offer

and redemption prices daily.

Closed-ended mutual funds

x

Closed-ended mutual funds have a fixed number of units which are

quoted on an exchange.

Units can be traded at the market rates set by the exchange.

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5.2 Accounting issues

Accounting for interests in funds by the AMCs
A mutual fund is an entity controlled by the AMC that manages it. In the absence
of rules to the contrary, an AMC which managed a fund would classify it as a
subsidiary and therefore have consolidate it.
IFRS 10 contains an exemption from the general requirement to consolidated
controlled entities in this circumstance.
An investment entity must not consolidate the entities that it controls but it must
measure them at fair value through profit or loss in accordance with IFRS 9:
Financial Instruments.
Nature of the units
Units in open ended mutual funds are redeemable on demand. This means that
in the absence of further guidance they would be classified as liabilities in
accordance with the definition of liabilities found in IAS 32: Financial instruments:
Presentation. In that case, the statement of financial position of such a fund
would have no equity.
IAS 32 contains rules under which instruments of this kind are classified as
equity. It describes such instruments as puttable instruments and rules that they
should be classified as equity as long as they meet certain criteria. These criteria
are designed to include units of mutual funds but prevent other liabilities from
being classified as equity when it would not be appropriate to do so.

5.3 Financial statements of mutual funds

Mutual funds: Statement of financial performance
Illustration: Statement of comprehensive income format for a mutual fund
Statement of comprehensive income for the year ended XX/XX/XXXX
INCOME
Mark-up/ interest income
Dividend income

Rs. m
X
X

Gain/(loss) on sale of investments

Other income

X
X

EXPENSES
Remuneration to management

Brokerage commissions and fees

Administrative and general expenses

Othe expenses

X
X
(X)

NET INCOME FOR THE YEAR

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Mutual funds: Statement of financial position

Illustration: Statement of financial position format for a mutual fund
Statement of financial position as at XX/XX/XXXX
Rs. m
TOTAL EQUITY
Certificate holders equity
Reserves
Unappropriated profit/loss
Others

X
X
X
X
X

LIABILITIES
Payable to investment advisor
Others

X
X
X
X

ASSETS
Cash and bank balances
Investments
Others
NET ASSETS

X
X
X
X

5.4 Other statements and disclosures

Mutual funds must provide information on distributions made in the period and
explain the movement on unit holders funds in the period.
Illustration: Distribution statement
Distribution statement for the year ended XX/XX/XXXX
Undistributed Income brought forward
Realised
Unrealised
Final distribution of Rs. X for the year ended xxx xxx
Cash distributions
Bonus units
Net income for the year
Element of income/(loss) and capital gains/(losses) included in
prices of units issued less those in units redeemed - amount
representing unrealised (dimunition)/appreciation
Undistributed income carried forward
Undistributed income carried forward
Realised
Unrealised

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X
X
X
X
X
X

X
X

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Movement in unit holders funds

Illustration: Movement in unit holders funds
Movement in unit holders fund for the year ended XX/XX/XXXX
Rs. m
X

Net assets at beginning of the year (A)

Issue of xxxx ints

Redemption of xxxx units

(B)

A+B

Element of Income / (Loss) and Capital Gains / (Losses)

included in prices of units issued less those in units redeemed
amount representing income/(loss) and capital
gains/(losses) - transferred to income statement
amount representing unrealised
appreciation/(diminution) in value of investments
transferred directly to distribution statement

X
X

Net unrealised appreciation/(diminution) in value of

investments calssified as 'available for sale"

Capital gain / (loss) on sale of investments

unrealized appreciation / (diminution) in value of investments
at fair value through profit and loss- net

Other net income for the year

Element of income/(loss) and capital gains/(losses) included in
prices of units issued less those in units redeemed - amount
representing unrealised appreciation

Final distribution
-

cash distribution

issue of bonus units

X
X

Issue of xxx bonus units for the year ended xxxx

Net assets at the end of year

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IAS 26: RETIREMENT BENEFIT PLANS

Section overview

Scope

Definitions

Valuation of plan assets

Defined contribution plans

Defined benefit plans

Disclosure

Other statements

6.1 Scope
IAS 26 complements IAS 19, Employee Benefits which is concerned with the
determination of the cost of retirement benefits in the financial statements of
employers.
IAS 26 applies to the reports of retirement benefit plans whether they are:

defined contribution plans; or

defined benefit plans; and

regardless of:
x whether a fund has a separate legal identity; or
x whether there are trustees.

All other IFRS apply to the reports of retirement benefit plans to the extent that
they are not superseded by IAS 26.
Insured benefits
Retirement benefit plans with assets invested with insurance companies are
within the scope of IAS 26 unless the contract with the insurance company is in
the name of a specified participant or a group of participants and the retirement
benefit obligation is solely the responsibility of the insurance company.
Outside scope
IAS 26 does not deal with other forms of employment benefits such as
employment termination indemnities, deferred compensation arrangements, longservice leave benefits, special early retirement or redundancy plans, health and
welfare plans or bonus plans.
Government social security type arrangements are also excluded from the scope
of IAS 26.

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6.2 Definitions
Definition
Retirement benefit plans are arrangements whereby an entity provides benefits
for its employees on or after termination of service (either in the form of an
annual income or as a lump sum) when such benefits, or the employer's
contributions towards them, can be determined or estimated in advance of
retirement from the provisions of a document or from the entity's practices.
A retirement benefit plan is a reporting entity separate from the employers of the
participants in the plan.
Retirement benefit plans are known by a variety of names, for example, pension
schemes, superannuation schemes; or retirement benefit schemes'
Definitions
Defined contribution plans are retirement benefit plans under which amounts to
be paid as retirement benefits are determined by contributions to a fund together
with investment earnings thereon.
Defined benefit plans are retirement benefit plans under which amounts to be
paid as retirement benefits are determined by reference to a formula usually
based on employees' earnings and/or years of service.
Funding is the transfer of assets to an entity (the fund) separate from the
employer's entity to meet future obligations for the payment of retirement
benefits.
Participants are the members of a retirement benefit plan and others who are
entitled to benefits under the plan.
Net assets available for benefits are the assets of a plan less liabilities other than
the actuarial present value of promised retirement benefits.
Actuarial present value of promised retirement benefits is the present value of
the expected payments by a retirement benefit plan to existing and past
employees, attributable to the service already rendered.
Vested benefits are benefits, the rights to which, under the conditions of a
retirement benefit plan, are not conditional on continued employment.

6.3 Valuation of plan assets

Retirement benefit plan investments are carried at fair value.
The fair value of marketable securities is market value.
Where an estimate of fair value is not possible for plan asset the reason why this
is the case must be disclosed.
Securities that have a fixed redemption value and that have been acquired to
match the obligations of the plan may be carried at amounts based on their
ultimate redemption value assuming a constant rate of return to maturity
(amortised cost).
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6.4 Defined Contribution Plans

Objective of report
The reporting objective is to provide information about the plan and the
performance of its investments.

The participants are interested in

x the activities of the plan because they directly affect the level of future

benefits; and
x knowing whether contributions have been received and proper control

has been exercised to protect the rights of beneficiaries.

An employer is interested in the efficient and fair operation of the plan.

The reporting objective is usually achieved by providing a report including:

a description of significant activities for the period and the effect of any
changes relating to the plan, and its membership and terms and conditions;

statements reporting on the transactions and investment performance for

the period and the financial position of the plan at the end of the period; and

a description of the investment policies.

Requirement
The report of a defined contribution plan must contain:

a statement of net assets available for benefits; and

a description of the funding policy.

6.5 Defined Benefit Plans

Objective of report
The reporting objective is to provide information about the financial resources
and activities of the plan that is useful in assessing the relationships between the
accumulation of resources and plan benefits over time.
This is usually achieved by providing a report including the following:

a description of significant activities for the period and the effect of any
changes relating to the plan, and its membership and terms and conditions;

statements reporting on the transactions and investment performance for

the period and the financial position of the plan at the end of the period;

actuarial information either as part of the statements or by way of a

separate report; and

a description of the investment policies.

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Requirement
The report must contain either:

a statement that shows:

x the net assets available for benefits;
x the actuarial present value of promised retirement benefits,

distinguishing between vested benefits and non-vested benefits; and

x the resulting excess or deficit; or

a statement of net assets available for benefits including either:

x a note disclosing the actuarial present value of promised retirement

benefits, distinguishing between vested benefits and non-vested

benefits; or
x a reference to this information in an accompanying actuarial report.

The report should explain:

the relationship between the actuarial present value of promised retirement

benefits; and the net assets available for benefits; and

the policy for the funding of promised benefits.

If an actuarial valuation has not been prepared at the date of the report, the most
recent valuation is used as a base and the date of the valuation disclosed.
Actuarial Present Value of Promised Retirement Benefits
The actuarial present value of promised retirement benefits is based on the
benefits promised under the terms of the plan on service rendered to date using
either:

current salary levels; or

projected salary levels

6.6 Disclosure
Specific requirement
The report of a retirement benefit plan (defined benefit or defined contribution)
must contain the following information:

a statement of changes in net assets available for benefits;

a summary of significant accounting policies; and

a description of the plan and the effect of any changes in the plan during
the period.

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Guidance
Reports provided by retirement benefit plans include the following, if applicable:

a statement of net assets available for benefits disclosing:

x assets at the end of the period suitably classified;
x the basis of valuation of assets;
x details of any single investment exceeding either 5% of the net assets

available for benefits or 5% of any class or type of security;

x details of any investment in the employer; and
x liabilities other than the actuarial present value of promised retirement

benefits;

a statement of changes in net assets available for benefits showing the

following:
x employer contributions;
x employee contributions;
x investment income such as interest and dividends;
x other income;
x benefits paid or payable (analysed, for example, as retirement, death

and disability benefits, and lump sum payments);

x administrative expenses;
x other expenses;
x taxes on income;
x profits and losses on disposal of investments and changes in value of

investments; and
x transfers from and to other plans;

a description of the funding policy;

For defined benefit plans:

the actuarial present value of promised retirement benefits (which may

distinguish between vested benefits and non-vested benefits) based on the
benefits promised under the terms of the plan on service rendered to date
using either:
x current salary levels; or
x projected salary levels;

a description of the significant actuarial assumptions made and the method

used to calculate the actuarial present value of promised retirement
benefits.

This information may be included in an accompanying actuarial report to be read

in conjunction with the related financial information.

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Description of the plan

A description of the plan must be provided either as part of the financial
information or in a separate report.
It may contain the following:

the names of the employers and the employee groups covered;

the number of participants receiving benefits and the number of other

participants, classified as appropriate;

the type of plan - defined contribution or defined benefit;

a note as to whether participants contribute to the plan;

a description of the retirement benefits promised to participants;

a description of any plan termination terms; and

changes in any of the above during the period covered by the report.

It is not uncommon to refer to other documents that are readily available to users
and in which the plan is described, and to include only information on subsequent
changes in the report.

6.7 Other statements

Net assets available for benefits
Illustration: Net assets available for benefits
Statement of net assets available for benefits as at XX/XX/XXXX
Rs. m
Investments
Cash at bank

Loan receivable from member

X
X

Payable to outgoing members

Audit fee payable

X
(X)

Net assets

Represented by:
Members account

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Changes in net assets

Illustration: Changes in net assets
Statement of changes in net assets available for benefits for the year
XX/XX/XXXX
Rs. m
Contribution during the year

Net income for the year

X
X

Less:

Paid to outgoing members

Permanent withdrawals

X
(X)

Increase in net assets during the year

Net assets at the beginning of the year

X
X

Net assets at the end of the year

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

33

International public sector

accounting standards (IPSAS)
Contents
1 Overview of international public sector accounting
standards
2 The conceptual framework for general purpose
financial reporting by public sector entities
3 IPSAS 1: Presentation of financial statements
4 Financial reporting under the cash basis of accounting

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with international

pronouncements and under the Companies Ordinance, 1984.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A 11

Overview of IPSASs and the conceptual framework for general purpose

financial reporting by public sector entities

A 12

IPSAS 1 Presentation of financial statements

A 13

IPSAS Financial reporting under the cash basis of accounting (this IPSAS has
not been given any number).

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OVERVIEW OF INTERNATIONAL PUBLIC SECTOR ACCOUNTING

STANDARDS
Section overview

International federation of accountants (IFAC)

International Public Sector Accounting Standards Board (IPSASB)

Scope of IPSAS

Authority of IPSAS

1.1 International federation of accountants (IFAC)

IFAC is the global organisation for the accountancy profession. It is dedicated to
serving the public interest by strengthening the profession and contributing to the
development of strong international economies.
IFAC is comprised of over 175 members and associates in 130 countries and
jurisdictions, representing approximately 2.84 million accountants in public
practice, education, government service, industry, and commerce.
As part of its public interest mandate, IFAC contributes to the development,
adoption, and implementation of high-quality international public sector
accounting standards through its support of the International Public Sector
Accounting Standards Board (IPSASB).

1.2 International Public Sector Accounting Standards Board (IPSASB)

The IPSASBs objective is to serve the public interest by developing high quality
accounting standards and other publications for use by public sector entities
around the world in the preparation of general purpose financial reports with the
aim of enhancing the quality, consistency, and transparency of public sector
financial reporting worldwide.
Definitions
Public sector: National governments, regional (e.g., state, provincial,
territorial) governments, local (e.g., city, town) governments and related
governmental entities (e.g., agencies, boards, commissions and enterprises).
General purpose financial reports: Financial reports intended to meet the
information needs of users who are unable to require the preparation of
financial reports tailored to meet their specific information needs
In fulfilling its objective, the IPSASB develops and issues the following
publications:

International Public Sector Accounting Standards (IPSAS) as the standards

to be applied in the preparation of general purpose financial reports of
public sector entities other than government business enterprises (see
below).

Recommended Practice Guidelines (RPGs) to provide guidance on good

practice that public sector entities are encouraged to follow.

Studies to provide advice on financial reporting issues in the public sector.

They are based on study of the good practices and most effective methods
for dealing with the issues being addressed.

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Other papers and research reports to provide information that contributes to

the body of knowledge about public sector financial reporting issues and
developments. They are aimed at providing new information or fresh
insights and generally result from research activities such as: literature
searches, questionnaire surveys, interviews, experiments, case studies and
analysis.

Due process
The IPSASB issues exposure drafts of all proposed IPSAS and RPGs for public
comment. In some cases, the IPSASB may also issue a Consultation Paper prior
to the development of an exposure draft.
This provides an opportunity for those affected by IPSASB pronouncements to
provide input and present their views before the pronouncements are finalised
and approved.
In developing its pronouncements, the IPSASB seeks input from its consultative
group and considers and makes use of pronouncements issued by:

The International Accounting Standards Board (IASB) to the extent they are
applicable to the public sector;

National standard setters, regulatory authorities and other authoritative

bodies;

Professional accounting bodies; and

Other organisations interested in financial reporting in the public sector.

The IPSASB works to ensure that its pronouncements are consistent with those
of IASB to the extent those pronouncements are applicable and appropriate to
the public sector.

1.3 Scope of IPSAS

As stated above IPSAS set out requirements dealing with transactions and other
events in general purpose financial reports.
The IPSAS are designed to apply to the general purpose financial reports of all
public sector entities other than government business enterprises GBEs.
Definition
Government business enterprise: An entity that has all the following
characteristics:
a)

is an entity with the power to contract in its own name;

b)

has been assigned the financial and operational authority to carry on a

business;

c)

sells goods and services, in the normal course of its business, to other
entities at a profit or full cost recovery;

d)

is not reliant on continuing government funding to be a going concern

(other than purchases of outputs at arms length); and

e)

is controlled by a public sector entity.

GBEs exist for a profit motive so should apply IFRS rather than IPSAS.

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The IPSASB issues IPSAS dealing with financial reporting under the cash basis
of accounting and the accrual basis of accounting. The IPSASB has also issued
a comprehensive Cash Basis IPSAS that includes mandatory and encouraged
disclosures sections. This is covered in a later section.
Accruals based IPSAS
The IPSASB has published many accrual based IPSAS that are based very
closely on the equivalent IFRS. The IPSASB attempts, wherever possible, to
maintain the accounting treatment and original text of the IFRSs unless there is a
significant public sector issue which warrants a departure.
The IPSASB has also published accrual based IPSAS that deal with public sector
financial reporting issues that are not addressed by IFRS.
The following table lists the accruals based IPSAS.
IPSAS

IFRS equivalent

IPSAS 1: Presentation of financial statements

IAS 1

IPSAS 2: Cash flow statements

IAS 7

IPSAS 3: Accounting policies, changes in accounting

estimates and errors

IAS 8

IPSAS 4: The effects of changes in foreign exchange

IAS 21

IPSAS 5: Borrowing costs

IAS 23

IPSAS 6: Consolidated and separate financial statements

IAS 27

IPSAS 7: Investments in associates

IFRS 28

IPSAS 8: Interests in joint ventures

IAS 31 (now
superseded)

IPSAS 9: Revenue from exchange transactions

IAS 18

IPSAS 10: Financial reporting in hyperinflationary

economies

IAS 29

IPSAS 11: Construction contracts

IAS 11

IPSAS 12: Inventories

IAS 2

IPSAS 13: Leases

IAS 17

IPSAS 14: Events after the reporting date

IAS 10

IPSAS 15: Financial instruments: disclosure and

presentation

IAS 32

IPSAS 16: Investment property

IAS 40

IPSAS 17: Property, plant, and equipment

IAS 16

IPSAS 18: Segment reporting

IFRS 8

IPSAS 19: Provisions, contingent liabilities and contingent

assets

IAS 37

IPSAS 20: Related party disclosures

IAS 24

IPSAS 21: Impairment of non-cash-generating assets

None

IPSAS 22: Disclosure of information about the general

government sector

None

IPSAS 23: Revenue from non-exchange transactions

(taxes and transfers)

None

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IPSAS

IFRS equivalent

IPSAS 24: Presentation of budget information in financial

statements

None

IPSAS 25: Employee benefits

IAS 19

IPSAS 26: Impairment of cash-generating assets

IAS 36

IPSAS 27: Agriculture

IAS 41

IPSAS 28: Financial instruments: presentation

IAS 32

IPSAS 29: Financial instruments: recognition and

measurement

IAS 39

IPSAS 30: Financial instruments: disclosures

IFRS 7

IPSAS 31: Intangible assets

IAS 38

IPSAS 32: Service concession arrangements

SIC 12

IPSAS 33: First time adoption of accruals basis

none

IPSAS 34: Separate financial statements

IAS 27 (revised)

IPSAS 35: Consolidated financial statements

IFRS 10

IPSAS 36: Investments in associates and joint ventures

IAS 28 (revised)

IPSAS 37: Joint arrangements

IFRS 11

IPSAS 38: Disclosure of interests in other entities

IFRS 12

Financial statements should be described as complying with IPSAS only if they

comply with all the requirements of each applicable IPSAS.

1.4 Authority of IPSAS

The IPSASB does not have the power to require compliance with IPSAS.
However, the IPSASB strongly encourages governments and national standardsetters to adopt IPSAS in order to both the quality and comparability of financial
information reported by public sector entities around the world.
IPSAS has been adopted in many jurisdictions. In Pakistan, the federal
government, all provincial governments, and district governments present their
annual financial statements on the cash-basis IPSAS.
IPSAS has also been adopted and by many supranational organisations
including:

ASEAN (Association of South-East Asian Nations);

Commonwealth Secretariat;

Council of Europe;

EC (European Commission);

Organisation for Economic Cooperation and Development (the first body in

the world to produce financial statements compliant with IPSAS in 2000).

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THE CONCEPTUAL FRAMEWORK FOR GENERAL PURPOSE FINANCIAL

REPORTING BY PUBLIC SECTOR ENTITIES
Section overview

Introduction

Chapter 1 The role and authority of the conceptual framework.

Chapter 2 Objectives and users of general purpose financial reporting.

Chapter 3 Qualitative characteristics of financial information.

Chapter 4 Reporting entity.

Chapter 5 Elements in financial statements.

Chapter 6 Recognition of the elements of financial statements.

Chapter 7 Measurement of assets and liabilities in financial statements.

Chapter 8 Presentation in general purpose financial statements

2.1 Introduction
A conceptual framework is a system of concepts and principles that underpin the
preparation of financial statements. These concepts and principles should be
consistent with one another.
The IPSASB have published a conceptual framework called The conceptual
framework for general purpose financial reporting (GPFRs) by public sector
entities.
This deals with concepts that apply to general purpose financial reporting
(financial reporting) under the accrual basis of accounting.
This is made up of the following chapters:

Chapter 1 The role and authority of the conceptual framework.

Chapter 2 Objectives and users of general purpose financial reporting.

Chapter 3 Qualitative characteristics of financial information.

Chapter 4 Reporting entity.

Chapter 5 Elements in financial statements.

Chapter 6 Recognition of the elements of financial statements.

Chapter 7 Measurement of assets and liabilities in financial statements.

Chapter 8 Presentation in general purpose financial statements

2.2 Chapter 1 The role and authority of the conceptual framework.

The Conceptual Framework establishes the concepts that underpin general
purpose financial reporting (financial reporting) by public sector entities using the
accrual basis of accounting when preparing and presenting general purpose
financial reports.
The Conceptual Framework does not contain authoritative requirements that
must be followed nor does it override the requirements of IPSAS or RPGs.
However, it might be useful in providing guidance on accounting for issues not
dealt with by IPSAS or RPGs. In these circumstances,

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2.3 Chapter 2 Objectives and users of general purpose financial reporting.

The objective
Financial reporting is not an end in itself.
The objectives of financial reporting by public sector entities are to provide
information about the entity that is useful to users of GPFRs for accountability
purposes and for decision-making purposes.
Users
Governments and other public sector entities raise resources from taxpayers,
donors, lenders and other resource providers for use in the provision of services
to citizens and other service recipients.
These entities are accountable for their management and use of resources to
those that provide them with resources, and to those that depend on them to use
those resources to deliver necessary services.
Therefore, GPFRs of public sector entities are developed primarily to respond to
the information needs of service recipients and resource providers who do not
possess the authority to require tailored information.
Taxpayers do not provide funds on a voluntary basis so it might seem that they
have little influence and therefore no need for information but the information
provided about the use of the resources can inform voting decisions.
Information is needed to allow the assessments of such matters as:

the performance of the entity during the reporting period in, for example:
x

meeting its service delivery and other operating and financial

objectives;

managing the resources it is responsible for; and

complying with relevant budgetary, legislative, and other authority

regulating the raising and use of resources;

the entitys liquidity; and

the sustainability of the entitys service delivery.

Information provided by general purpose financial reports might include

financial position, financial performance and cash flows:

budget information and compliance with legislation or other authority

governing the raising and use of resources; and

service delivery achievements.

2.4 Chapter 3 Qualitative characteristics of financial information.

GPFRs present financial and non-financial information about economic and other
phenomena.
The qualitative characteristics of information are the attributes that make that
information useful for accountability and decision-making purposes.

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The qualitative characteristics of information included in GPFRs of public sector

entities are:

relevance;

faithful representation;

understandability;

timeliness;

comparability; and

verifiability.

Pervasive constraints on information provided are materiality, cost vs benefit, and

achieving an appropriate balance between the qualitative characteristics.

2.5 Chapter 4 Reporting entity.

A public sector reporting entity is a government or other public sector
organisation, program or identifiable area of activity that prepares GPFRs.
Key characteristics of a reporting entity are that:

it raises resources from (or for) constituents and/or uses resources to

undertake activities for the benefit of those constituents; and

there are service recipients or resource providers dependent on GPFRs of

the entity for information for accountability or decision-making purposes.

2.6 Chapter 5 Elements in financial statements.

Financial statements portray the financial effects of transactions and other events
by grouping them into broad classes which share common economic
characteristics. These broad classes are termed the elements of financial
statements.
Element

Definition

An asset

A resource presently controlled by the entity as a result of a

past event.

A liability

A present obligation of the entity for an outflow of resources

that results from a past event.

Revenue

Increases in the net financial position of the entity, other

than increases arising from ownership contributions.

Expense

Decreases in the net financial position of the entity, other

than decreases arising from ownership distributions.

Ownership
contributions

Inflows of resources to an entity, contributed by external

parties in their capacity as owners, which establish or
increase an interest in the net financial position of the entity.

Ownership
distributions

Outflows of resources from the entity, distributed to external

parties in their capacity as owners, which return or reduce
an interest in the net financial position of the entity.

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2.7 Chapter 6 Recognition of the elements of financial statements.

The recognition criteria for an item are that:

it satisfies the definition of an element; and

it can be measured in a way that achieves the qualitative characteristics

taking account of constraints on information.

2.8 Chapter 7 Measurement of assets and liabilities in financial statements.

Measurement bases should be chosen to fairly reflect the cost of services,
operational capacity and financial capacity of the entity in a manner that is useful
in holding the entity to account, and for decision-making purposes.
The measurement basis chosen should enable users to assess:

the cost of services provided in the period in historical or current terms;

operational capacity (the capacity of the entity to support the provision of

services in future periods through physical and other resources); and

financial capacity (the capacity of the entity to fund its activities).

It is not possible to identify a single measurement basis that meets the above
requirements:
Any of the following bases might be used depending on circumstance:

historical cost;

market value;

replacement cost;

net selling price; and

value in use.

2.9 Chapter 8 Presentation in general purpose financial statements

Presentation involves the selection, location and organisation of information that
is reported in the GPFRs.
Presentation aims to provide information that contributes towards the objectives
of financial reporting and achieves the qualitative characteristics while taking into
account the constraints on information included in GPFRs.

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IPSAS 1: PRESENTATION OF FINANCIAL STATEMENTS

Section overview

General requirements

Structure and content

3.1 General requirements

IPSAS 1 is based very closely on IAS 1 with many paragraphs being identical
apart from changes to reflect public sector terminology and changes to
references from IFRS to IPSAS.
Objective
The objective of IPSAS 1 is to prescribe the basis for presentation of general
purpose financial statements, to ensure comparability both with the entity's
financial statements of previous periods and with the financial statements of other
entities
Scope
IPSAS 1 must be applied to all general purpose financial statements prepared
and presented under the accrual basis of accounting in accordance with IPSAS.
Components
A complete set of financial statements comprises:

statement of financial position;

statement of financial performance;

statement of changes in net assets/equity;

cash flow statement (IPSAS 2 not in this syllabus);

a comparison of budget and accrual amounts when the entity makes its
approved budget publicly available; and

notes, comprising a summary of significant accounting policies and other

explanatory notes.

Comparative information must be disclosed for all amounts unless IPSAS permits
or requires otherwise.
Overall consideration
The standard describes the following overall considerations when presenting
financial statements:

fair presentation and compliance with IPSAS;

going concern;

consistency of presentation;

materiality and aggregation; and

offset.

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Fair presentation and compliance with IPSAS;

Fair presentation requires the faithful representation of the effects of transactions,
other events, and conditions in accordance with the definitions and recognition
criteria set out in IPSAS.
The application of IPSAS, with additional disclosures when necessary, is
presumed to result in fair presentation.
An entity whose financial statements comply with all the requirements of IPSAS
must make an explicit and unreserved statement of such compliance in the
notes.
Financial statements must generally be prepared annually. Disclosure is required
if the date of the year-end changes, and financial statements are presented for a
period other than one year.

3.2 Structure and content

Statement of financial position (balance sheet)
IPSAS 1 requires an entity to present current and non-current assets, and current
and non-current liabilities, as separate classifications on the face of its statement
of financial position unless a liquidity presentation provides more relevant and
reliable information. In such cases, all assets and liabilities must be presented
broadly in order of liquidity.
Some items may be presented using a current/non-current distinction and others
in order of liquidity if this provides information that is more relevant and reliable.
Whichever method of presentation is adopted an entity must disclose the amount
expected to be recovered or settled after more than twelve months for each asset
and liability line item that combines current and non-current amounts.
IPSAS 1 provides a list of items that, as a minimum, must be shown on the face
of the statement of financial position as a line item (in other words, on a
separate line in the statement):
Additional line items should be included in the statement of financial position
when presenting them separately and is relevant to an understanding of the
entitys financial position.
Statement of financial performance (income statement)
All items of revenue and expense recognised in a period must be included in
surplus or deficit unless IPSAS requires otherwise.
The minimum line items that should be included on the face of the statement of
financial performance are:

revenue;

finance costs;

share of the surplus or deficit of associates and joint ventures accounted for
using the equity method;

pre-tax gain or loss recognised on the disposal of assets or settlement of

liabilities attributable to discontinued operations;

surplus or deficit for the period;

Additional line items may be needed to achieve fair presentation of an entity's

financial performance.

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The surplus or deficit attributable to minority interests (non-controlling interests)

and that attributable to the owners of the controlling entity must also be disclosed
in the statement of financial performance as allocations for the period.
When items of revenue and expense are material, their nature and amount must
be disclosed separately
Expenses should be analysed either by nature or by function.
Statement of changes in net assets (equity)
A statement of changes in net assets/equity must be presented showing:

Surplus or deficit for the period;

Each item of revenue and expense for the period that is recognised directly
in net assets/equity, and the total of these items;

The total revenue and expense for the period (calculated as the sum of the
above);

For each component of net assets/equity the effects of changes in

accounting policies and corrections of errors.

The following must be disclosed either on the face of the statement of changes in
net assets/equity or in the notes:

amounts of transactions with owners acting in their capacity as owners,

showing separately distributions to owners;

the balance of accumulated surpluses or deficits at the beginning of the

period and at the reporting date, and the changes during the period; and

reconciliations of the carrying amount of each component of net

assets/equity from the beginning to the end of the period.

Notes
The requirements are very similar to those set out in IAS 1 and are not repeated
here.

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FINANCIAL REPORTING UNDER THE CASH BASIS OF ACCOUNTING

Section overview

Introduction
Financial statements

Accounting policies and explanatory notes

Budget comparison

4.1 Introduction
The cash basis of accounting recognises transactions and events only when
cash (including cash equivalents) is received or paid by the entity.
Objective
This standard prescribes the manner in which general purpose financial
statements should be presented under the cash basis of accounting.
The standard is comprised of two parts:

Part 1 is mandatory and sets out the requirements which are applicable to
all entities preparing general purpose financial statements under the cash
basis of accounting.

Part 2 is not mandatory but identifies additional accounting policies and

disclosures that an entity is encouraged to adopt to enhance its financial
accountability and the transparency of its financial statements.

Scope
An entity which prepares and presents financial statements under the cash basis
of accounting should apply the requirements of part 1 of the standard.
Compliance with part 1 of the standard should be disclosed.
The rules apply both to financial statements of an individual entity and to
consolidated financial statements.
The standard does not apply to government business enterprises.

4.2 Financial statements

Financial statements under the cash basis consist of the following components:

statement of cash receipts and payments;

accounting policies and explanatory notes; and

comparison of original budget, revised budget, and actual amounts on a

comparable basis (only when the entity makes publicly available its
approved budget).

Information to be presented in the statement of cash receipts and payments

The statement of cash receipts and payments should present the following
amounts for the reporting period:

total cash receipts showing separately a sub-classification of total cash

receipts using a classification basis appropriate to the entitys operations;

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total cash payments showing separately a sub-classification of total cash

payments using a classification basis appropriate to the entitys operations;
and

opening and closing cash balances.

Total cash receipts and total cash payments should be reported on a gross basis.
However, they may be reported on a net basis when:

they arise from transactions administered on behalf of other parties; or

they are for items in which the turnover is quick, the amounts are large, and
the maturities are short.

Payments made by a third party on behalf of the entity should be disclosed in

separate columns on the face of the statement of cash receipts and payments:

4.3 Accounting policies and explanatory notes

Financial statements prepared under the cash basis provide readers with
information about the sources of cash raised during the period, the purposes for
which cash was used and the cash balances at the reporting date.
The measurement focus in the financial statements is balances of cash and
changes therein. Notes to the financial statements may provide additional
information about liabilities, such as payables and borrowings, and some noncash assets, such as receivables, investments and property, plant and
equipment.
The notes to the financial statements of an entity should:

present information about the basis of preparation of the financial

statements and the specific accounting policies selected and applied for
significant transactions and other events; and

provide additional information which is not presented on the face of the

financial statements but is necessary for a fair presentation of the entitys
cash receipts, cash payments and cash balances.

Notes to the financial statements should be presented in a systematic manner.

Each item on the face of the statement of cash receipts and payments and other
financial statements should be cross referenced to any related information in the
notes.
General disclosures
Financial statements must generally be prepared annually. Disclosure is required
if the date of the year-end changes, and financial statements are presented for a
period other than one year.
An entity should disclose the date when the financial statements were authorised
for issue and who gave that authorisation.
Comparative information should be disclosed for all numerical information
required.
The presentation and classification of items in the financial statements should be
retained from one period to the next.
An entity should disclose information on any restrictions on the use of cash
balances and undrawn borrowing facilities.
An entity should disclose the following:

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the domicile and legal form of the entity, and the jurisdiction within which it
operates;

a description of the nature of the entitys operations and principal activities;

a reference to the relevant legislation governing the entitys operations, if

any; and

the name of the controlling entity and the ultimate controlling entity of the
economic entity (where applicable, if any).

The financial statements should be clearly identified and distinguished from other
information in the same published document.
Foreign currency
Cash receipts and payments arising from transactions in a foreign currency
should be recorded using the exchange rate at the date of the receipts and
payments.
Cash balances held in a foreign currency should be reported using the closing
rate.

4.4 Budget comparison

If an entity makes its approved budget publicly available it must present a
comparison of the budget amounts for which it is held publicly accountable and
actual amounts.
This could be presented either as a separate additional financial statement or
using additional budget columns in the statement of cash receipts and payments.

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

34

Accounting for hyperinflation

Contents
1 IAS 29: Financial reporting in hyperinflationary
economies
2 Restatement of historical cost financial statements
3 Restatement of current cost financial statements
4 Other issues
5 IFRIC 7: Applying the restatement approach under
IAS 29

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 1

Prepare financial statements in accordance with international

pronouncements and under the Companies Ordinance, 1984.

PRESENTATION OF FINANCIAL STATEMENTS INCLUDING PUBLIC SECTOR

ACCOUNTING
A8

IAS 29: Financial Reporting in Hyperinflationary Economies

FINANCIAL REPORTING AND ETHICS

Financial reporting
B(a) 51

IFRIC 07: Applying the Restatement Approach under IAS 29 Financial

Reporting in Hyperinflationary Economies

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IAS 29: FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES

Section overview

Introduction

Scope

IAS 29 requirements

1.1 Introduction
Primary financial statements are normally prepared on the historical cost basis
without taking into account:

changes in the general level of prices or

changes in specific prices of assets held (except to the extent that property,
plant and equipment and investments may be revalued).

Some entities may present primary financial statements prepared on a current

cost basis. Current cost accounts reflect the effects of specific price changes on
the financial statements of the entity. They do not reflect the general rate of
inflation.
The accounting problem
In a hyperinflationary economy money loses purchasing power at such a rate that
comparison of amounts from transactions occurring at different times (even within
the same accounting period) is misleading.
Reporting operating results and financial position in a hyperinflationary economy
is not useful without restatement.
What is hyperinflation?
IAS 29 does not establish an absolute rate at which hyperinflation is deemed to
arise.
Features of a hyperinflationary economy include (but are not limited to) the
following:

the general population prefers to keep its wealth in non-monetary assets or

in a relatively stable foreign currency. Amounts of local currency held are
immediately invested to maintain purchasing power;

the general population regards monetary amounts not in terms of the local
currency but in terms of a relatively stable foreign currency. Prices may be
quoted in that currency;

sales and purchases on credit take place at prices that compensate for the
expected loss of purchasing power during the credit period, even if the
period is short;

interest rates, wages and prices are linked to a price index; and

the cumulative inflation rate over three years is approaching, or exceeds,

100%.

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It is a matter of judgement when restatement of financial statements in

accordance with this standard becomes necessary.

1.2 Scope
IAS 29 must be applied to the primary financial statements (including the
consolidated financial statements) of any entity whose functional currency is the
currency of a hyperinflationary economy.
IAS 29 applies from the beginning of the reporting period in which an entity
identifies the existence of hyperinflation in the country in whose currency it
reports.

1.3 IAS 29 requirements

The financial statements of an entity that reports in the currency of a hyperinflationary economy must be stated in terms of the measuring unit current at the
statement of financial position date.
This applies to both:

historical cost accounts; and,

current cost accounts.

Comparatives should be restated in terms of the measuring unit current at the

statement of financial position date.
The gain or loss on the net monetary position should be included in net income
and separately disclosed.
It is not permitted to present the required information as a supplement to financial
statements that have not been restated. Also, separate presentation of the
financial statements before restatement is discouraged.

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RESTATEMENT OF HISTORICAL COST FINANCIAL STATEMENTS

Section overview

Statement of financial position

Non-monetary items

Equity balances

Statement of profit or loss

Gain or loss on net monetary position

2.1 Statement of financial position

All balances must be stated in terms of the measuring unit current at the
statement of financial position date.
Not restated
Monetary items No restatement is necessary as monetary items are already
expressed in terms of the monetary unit current at the statement of financial
position date.
Index linked assets and liabilities The carrying value of these items will already
have been adjusted for inflation. Such items are carried at the adjusted amount in
the restated statement of financial position.
All other assets and liabilities are non-monetary.

2.2 Non-monetary items

Some non-monetary items will already be carried at the amount current at the
statement of financial position date (eg net realisable value or market value).
These are not restated.
All other non-monetary assets and liabilities are restated. There is a different
treatment for items carried at cost and those not carried at cost.
Non-monetary items carried at cost (or cost less depreciation)
The restated cost (or cost less depreciation) is determined by applying the
change in a general price index from the date of acquisition to the statement of
financial position date. Both the cost and the accumulated depreciation will be
restated. Thus the following are restated from the date of purchase:

property, plant and equipment;

investments;

inventories of raw materials and merchandise;

goodwill; and

patents, trademarks and similar assets.

Inventories of partly-finished and finished goods are restated from the dates on
which the costs of purchase and of conversion were incurred.

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Non monetary items carried at amounts other than cost

Revalued items will be indexed from the date of revaluation. No asset must be
valued in excess of its recoverable amount.
Equity accounted investments
Sometimes an entity may hold an investment in another entity that is accounted
for under the equity method and whose functional currency is that of a
hyperinflationary economy.
In these cases the statement of financial position and statement of profit or loss
of the investee must be restated in accordance with this standard before applying
the equity method.
Where the restated financial statements of the investee are expressed in a
foreign currency they are translated at closing rates.

2.3 Equity balances

At the beginning of the first period of application of this standard:

The components of owners' equity (except retained earnings and any

revaluation surplus) are restated by applying a general price index from the
dates the components were contributed/arose.

Any revaluation surplus that arose in previous periods is eliminated.

Restated retained earnings are derived from all the other amounts in the
restated statement of financial position.

At the end of the first period and in subsequent periods, all components of
owners' equity are restated by applying a general price index from the beginning
of the period (or the date of contribution, if later).
Practical problems
If detailed records of the date and cost of acquisition of property, plant and
equipment are not available, then an independent professional assessment can
be made of the items value in the first period of restatement.
If a general price index is not available for the whole period (or periods) required
then an estimated index can be used. This could be based on, say, movements
in the exchange rate between the local currency and a relatively stable foreign
currency.

2.4 Statement of profit or loss

The statement of profit or loss must be expressed in terms of the measuring unit
current at the reporting date.
All items in the statement of profit or loss will be restated by applying the change
in the general price index from the dates when the items of income and expenses
occurred and the reporting date.

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2.5 Gain or loss on net monetary position

During a period of inflation an entity will:

suffer a loss if it holds net monetary assets during a period of inflation

because the purchasing power of those assets will be eroded.

make a gain if it holds net monetary liabilities because the burden of the
liabilities is reduced by inflation.

This gain or loss on the net monetary position may be derived as the difference
resulting from the restatement of non-monetary assets, owners' equity and
statement of profit or loss items and the adjustment of index linked assets and
liabilities.
The gain or loss may be estimated by applying the change in a general price
index to the weighted average for the period of the difference between monetary
assets and monetary liabilities.

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RESTATEMENT OF CURRENT COST FINANCIAL STATEMENTS

Section overview

Statement of financial position

Statement of profit or loss

Gain or loss on net monetary position

3.1 Statement of financial position

Items stated at current cost are not restated because they are already expressed
in terms of the measuring unit current at the statement of financial position date.
Other items in the statement of financial position are restated.

3.2 Statement of profit or loss

The current cost statement of profit or loss, before restatement, generally reports
costs current at the time at which the underlying transactions or events occurred.
Cost of sales and depreciation are recorded at current costs at the time of
consumption;
Sales and other expenses are recorded at their money amounts when they
occurred.
All amounts need to be restated into the measuring unit current at the statement
of financial position date by applying a general price index.

3.3 Gain or loss on net monetary position

The gain or loss on the net monetary position is credited or charged to the
statement of profit or loss.

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OTHER ISSUES
Section overview

Cash flow statement

Corresponding figures

Consolidated financial statements

Economies ceasing to be hyperinflationary

Disclosures

4.1 Cash flow statement

All items in the cash flow statement must be expressed in terms of the measuring
unit current at the statement of financial position date.

4.2 Corresponding figures

Corresponding figures for the previous reporting period must be restated by
applying a general price index so that the comparative financial statements are
presented in terms of the measuring unit current at the end of the reporting
period.
Information that is disclosed in respect of earlier periods must also be expressed
in terms of the measuring unit current at the end of the reporting period.
This applies to financial statements based on a historical cost approach and on a
current cost approach.

4.3 Consolidated financial statements

A parent that reports in the currency of a hyperinflationary economy may have
subsidiaries that also report in the currencies of hyperinflationary economies.
The financial statements of any such subsidiary must be restated by applying a
general price index of the country in whose currency it reports before they are
included in the consolidated financial statements issued by its parent.
If the subsidiary is a foreign subsidiary, its restated financial statements are
translated at closing rates.
If financial statements with different reporting dates are consolidated, all items,
whether non-monetary or monetary, need to be restated into the measuring unit
current at the date of the consolidated financial statements.

4.4 Economies ceasing to be hyperinflationary

When an economy ceases to be hyperinflationary, an entity will discontinue the
preparation and presentation of financial statements prepared in accordance with
IAS 29.
The amounts expressed in the measuring unit current at the end of the previous
reporting period are used as the basis for the carrying amounts in subsequent
financial statements.

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4.5 Disclosures
An entity must disclose the following:

the fact that the financial statements and the corresponding figures for
previous periods have been restated for the changes in the general
purchasing power of the functional currency and, as a result, are stated in
terms of the measuring unit current at the statement of financial position
date;

whether the financial statements are based on a historical cost approach or

a current cost approach; and

the identity and level of the price index at the statement of financial position
date and the movement in the index during the current and the previous
reporting period.

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IFRIC 7: APPLYING THE RESTATEMENT APPROACH UNDER IAS 29

Section overview

IFRIC 7: Applying the restatement approach under IAS 29

Deferred taxation

5.1 IFRIC 7: Applying the restatement approach under IAS 29

In the period in which an entity first identifies the existence of hyperinflation in the
economy of its functional currency, it must apply the requirements of IAS 29 as if
the economy had always been hyperinflationary.
This means that non-monetary items in the opening statement of financial
position at the beginning of the earliest period presented must be restated to
reflect the effect of inflation.

Non-monetary amounts carried at historical cost are restated to reflect

inflation form the date of recognition up to the date of the opening
statement of financial position.

Non-monetary amounts carried at revalued amounts are restated to reflect

inflation form the date of revaluation up to the date of the opening
statement of financial position.

Example: Restatement
Extracts of X Limiteds IFRS statement of financial position at 31 December 2015
(before restatement) are as follows:

Non-current assets

2015
Rs. m

2014
Rs. m

300

400

All non-current assets were bought in 2013 (i.e. before that start of the
comparative period).
X Limited identified that its functional currency was hyperinflationary in
2015.
X Limited has identified the following price indices and constructed the
following conversion factors:
Price indices
2015

223

2013

95

2015 conversion factor

(2013 prices to 2015 prices)

= 223/95 =2.347

This conversion factor must be applied to non-current assets from the

2015 and 2014 financial statements to rebase the figure in terms of
2015 prices.

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This results in the following restated amounts:

2015

2014

Rs. m

Rs. m

704

939

Non-current assets
300 u 2.347 and 400 u 2.347

5.2 Deferred taxation

Deferred tax is calculated by applying the rules in IAS 12 to the restated
balances.
The comparative deferred tax balance is based on the figure that would have
been in last years restated financials adjusted for this years price movement.
Example: Restatement deferred tax
Extracts of X Limiteds IFRS statement of financial position at 31 December 2015
(before restatement) are as follows:

Non-current assets
Deferred tax liability

2015

2014

Rs. m

Rs. m

300

400

30

20

All non-current assets were bought in 2013 (i.e. before that start of the
comparative period).
The deferred tax liability was calculated as follows
2015

2014

Rs. m

Rs. m

Non-current assets

300

400

Tax base

200

333

Temporary difference

100

67

Tax rate

30%

30%

Deferred taxation

30

20

X Limited identified that its functional currency was hyperinflationary in

2015.
X Limited has identified the following price indices and constructed the
following conversion factors:
Price indices
2015

223

2014

135

2013

95

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The following conversion factors are required:

2015 conversion factor (1)
(2013 prices to 2015 prices)

= 223/95 =2.347

Used to restate non-current assets (as before)

2015 conversion factor (2)
(2014 prices to 2015 prices)

= 223/135 = 1.652

Used to restate the deferred tax balance that would have been measured
in 2014 if restated financial statements had been prepared into 2015
prices.
2014 conversion factor (3)
(2013 prices to 2014 prices)

= 135/95 =1.421

Used to restate non-current assets to 2014 prices in order to calculate

the deferred tax balance that would have been measured in 2014 if
restated financial statements had been prepared.
The 2015 conversion factor (1) is applied to non-current assets from the
2015 and 2014 financial statements to restate the figure in terms of
2015 prices (as before):
2015

2014

Rs. m

Rs. m

704

939

Non-current assets
300 u 2.347 and 400 u 2.347

The deferred tax liability as at 31 December 2015 is calculated as

follows:
2015
Rs. m
Non-current assets

704

Tax base

200

Temporary difference

504

Tax rate

30%

Deferred taxation

151

The 2015 comparative deferred tax liability is calculated as follows:

2014
4
Rs. m
Non-current assets (rebased to 2014 prices
using the 2014 conversion factor (3)
400 u 1.421

568

Tax base

333

Temporary difference

235

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Tax rate

30%

Deferred taxation

71

Rebase to 2015 prices using the 2015

conversion factor (2)

u 1.652

Tax at 30%

117

The restated deferred tax balances are as follows:

2015

2014

Rs. m

Rs. m

704

939

Non-current assets
300 u 2.347 and 400 u 2.347

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Certified Finance and Accounting Professional

Advanced accounting and financial reporting

35

Islamic accounting standards

Contents
1 Islamic accounting standards

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 4

Prepare financial statements of specialised entities (including small and

medium sized entities in accordance with the Companies Ordinance,
1984 and the applicable reporting framework, retirement benefit funds in
accordance with international pronouncements) and be able to
demonstrate an understanding of reporting requirements under the laws
specific to insurance, banking companies and mutual funds.

SPECIALISED FINANCIAL STATEMENTS

C6

Overview of Islamic accounting standards issued by ICAP

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ISLAMIC ACCOUNTING STANDARDS

Section overview

Introduction to Islamic finance

IFAS 1: Murabaha

IFAS 2: Ijarah

IFAS on profit and loss sharing deposits

1.1 Introduction to Islamic finance

Note that the Islamic Finance Resource is an excellent website full of useful
information and examples. It is recommended that you visit the site
(http://ifresource.com).
The main principles of Islamic finance are that:

Wealth must be generated from legitimate trade and asset-based

investment (the use of money for the purposes of making money is
expressly forbidden).

Investment should have a social and an ethical benefit to wider society

beyond pure return.

Risk should be shared.

Harmful activities (haram) should be avoided.

The intention is to avoid injustice, asymmetric risk and moral hazard (where the
party who causes a problem does not suffer its consequences) and unfair
enrichment at the expense of another party.
Permitted activities
Islamic banks are allowed to obtain their earnings through profit-sharing
investments or fee-based returns. If a loan is given for business purposes the
lender should take part in the risk. This usually involves the lender buying the
asset and then allowing a customer to use the asset for a fee.
Specific guidance
The following activities are prohibited:

Charging and receiving interest (riba).

x

Charging interest contradicts the principle that risk must be shared

and is also contrary to the ideas of partnership and justice.

Using money to make money is forbidden.

Investment in companies that have too much borrowing is also

prohibited. What constitutes too much borrowing is a matter for
interpretation but is typically defined as debt totalling more than 33%
of the stock market value over the last 12 months.

Investments in businesses involved in alcohol, gambling, or anything else

that the Shariah considers unlawful or undesirable (haram).

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Investments in transactions that involve speculation or extreme risk. (This is

seen as gambling).

Entering into contracts where there is uncertainty about the subject matter
and terms of contracts (This includes a prohibition on short selling, i.e.
selling something is not yet owned).

Financial institutions in Islamic countries face the problem of providing finance in

ways which do not contravene the injunctions of Shariah regarding riba or
interest.
There are a number of Shariah compliant financing methods which have become
widely used. The absence of guidance on how to account for these products has
led to diversity in practice thus reducing the usefulness of financial statements.
ICAP has produced several Islamic Financial Accounting Standards (IFAS) to
provide appropriate guidance with the aim of improving comparability of financial
statements.

1.2 IFAS 1: Murabaha

Introduction
The ideal mode of financing according to Shariah would be mudarabah or
musharakah.
Definitions
Mudaraba
Mudaraba is a partnership in profit whereby one party provides capital (rab al
maal) and the other party provides labour (mudarib).
In the context of lending, the bank provides capital and the customer provides
expertise to invest in a project. Profits generated are distributed according in a
predetermined ratio but cannot be guaranteed. The bank does not participate in
the management of the business. This is like the bank providing equity finance.
The project might make a loss. In this case the bank loses out. The customer
cannot be made to compensate the bank for this loss as that would be contrary
to the mutual sharing of risk.
Musharaka
Relationship established under a contract by the mutual consent of the parties
for sharing of profits and losses arising from a joint enterprise or venture.
This is a joint venture or investment partnership between two parties who both
provide capital towards the financing of new or established projects. Both parties
share the profits on a pre-agreed ratio, allowing managerial skills to be
remunerated, with losses being shared on the basis of equity participation.
It is difficult to use mudarabah and musharakah instruments in every type of
financing.
Murabaha may be used as a form of providing but should be restricted only to
those cases where the mudarabah and musharakah are not practicable.

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Murabaha
In traditional western finance a customer would borrow money from a bank in
order to finance activity, say the purchase of an asset. However, under Sharia the
bank cannot charge interest.
Murabaha is a form of trade credit for asset acquisition that avoids the payment
of interest. The bank buys the asset and then sells it on to the customer on a
deferred basis at a price that includes an agreed mark-up for profit. Payment can
be made by instalments but the mark-up is fixed in advance and cannot be
increased, even if there is a delay in payment.
Definition
Murabaha: Murabaha is a particular kind of sale where seller expressly mentions
the cost he has incurred on the commodities to be sold and sells it to another
person by adding some profit or mark-up thereon which is known to the buyer.
Thus, murabaha is a cost plus transaction where the seller expressly mentions
the cost of a commodity sold and sells it to another person by adding mutually
agreed profit thereon which can be either in lump-sum or through an agreed ratio
of profit to be charged over the cost.
Compliance with Sharia
A loan transaction is not made Shariah compliant by simply changing the term
interest in a contract to profit or mark-up. A murabaha transaction must satisfy
basic conditions as laid down in Shariah.
A Murabaha transaction is not valid under Shariah unless the subject of the
transaction is:

in existence; and

owned by the seller; and

in the physical or constructive possession of the seller.

The following conditions also apply:

The sale must be prompt and absolute. Thus a sale attributed to a future
date or a sale contingent on a future event is void.

The subject matter of sale must be a property of value and must be

specifically known and identified to the buyer.

The subject matter of sale cannot be a thing which is forbidden (Haram) by

Shariah.

There are further principles regarding deferred payment.

A sale in which the parties agree that the payment of price is deferred is
called a Bai'mu'ajjal.

Bai'mu'ajjal is valid if the price and due date of payment is fixed in an

unambiguous manner.

The due time of payment can be fixed either with reference to a particular
date, or by specifying a period of time, but it cannot be fixed with reference

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to a future event, the exact date of which is unknown or is uncertain. If the

time of payment is unknown or uncertain, the sale is void.

If a particular period (e.g. one month) is fixed for payment, the period is
deemed to start at the date of delivery unless the parties have agreed
otherwise.

A deferred price may be more than the cash price, but it must be fixed at
the time of sale.

Further comment on the structure of a Shariah compliant transaction

A bank may purchase the commodity and keep it in its own possession prior to
selling it or it could purchase the commodity through a third person appointed by
it as an agent.
A bank is also allowed to appoint the customer in the murabaha transaction as its
agent.
In this case the customer (who will eventually buy the commodity from the bank)
first purchases the commodity and takes possession of it on behalf of the bank
and then later buys it from the bank.
The following procedure can be used to accomplish a deal like the one above in a
way that is compliant with Shariah:

The client and the bank sign an agreement under which the bank promises
to sell and the client promises to buy commodity up to a maximum amount
of purchases at an agreed profit margin.

The bank appoints the client as his agent for purchasing the commodity on
its behalf.

The client purchases the commodity on behalf of the bank and takes its
possession as an agent of the bank.

The client informs the bank that the commodity has been purchased for the
bank and is in the clients possession. (The client is an agent of the bank
thus the bank has constructive possession of the commodity).

The client (at the same time) makes an offer to purchase the commodity
from the bank at the agreed profit margin referred to above.

The bank accepts the offer and raises an invoice for the sale. Ownership as
well as the risk of the commodity is transferred to the client.

Standard Accounting Practice

IFAS 1 applies to murabaha transactions undertaken by a bank in historical cost
financial statements.
Cost of inventories should comprise all costs of purchases and other costs
incurred in bringing the inventories to their present location and condition.
Inventories remaining unsold with the bank at the reporting date are inventories
of the bank and must be valued in accordance with IAS 2 and shown under other
assets.

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The information required by IAS 2 should be disclosed.

Murabaha receivables must be recorded at the invoiced amounts.
Purchases and sales and the resulting profit are accounted for at the conclusion
of a Murabaha transaction.
Profit on that portion of sales not due for payment should be deferred by debiting
to unearned murabaha income and crediting deferred murabaha income
which should be shown as a liability.

1.3 IFAS 2: Ijarah

Ijarah are leases that are Shariah compliant.
The objective of IFAS 2 is to prescribe the accounting treatment and required
disclosures for lessees and lessors in respect of ijarah.
IFAS 2 does not apply to:

lease agreements to explore for or use minerals, oil, natural gas and similar
non-regenerative resources;

licensing agreements for such items as motion picture films, video

recordings, plays, manuscripts, patents and copyrights;

lessors of investment property leased out under operating leases; and

lessors of biological assets leased out under operating leases.

Compliance with Sharia (the Shariah essentials)

The following characteristics are necessary for a lease to be compliant with
Shariah:

In Ijara/leasing, the asset that is the subject of the lease remains in the
ownership of the lessor and only its usufruct is transferred to the lessee.

Only owned assets can be leased out except that a lessee can effect a sublease with the express permission of the lessor.

Any asset that cannot be used without being consumed cannot be a leased
asset (e.g money, edibles, fuel, etc.).

Lease rentals do not become due and payable until the assets to be leased
are delivered to the lessee.

The lessor must retain title to the asset and bear all risks and rewards
pertaining to ownership during the entire term of the lease. However, the
lessee is responsible for any damage or loss caused to the leased asset
due to the fault or negligence of the lessee or from non-customary use of
the asset and is also responsible for all risks and consequences in relation
to third party liability, arising from or incidental to operation or use of the
leased assets.

The insurance of the leased asset should be in the name of lessor and the
cost of such insurance borne by him.

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A lease can be terminated before expiry of the term of the lease but only
with the mutual consent of the parties.

Either party can make a unilateral promise to buy/sell the assets upon
expiry of the term of lease, or earlier at a price and at such terms and
conditions as are agreed. However, the lease agreement cannot be
conditional upon such a sale nor can the lease agreement contain a term
agreeing to transfer of ownership at a future date.

The amount of rental must be agreed in advance in an unambiguous

manner either for the full term of the lease or for a specific period in
absolute terms.

A lease contract of is considered terminated if the leased asset ceases to

give the service for which it was rented.

Definitions
Ijarah is a form of lease finance agreement where a bank buys an asset for a
customer and then leases it to the customer over a specific period for agreed
rentals which allow the bank to recover the capital cost of the asset and a profit
margin.
Definition: Ijarah (Lease)
Ijarah is a contract whereby the owner of an asset, other than consumables,
transfers its usufruct to another person for an agreed period for an agreed
consideration.
Usufruct: The right to use an asset.
The term ijarah also includes a contract of sublease executed by the lessee with
the express permission of the lessor (being the owner).
Whether a transaction is an ijarah or not depends on its substance rather than
the form of the contract provided it complies with the Shariah essentials (as
shown above).
An ijarah is an agreement that is cancellable only:

upon the occurrence of some remote contingency such as force majeure;

with the mutual consent of the mujir (lessor) and the mustajir (lessee); or

If the mustajir (lessee) enters into a new ijarah for the same or an
equivalent asset with the same mujir (lessor).

Definitions
Inception of the ijarah: The date the leased asset is put into mustajirs (lessees)
possession pursuant to an ijarah contract.
The term of the ijarah: The period for which the mustajir (lessee) has contracted
to lease the asset together with any further terms for which the mustajir (lessee)
has the option to continue to lease the asset, with or without further payment,
which option at the inception of the ijarah it is reasonably certain that the
mustajir (lessee) will exercise.

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Ujrah (lease) payments: Payments over the ijarah term that the mustajir is,
contractually required to pay.
Economic life: Either the period over which an asset is expected to be
economically usable by one or more users or the number of production or similar
units expected to be obtained from the asset by one or more users.
Useful life: The estimated period, from the beginning of the ijarah term, without
limitation by the ijarah term, over which the economic benefits embodied in the
asset are expected to be consumed by the enterprise.
Ijarah in the financial statements of mustajir (lessees)
Assets acquired for ijarah are recognised upon acquisition at historical cost which
is the net purchasing price plus all expenditures necessary to bring the asset to
its intended use, such as custom duties, taxes, freight, insurance, installation,
testing, etc.
Ujrah payments under an ijarah should be recognised as an expense in the
statement of profit or loss on a straight-line basis over the ijarah term unless
another systematic basis is representative of the time pattern of the users
benefit.
Ujrah payments are recognised as an expense in the statement of profit or loss
on a straight- line basis unless another systematic basis is representative of the
time pattern of the users benefit, even if the payments are not on that basis.
Mustajir (Lessees) should make the following disclosures for ijarah, in addition to
meeting the IFRS disclosure requirements in respect of financial instruments:

the total of future ujrah payments under ijarah, for each of the following
periods:
x

not later than one year;

later than one year and not later than five years;

later than five years;

the total of future sub-ijarah payments expected to be received under subijarah at the reporting date;

ijarah and sub-ijarah payments recognised in income for the period, with
separate amounts for ijarah payments and sub-ijarah payments;

a general description of the mustajirs (lessees) significant ijarah

arrangements including, but not limited to restrictions imposed by ijarah
arrangements, such as those concerning dividends, additional debt, and
further ijarah.

ijarah in the financial statements of mujir (lessors)

Mujir (lessors) should present assets subject to ijarah in their statement of
financial position according to the nature of the asset, distinguished from the
assets in own use.
Ijarah income from Ijarah should be recognised in income on accrual basis as
and when the rental becomes due, unless another ~ systematic basis is more

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representative of the time pattern in which benefit of use derived from the leased
asset is diminished.
Costs, including depreciation, incurred in earning the ijarah income are
recognised as an expense.
Ijarah income is recognised in income on accrual basis as and when the rental
becomes due, unless another systematic basis is more representative of the time
pattern in which use benefit derived from the leased asset is diminished.
Initial direct costs incurred specifically to earn revenues from an ijarah are either
deferred and allocated to income over the ijarah term in proportion to the
recognition of ujrah, or are recognised as an expense in the statement of profit or
loss in the period in which they are incurred.
Assets leased out should be depreciated over the period of lease term using
depreciation methods set out in lAS 16 However, in the event of an asset
expected to be available for re-ijarah after its first term, depreciation should be
charged over the economic life of such asset on the basis set out in IAS 16.
Mujir (Lessors) should make the following disclosures for ijarah, in addition to
meeting the IFRS disclosure requirements in respect of financial instruments:

the future ijarah payments in the aggregate and for each of the following
periods:
x

not later than one year;

later than one year and not later than five years;

later than five years; and

a general description of the mujir (lessors) significant leasing

arrangements.

In addition, the requirements on disclosure under IAS 16: Property, plant and
equipment, IAS 36: Impairment of assets, IAS 38: Intangible assets and IAS 40:
Investment property, apply to assets leased out under ijarah.
Sale and leaseback transactions
A sale and leaseback transaction involves the sale of an asset by the vendor and
the leasing of the same asset back to the vendor.
When an asset is sold with an intention to enter into an ijarah arrangement, any
profit or loss based on the assets fair value should be recognised immediately.
If the sale price is below fair value, any profit or loss should be recognised
immediately except that, if the loss is compensated by future lease payments at
below market price, it should be deferred and amortised in proportion to the lease
payments over the period for which the asset is expected to be used.
If the sale price is above fair value, the excess over fair value should be deferred
and amortised over the period for which the asset is expected to be used.

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1.4 IFAS on profit and loss sharing deposits

Financial institutions establish and manage funds for investment. Investors
contribute to the funds and share in the profit or loss of the fund. This is the return
on the investments made using the assets of the fund less the financial
institutions management fee.
Each investor owns a share of the fund determined by his investment. The
financial institution must keep records comprising individual accounts for each
investor which shows the balance on the account that belongs to the investor
(investment account holder).
Some funds are set up with limitations on the type of investments that can be
made by the financial institution on behalf of the investors. Other funds are set up
without such limitations. These funds are said to be unrestricted.
This standard provides guidance on accounting principles to be followed by
Institutions offering Islamic Financial Services (IIFS). The guidance covers
recognition, measurement, presentation and disclosure in respect of transactions
relating to equity (funds) of unrestricted investment / (Profit/Loss Sharing) PLS
deposit account holders and their equivalents (unrestricted funds) in which the
IIFS is acting as mudarib.
The standard only deals with funds which in effect are mudaraba or musharaka
contracts. These definitions are repeated here for your convenience.
Definitions
Mudaraba
Mudaraba is a partnership in profit whereby one party provides capital (rab al
maal) and the other party provides labour (mudarib). (Mudarib may also
contribute capital with the consent of the rab al maal).
Musharaka
Relationship established under a contract by the mutual consent of the parties
for sharing of profits and losses arising from a joint enterprise or venture.
The standard does not address the following:

The funds received by the IIFS on a basis other than mudaraba or

musharaka contracts.

Bases of calculation of Zakat on funds within the scope of the standard.

The standard addresses two issues:

The accounting principles relating to funds received by the IIFS for

investment in its capacity as a mudarib at the IIFS's discretion, in whatever
manner the IIFS deems appropriate (unrestricted funds); and

the disclosure of bases for profit allocation between owners' equity and that
of unrestricted funds.

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Definitions
Definition
Unrestricted investment accounts / PLS deposit accounts (unrestricted funds)
Accounts where the investment account holder authorises the IIFS to invest the
account holders funds on the basis of Mudaraba or Musharaka contract in a
manner which the IIFS deems appropriate without laying down any restrictions as
to where, how and for what purpose the funds should be invested.
The IIFS might also use other funds which it has the right to use with the
permission of Investment account holders.
The investment account holder authorises the IIFS to invest the account holders
funds on the basis of mudaraba or musharaka contract as IIFS deems
appropriate without laying down any restrictions as to where, how and for what
purpose the funds should be invested.
The IIFS can commingle the investment account holders funds with its own
equity or with other funds that it has the right to use with the permission of
Investment account holders.
Holders of investment accounts appoint IIFS to invest their funds on the basis of
an agency contract in return for a specified fee and perhaps a specified share of
the profit if the realised profit exceeds a certain level.
Profits (calculated after the IIFS has received its share of profits as a mudarib)
are allocated between investment account holders and the IIFS according to
relative amount of funds invested and a pre-agreed profit sharing formula.
Losses are allocated between the investment account holders and the IIFS based
on the relative amount of funds invested by each.
Accounting treatment in respect of unrestricted investment account holders / PLS
deposit account holders
Definition
Funds of unrestricted investment/PLS deposit account holders
The balance, at the reporting date, from the funds originally received by the IIFS
from the account holders plus (minus) their share in the profits (losses) and
decreased by withdrawals or transfers to other types of accounts.
Funds of the account holders are initially measured as the amount invested and
the subsequently measured as follows at each reporting date:

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Illustration:
Balance of investment account at the beginning of the period

Add: Any further deposits

Less: Any withdrawals

(X)

Add: Any share of profits allocated and reinvested

Less: Any share of losses allocated

(X)

Add / less: Any other necessary adjustment.

X/(X)
X

Profits of investments jointly financed by the investment account holders and the
IIFS are allocated between them according to the mutually agreed terms.
Profits which have been allocated but have not yet been repaid or reinvested
must be recognised and disclosed as a liability by the IIFS.
Any loss resulting from transactions in a jointly financed investment is accounted
as follows:

as a deduction from any unallocated profits; then

any loss remaining should be deducted from provisions for investment

losses set aside for this purpose; then

any remaining loss should be deducted from the respective equity shares in
the joint investment account holders and the IIFS according to each partys
investment for the period.

A loss due to negligence or similar on the part of the IIFS is deducted from its
share of the profits of the jointly financed investment. Any such loss in excess of
the IIFS's share of profits is deducted from its equity share in the joint investment.
Presentation and disclosure in financial statements
Funds of account holders must be accounted for as redeemable capital.
The financial statement must disclose the following in its note on significant
accounting policies:

the bases applied to allocate profits between owners' equity and the
account holders;

the bases applied by the IIFS for charging expenses to unrestricted account
holders;

the bases applied by the IIFS for charging provisions, such as provision for
non performing accounts, provisions on impairment etc and the parties to
whom they revert once they are no longer required.

The IIFS should disclose significant category of accounts and of the percentage
which the IIFS has agreed to invest in order to produce returns for them.

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Disclosure should be made of the aggregate balances of all unrestricted funds

(and their equivalent) classified as to type and also in terms of local and foreign
currency.
The following disclosures should be made either in the notes to the financial
statements or a separate statement:

the total administrative expenses charged in respect of unrestricted funds

with a brief description of their major components;

details of profit allocation between owner's equity investment account

holders applied in the current financial period;

the percentage of profit charged by the IIFS as a mudarib during the

financial period;

where the IIFS is unable to utilise all funds available for investment how the
investments made relates to the IIFS and investment account holders.

The following disclosures should alos be made:

the bases and the aggregate amounts (if applicable) for determining
incentive profits which IIFS receives from the profits of unrestricted funds
and incentive profits which IIFS pays from its profits to investment account
holders;

concentration of sources of investment accounts;

maturity profile of the unrestricted investment funds.

Disclosure should be made of sources of financing of material classes of assets

showing separately those:

exclusively financed by investment account holders;

exclusively financed by IIFS; and

jointly financed by IIFS and investment account holders.

The rights, conditions and obligations of each class of investment account

holders shown in the statement of financial position should be disclosed.
Separate disclosures must be made of all material items of revenues, expenses,
gains and losses classified under the headings appropriate to the IIFS
distinguishing those attributable to investment accounts, IIFS, and IIFS and
investment account holders jointly.

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CHAPTER

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

36

Ethical issues in financial reporting

Contents
1 ICAP Code of Ethics
2 General application of the code
3 Accountants in public practice
4 Accountants in business

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INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.

Learning outcomes
LO 3

Exercise professional judgment and act in an ethical manner (that is in

the best interest of society and the profession).

FINANCIAL REPORTING AND ETHICS

Ethics
B (b) 1

Professional misconduct under the Chartered Accountants Ordinance 1961

B (b) 2

Code of Ethics issued by the Institute of Chartered Accountants of Pakistan

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ICAP CODE OF ETHICS

Section overview

Introduction

Revised code of ethics

Structure of the revised code of ethics

1.1 Introduction
Illustration: Quotation from the Revised Code of Ethics for Chartered Accountants
Chartered Accountants are expected to demonstrate the highest standards of
professional conduct and to take into consideration the public interest. Ethical
behaviour by Chartered Accountants plays a vital role in ensuring public trust in
financial reporting and business practices and upholding the reputation of the
accountancy profession.
The Code of Ethics helps members of the Institute meet these obligations by
providing them with ethical guidance. The Code applies to all members, students,
affiliates, employees of member firms and, where applicable, member firms, in
all of their professional and business activities, whether remunerated or
voluntary.
Meaning of ethics
Ethics can be difficult to define but it is principally concerned with human
character and conduct. Ethical behaviour is more than obeying laws, rules and
regulations. It is about doing the right thing. The accountancy profession is
committed to acting ethically and in the public interest.
Most people are honest and have integrity and will always try to behave in the
right way in a given set of circumstances. However, accountants might face
situations where it is not easy to see the most ethical course of action. One of the
main roles of the ICAP code is to provide guidance in these situations.
Professional accountants may find themselves in situations where values are in
conflict with one another due to responsibilities to employers, clients and the
public.
ICAP has a code of conduct which members and student members must follow.
The code provides guidance in situations where ethical issues arise.

1.2 Revised code of ethics

The International Ethics Standards Board for Accountants (IESBA) of IFAC
issues a Code of Ethics every year.
ICAPs Auditing Standards Committee has made an exhaustive study of the
IESBA Codes and recommended the latest IESBA Code for adoption as ICAPs
code subject to few changes. The changes are not in conflict with the
requirements of IESBA Code. They principally arise out of the requirements of

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the Chartered Accountants Ordinance, 1961 and result in making the code more
stringent than the original.
ICAPs has adopted the revised ICAP Code of Ethics to be effective from July 01,
2015.
Any violation of the provisions of the Code will fall under Part 4 of Schedule 1 of
the Chartered Accountants Ordinance, 1961.
If any conflict arises between the guidance in the Code and the content of CAO,
Chartered Accountants bye-laws, or any specific directive issued by the Council,
the provisions of CAO, Chartered Accountants bye-laws, and the specific
directive must prevail in that order respectively.

1.3 Structure of the revised code of ethics

The Code contains three parts.

Part A establishes the fundamental principles of professional ethics for

chartered accountants and provides a conceptual framework that chartered
accountants must apply to:
x

identify threats to compliance with the fundamental principles;

evaluate the significance of the threats identified; and

apply safeguards, when necessary, to eliminate the threats or reduce

them to an acceptable level.

Parts B (applying to chartered accountants in public practice) and C

(applying to chartered accountants in business):
x

describe how the conceptual framework applies in certain situations;

provide examples of safeguards that may be appropriate to address

threats to compliance with the fundamental principles; and

describe situations which must be avoided because safeguards are

not available to address the threats.

Illustration: Quotation from the Revised Code of Ethics for Chartered Accountants
A distinguishing mark of the accountancy profession is its acceptance of the
responsibility to act in the public interest. Therefore, a chartered accountants
responsibility is not exclusively to satisfy the needs of an individual client or
employer. In acting in the public interest, a chartered accountant must observe
and comply with this Code.
This chapter explains ethical issues surrounding the preparation of financial
statements and other financial information.
References to chartered accountants in the following pages should be taken to
include student members of ICAP.

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GENERAL APPLICATION OF THE CODE

Section overview

The fundamental principles

Threats to the fundamental principles

Safeguards

Resolving ethical conflicts

2.1 The fundamental principles

ICAPs Code of Ethics expresses its guidance in terms of five fundamental
principles which a chartered accountant must comply with. . These are:

integrity;

objectivity;

professional competence and due care;

confidentiality; and

professional behaviour

Integrity
Members should be straightforward and honest in all professional and business
relationships. Integrity implies not just honesty but also fair dealing and
truthfulness.
A chartered accountant should not be associated with reports, returns,
communications or other information where they believe that the information:

Contains a materially false or misleading statement;

Contains statements or information furnished recklessly; or

Omits or obscures information required to be included where such omission

or obscurity would be misleading.

Objectivity
Members should not allow bias, conflicts of interest or undue influence of others
to override their professional or business judgements.
A chartered accountant may be exposed to situations that may impair objectivity.
It is impracticable to define and prescribe all such situations.
Relationships that bias or unduly influence the professional judgment of the
chartered accountant should be avoided.
Professional competence and due care
Practising as a chartered accountant involves a commitment to learning over
ones entire working life.
Members have a duty to maintain their professional knowledge and skill at such a
level that a client or employer receives a competent service, based on current

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developments in practice, legislation and techniques. Members should act

diligently and in accordance with applicable technical and professional standards.
Continuing professional development develops and maintains the capabilities
that enable a chartered accountant to perform competently within the
professional environments.
Confidentiality
Members must respect the confidentiality of information acquired as a result of
professional and business relationships and should not disclose such information
to third parties without authority or unless there is a legal or professional right or
duty to disclose.
Confidential information acquired as a result of professional and business
relationships should not be used for the personal advantage of members or third
parties.
Professional behaviour
Members must comply with relevant laws and regulations and should avoid any
action which discredits the profession. They should behave with courtesy and
consideration towards all with whom they come into contact in a professional
capacity.

2.2 Threats to the fundamental principles

The circumstances in which chartered accountants operate may create specific
threats to compliance with the fundamental principles. It is impossible to define
every situation that creates threats to compliance with the fundamental principles
and specify the appropriate action.
Therefore, the Code establishes a conceptual framework that requires a
chartered accountant to identify, evaluate, and address threats to compliance
with the fundamental principles.
Compliance with the fundamental principles may potentially be threatened by a
broad range of circumstances. Many threats fall into the following categories:

self-interest;

self-review;

advocacy;

familiarity; and

intimidation.

Threats could compromise, or could be perceived to compromise, a chartered

accountants compliance with the fundamental principles.
Members must identify, evaluate and respond to such threats. Unless any threat
is clearly insignificant, members must implement safeguards to eliminate the
threats or reduce them to an acceptable level so that compliance with the
fundamental principles is not compromised.

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Self- interest threats

This is the threat that a financial or other interest will inappropriately influence the
chartered accountants judgment or behaviour
Self-interest threats may occur as a result of the financial or other interests of
members or their immediate or close family members.
Such financial interests might cause members to be reluctant to take actions that
would be against their own interests.
Examples of circumstances that may create self-interest threats include, but are
not limited to:

Incentive compensation arrangements.

Concern over employment security.

Commercial pressure from outside the employing organization.

Example:
Ibrahim is member of ICAP working as a unit accountant.
He is a member of a bonus scheme under which, staff receive a bonus of 10% of
their annual salary if profit for the year exceeds a trigger level.
Ibrahim has been reviewing working papers prepared to support this years
financial statements. He has found a logic error in a spreadsheet used as a
measurement tool for provisions.
Correction of this error would lead to an increase in provisions. This would decrease
profit below the trigger level for the bonus.
Analysis:
Ibrahim faces a self-interest threat which might distort his objectivity.
Self-review threats
Self-review threats occur when a previous judgement needs to be re-evaluated
by members responsible for that judgement. For example, where a member has
been involved in maintaining the accounting records of a client he may be
unwilling to find fault with the financial statements derived from those records.
Again, this would threaten the fundamental principle of objectivity.
Circumstances that may create self-review threats include, but are not limited to,
business decisions or data being subject to review and justification by the same
chartered accountant in business responsible for making those decisions or
preparing that data.
Advocacy threats
A chartered accountant in business may often need to promote an organisations
position by providing financial information to the point that the chartered
accountants objectivity is compromised. As long as information provided is
neither false nor misleading such actions would not create an advocacy threat.

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Familiarity threats
Familiarity threats occur when, because of a close relationship, members
become too sympathetic to the interests of others. Examples of circumstances
that may create familiarity threats include:

A chartered accountant in business in a position to influence financial or

non-financial reporting or business decisions having an immediate or close
family member who is in a position to benefit from that influence.

Long association with business contacts influencing business decisions.

Acceptance of a gift or preferential treatment, unless the value is clearly

insignificant.

Intimidation threats
Intimidation threats occur when a members conduct is influenced by fear or
threats (for example, when he encounters an aggressive and dominating
individual at a client or at his employer).
Examples of circumstances that may create intimidation threats include:

Threat of dismissal or replacement over a disagreement about the

application of an accounting principle or the way in which financial
information is to be reported.

A dominant personality attempting to influence decisions of the chartered

accountant.

2.3 Safeguards
Safeguards are actions or other measures that may eliminate threats or reduce
them to an acceptable level.
When a chartered accountant identifies threats to compliance with the
fundamental principles chartered accountant must then determine whether or not
that they are at an acceptable level.
If they are not at an acceptable level, the chartered accountant must determine
whether appropriate safeguards are available that, if applied, would eliminate the
threats or reduce them to an acceptable level.
Safeguards fall into two broad categories:

safeguards created by the profession, for example:

x

educational, training and experience requirements for entry into the

profession;

continuing professional development requirements;

corporate governance regulations;

professional standards; and

professional or regulatory monitoring and disciplinary procedures.

safeguards in the work environment.

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2.4 Resolving ethical conflicts

The following factors might be relevant to a when resolving a conflict in
complying with the fundamental principles.

relevant facts;

ethical issues involved;

fundamental principles related to the matter in question;

established internal procedures; and

alternative courses of action.

After considering the relevant a chartered accountant must decide on an

appropriate course of action.
If a matter remains unresolved, the chartered accountant could consult with other
appropriate persons within the firm or employing organisation.
If a significant conflict cannot be resolved, a chartered accountant may consider
obtaining professional advice from the relevant professional body or from legal
advisors. This would not breach confidentiality if the matter is discussed with:

the relevant professional body on an anonymous basis; or

a legal advisor under the protection of legal privilege.

If an ethical conflict remains unresolved all relevant possibilities have been

exhausted a chartered accountant must refuse to remain associated with the
matter creating the conflict.

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ACCOUNTANTS IN PUBLIC PRACTICE

Section overview

Introduction

Questionable issues associated with the client

Provision of non-audit services

3.1 Introduction
This is a large section of Code. The following explanations focus on those areas
that might form the basis of an ethical conflict in the context of financial reporting.
A chartered accountant in public practice must not knowingly act in a way that
conflicts with the fundamental principles.
A chartered accountant must not accept a new client if that would create threats
to compliance with the fundamental principles. Such threats might include:

questionable issues associated with the client; and

conflicts of interest.

3.2 Questionable issues associated with the client

Replacing an existing auditor
A chartered accountant who is asked to replace another chartered accountant
must determine whether there are any reasons for not accepting the
engagement. Such reasons might include the existence of circumstances that
create threats to compliance with the fundamental principles that cannot be
eliminated or reduced to an acceptable level by the application of safeguards. For
example, there may be a threat to professional competence and due care if a
chartered accountant accepts the engagement before knowing all the pertinent
facts. It could be that the firm is not competent or has insufficient resource to
undertake the necessary work.
This also applies to chartered accountant who is considering tendering for an
engagement currently held by another chartered accountant.
Work of a complimentary nature
A chartered accountant may be asked to undertake work that is complementary
or additional to the work of the existing accountant. Such circumstances may
create threats to professional competence and due care resulting from, for
example, a lack of or incomplete information.
A possible safeguard in such a case might be the notification of the existing
accountant of the proposed work, which giving him the opportunity to provide any
relevant information needed for the proper conduct of the work.
Second Opinions
A chartered accountant might be asked to provide a second opinion on a
financial reporting issue by a company that is not an existing client. This may

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threaten compliance with the fundamental principles. For example, there may be
a threat to professional competence and due care in circumstances where the
second opinion is not based on the same set of facts that were made available to
the existing accountant or is based on inadequate evidence.
A possible safeguard in such a case might include seeking client permission to
contact the existing accountant, describing the limitations surrounding any
opinion in communications with the client and providing the existing accountant
with a copy of the opinion.
If the company seeking the opinion will not allow communication with the existing
accountant, it might not be appropriate to provide the opinion sought.
Conflicts of interest
A chartered accountant may be faced with a conflict of interest when performing
a professional service.
A conflict of interest creates a threat to objectivity and may create threats to the
other fundamental principles.
Examples of situations in which conflicts of interest may arise include:

Providing a transaction advisory service to a client seeking to acquire an

audit client of the firm, where the firm has obtained confidential information
during the course of the audit that may be relevant to the transaction.

Advising two clients at the same time who are competing to acquire the
same company where the advice might be relevant to the parties
competitive positions.

Providing services to both a vendor and a purchaser in relation to the same

transaction.

ICAP members or firms should not accept or continue an engagement where

there is a conflict of interest between the member or firm and its client. The test is
whether or not a reasonable and informed third party would consider the conflict
of interest as likely to affect the judgement of the member or the firm.

3.3 Provision of non-audit services

It is common for audit firms of all sizes to provide non-audit services.
Most auditors recognise the potential threat to their independence and they try to
deal with the problem through their internal organisational structure.

Larger firms will operate in a number of separate departments, each with its
own partners and members of staff. By dividing the work of the audit firm
into different functions, employees involved in audit work will not be the
same as those involved in providing, say, consultancy advice to the same
client.

A similar approach is often taken by smaller audit firms. Although these

firms may not be large enough to be organised in separate departments,
efforts are usually made to ensure that different members of staff and
partners are responsible for different services provided to clients.

Emile Woolf International

987

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Preparing accounting records and financial statements

Preparing accounting records and financial statements and then auditing them
creates a significant self-review threat. This may also apply where an assurance
engagement involves reviewing subject matter (such as forecasts) prepared by
the firm itself.
In providing such assistance, firms must not make management decisions such
as:

deciding on or changing journal entries without the clients approval;

authorising or approving transactions; or

preparing source documents or originating data (including decisions on

valuation assumptions).

The provision of advice on accounting principles and presentation in the financial

statements given during the course of an audit will not generally threaten the
firms independence. Such advice is considered to be part of the normal audit
process.
For non-listed clients, accounting or book-keeping services, including payroll
services, of a routine or mechanical nature may be provided with appropriate
safeguards such as:

the service not being performed by a member of the audit team;

the firm having policies and procedures such that an individual is prevented
from making any management decision on behalf of the client;

requiring the source data for accounting entries to be originated by the

client;

requiring the underlying assumptions to be originated and approved by the

client; or

obtaining the clients approval for any changes to the financial statements.

Emile Woolf International

988

The Institute of Chartered Accountants of Pakistan

Chapter 36: Ethical issues in financial reporting

ACCOUNTANTS IN BUSINESS
Section overview

Introduction

Section 320 of the ICAP Code of Ethics

Potential conflicts

4.1 Introduction
Accountants in business are often responsible for the preparation of accounting
information.
Accountants in business need to ensure that they do not prepare financial
information in a way that is misleading or that does not show a true and fair view
of the entitys operations.
Accountants who are responsible for the preparation of financial information must
ensure that the information they prepare is technically correct, reports the
substance of the transaction and is adequately disclosed.
There is a danger of influence from senior managers to present figures that
inflate profit or assets or understate liabilities. This puts the accountant in a
difficult position. On one hand, they wish to prepare proper information and on
the other hand, there is a possibility they might lose their job if they do not comply
with their managers wishes.
In this case, ethics starts with the individual preparing the information. They have
a difficult decision to make; whether to keep quiet or take the matter further. If
they keep quiet, they will certainly be aware that they are not complying with the
ethics of the accounting body they belong to. If they speak out, they may be
bullied at work into changing the information or sacked.

4.2 Section 320 of the ICAP Code of Ethics

Chartered accountants in business are often involved in the preparation and
reporting of information that may either be made public or used by others inside
or outside the employing organisation. Such information may include financial or
management information, for example:

forecasts and budgets;

financial statements;

management discussion and analysis; and

the management letter of representation provided to the auditors as part of

an audit of financial statements.

Information must be prepared and presented fairly, honestly and in accordance

with relevant professional standards. In particular financial statements must be
prepared and presented in accordance with the applicable financial reporting
standards.

Emile Woolf International

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The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

A chartered accountant in business must maintain information for which he is

responsible in a manner that:

describes clearly the true nature of business transactions, assets or

liabilities;

classifies and records information in a timely and proper manner; and

represents the facts accurately and completely in all material respects.

Threats to compliance with the fundamental principles, for example self-interest

or intimidation threats to objectivity or professional competence and due care,
may be created where a chartered accountant in business may be pressured
(either externally or by the possibility of personal gain) to become associated with
misleading information or to become associated with misleading information
through the actions of others.
The significance of such threats will depend on factors such as the source of the
pressure and the degree to which the information is, or may be, misleading.
The significance of the threats should be evaluated and unless they are clearly
insignificant, safeguards should be considered and applied as necessary to
eliminate them or reduce them to an acceptable level. Such safeguards may
include consultation with superiors within the employing organization, for
example, the audit committee or other body responsible for governance, or with a
relevant professional body.
Where it is not possible to reduce the threat to an acceptable level, a chartered
accountant should refuse to remain associated with information they consider is
or may be misleading.
If the chartered accountant is aware that the issuance of misleading information
is either significant or persistent, he should consider informing appropriate
authorities in line with the guidance in this code. The chartered accountant in
business may also wish to seek legal advice or resign.

4.3 Potential conflicts

There may be times when the responsibilities of a chartered accountant to an
employing organisation come into conflict with their professional obligations to
comply with the fundamental principles in the Code. Where compliance with the
fundamental principles is threatened, a chartered accountant in business must
consider a response to the circumstances.
Responsibilities to an employer may put a chartered accountant under pressure
to act or behave in ways that could directly or indirectly threaten compliance with
the fundamental principles. Such pressure may be explicit or implicit; it may come
from a supervisor, manager, director or another individual within the employing
organization.
A chartered accountant in business may face pressure to:

Act contrary to law or regulation.

Act contrary to technical or professional standards.

Emile Woolf International

990

The Institute of Chartered Accountants of Pakistan

Chapter 36: Ethical issues in financial reporting

Lie to, or otherwise intentionally mislead (including misleading by remaining

silent) others, in particular:
x

the auditors of the employing organization; or

regulators.

Issue, or otherwise be associated with, a financial or non-financial report

that materially misrepresents the facts, including statements in connection
with, for example:
x

the financial statements;

tax compliance;

legal compliance; or

reports required by securities regulators.

The significance of threats must be evaluated and unless they are clearly
insignificant, safeguards should be considered and applied to eliminate them or
reduce them to an acceptable level.
Such safeguards may include:

Obtaining advice where appropriate from within the employing organisation,

or an independent professional advisor or a relevant professional body.

The existence of a formal dispute resolution process within the employing

organization.

Seeking legal advice.

Example:
Ibrahim is member of ICAP working as a unit accountant.
He is a member of a bonus scheme under which, staff receive a bonus of 10% of
their annual salary if profit for the year exceeds a trigger level.
Ibrahim has been reviewing working papers prepared to support this years
financial statements. He has found a logic error in a spreadsheet used as a
measurement tool for provisions.
Correction of this error would lead to an increase in provisions. This would decrease
profit below the trigger level for the bonus.
Analysis:
Ibrahim faces a self-interest threat which might distort his objectivity.
Ibrahim has a professional responsibility to ensure that financial information is
prepared and presented fairly, honestly and in accordance with relevant
professional standards. He has further obligations to ensure that financial
information is prepared in accordance with applicable accounting standards and
that records maintained represent the facts accurately and completely in all
material respects.
Ibrahim must make the necessary adjustment even though it would lead to a loss
to himself.

Emile Woolf International

991

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example:
Ali is a chartered accountant recruited on a short-term contract to assist the
finance director, Bashir (who is not a chartered accountant) in finalising the draft
financial statements.
The decision on whether to employ Ali on a permanent basis rests with Bashir.
Ali has been instructed to prepare information on leases to be included in the
financial statements. He has identified a number of large leases which are being
accounted for as operating leases even though the terms of the contract contain
clear indicators that the risks and benefits have passed to the company. Changing
the accounting treatment for the leases would have a material impact on asset
and liability figures.
Ali has explained this to Bashir. Bashir responded that Ali should ignore this
information as the company need to maintain a certain ratio between the assets
and liabilities in the statement of financial position.
Analysis
Ali faces a self-interest threat which might distort his objectivity.
The current accounting treatment is incorrect.
Ali has a professional responsibility to ensure that financial information is prepared
and presented fairly, honestly and in accordance with relevant professional
standards. He has further obligations to ensure that financial information is
prepared in accordance with applicable accounting standards and that records
maintained represent the facts accurately and completely in all material respects.
Possible course of action
Ali must explain his professional obligations to Bashir in particular that he cannot
be party to the preparation and presentation of knowingly misleading information.
Ali should refuse to remain associated with information that is misleading.
If Bashir refuses to allow the necessary changes to the information Ali should
report the matter to the audit committee or the other directors.
As a last resort if the company refuses to change the information Ali should resign
from his post.
Ali may need to consider informing the appropriate authorities in line with the ICAP
guidance on confidentiality.

Emile Woolf International

992

The Institute of Chartered Accountants of Pakistan

Chapter 36: Ethical issues in financial reporting

Example:
Etishad is a chartered accountant who works in a team that reports to Fahad, the
finance director of Kohat Holdings.
Fahad Is also a chartered accountant. He has a domineering personality.
Kohat Holdings revalues commercial properties as allowed by IAS 16. Valuation
information received last year showed that the fair value of the property portfolio
was 2% less than the carrying amount of the properties (with no single property
being more than 4% different). A downward revaluation was not recognised on the
grounds that the carrying amount was not materially different from the fair value.
This years valuation shows a continued decline in the fair value of the property
portfolio. It is now 5% less than the carrying amount of the properties with some
properties now being 15% below the carrying amount.
Etishad submitted workings to Fahad in which he had recognised the downward
revaluations in accordance with IAS 16.
Fahad has sent him an email in response in which he wrote Stop bothering me
with this rubbish. There is no need to write the properties down. The fair value of
the portfolio is only 5% different from its carrying amount. Restate the numbers
immediately.
Analysis
Etishad faces an intimidation threat which might distort his objectivity.
The current accounting treatment might be incorrect. The value of the properties as
a group is irrelevant in applying IAS 16s revalution model. IAS 16 allows the use of
a revalution model but requires that the carrying amount of a property should not
be materially different from its fair value. This applies to individual properties not
the whole class taken together.
(It could be that Fahad is correct because there is insufficient information to judge
materiality in this circumstance. However, a 15% discrepancy does sound
significant).
Etishad has a professional responsibility to ensure that financial information is
prepared and presented fairly, honestly and in accordance with relevant
professional standards. He has further obligations to ensure that financial
information is prepared in accordance with applicable accounting standards and
that records maintained represent the facts accurately and completely in all
material respects.

Emile Woolf International

993

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example continued
Possible course of action
Etishad should arrange a meeting with Fahad to try to explain Fahads
misapplication of the IAS 16 guidance and to try to persuade Fahad that a change
might be necessary.
Fahad should be reminded that he too is bound by the same guidance that applies
to Etishad. Indeed he has a greater responsibility as the more senior person to
show leadership in this area.
Etishad cannot be party to the preparation and presentation of knowingly
misleading information. He should explain that he cannot remain associated with
information that is misleading. If Fahad refuses to allow the necessary changes to
the information, Etishad should report the matter to the audit committee or the
other directors.
As a last resort if the company refuses to change the information, Etishad should
resign from his post.
Etishad may need to consider informing the appropriate authorities in line with the
ICAP guidance on confidentiality.

Emile Woolf International

994

The Institute of Chartered Accountants of Pakistan

Certified Finance and Accounting Professional

Advanced accounting and financial reporting

I
Index

a
About the IFRS for SMEs
Accounting
concepts
estimates
for revaluation
Acid test ratio
Acquisition of a subsidiary in
the statement of cash flows
Actuarial method
Adjusting events after the
reporting period
Agricultural activities
Agriculture
Amortised cost
Analysis of expenses
Assets
Associates and the group
statement of cash flows
Available-for-sale financial
assets
AVCO
Average
time for holding inventory
time to collect
time to pay suppliers

Emile Woolf International

Bargain purchase option

Barter transactions
Basic EPS
Bearer plant
Bid /Offer prices
Biological
asset
transformation
Bonus issues of shares

933
43
89
129,165
871
794
256,292

284
107
776,814
120,156, 899
487,559
860,899
860,899
786,824

77
860,898
860,898
444,445
56
37

Call option
460,438
Capital maintenance
46
Cash flow
hedge
431,469
statements
757,795
Cash operating cycle
830,868
Cash-generating units
205,241
Changes in accounting
estimates
90
Changes in accounting policies 84,947,909
Code of ethics
979,1017
Commencement of a lease
274

790
441
857,896
828,866
827,865
828,866

995

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Companies Ordinance 1984:

Rules on revaluation
Fifth schedule
Fourth schedule
Comparability
Components of tax expense
Compound instruments
Conceptual framework
for financial reporting
Consistency of presentation
Consolidated statement of
cash flows
other comprehensive
income
profit or loss
Consolidation stage
Construction contracts: IAS 11
Constructive obligation
Contingent
asset
consideration
liabilities
liability
Contingently issuable shares
Contract
costs
revenue
Control
Conversion costs
Convertible bonds
deferred taxation
Convertible preference shares
Core inventories
Correction of prior period errors
Costs
constraint on useful
information
formulas for inventory
model for investment
property
sales ratios
of acquisition: transaction
costs
Creative accounting
Credit risk
Current ratio
Current value

Emile Woolf International

4
165
19
8
35
528,566
460,498
27
27
43

d
Days sales outstanding
Debt ratios
Decommissioning liabilities and
similar provisions
Defaults and breaches
Deferred
consideration
tax: business combinations
Defined
benefit pension plans
contribution pension plans
Depreciation
of a re-valued asset
Derecognition of financial
instruments
Development costs
Diluted EPS
options and warrants
Direct method
Discontinued operations
Disposal of a
foreign subsidiary
subsidiary in the statement
of cash flows
Dividends
cover
received from an associate
yield

784
623
617
715,753
125
327,334
319,357
553,591
555,593
318,356
839
111,126
110,125
212,577
856,894
830
499,537
791,830
147,183
93

865
834,872
347
471,509
590
562
330,368
329,367
161
172
491
218
876
833
633,772
265,682
762
794
78
876
791
876

36
895

Earnings per share (EPS) 804,806,811,875

and trends
844
ED/2013/6: LEASES
326
ED/2013/9: IFRS for SMEs
943
ED/2014/1: DISCLOSURE
INITIATIVE
60
ED/2014/2: Investment entities:
Applying the consolidation
exemption
584
ED/2014/4: Measuring quoted
investments in subsidiaries,
joint ventures and
associates at fair value
586
Effective rate
445
Elements of cost
157

203
819,861
590
29
473,511
832,870
44

996

The Institute of Chartered Accountants of Pakistan

Index

Elements of financial
statements
Embedded derivatives
Employee benefits
Employee share option
Enhancing qualitative
characteristics
EPS: convertible preference
shares and convertible
bonds
Equity
instrument
method
Errors
Estimates
Ethics and Conduct
Events after the reporting
period: IAS 10
Exchange
differences
of goods or services
rate differences (statement
of cash flows)
Expenses

operation: accounting rules

Forward contracts
Functional currency
Fundamental principles
Future operating losses
Futures

37
461, 491
363
352,390

750
399,437
700,738
981,1019
308,346
400,438

35

830
38
479
9,636
93
89
1017

GAAP
27
Gain or loss on
disposal
139,175,205
translation
751
Gearing ratio
834,872
Going concern assumption
78
Government assistance
192,198
Government grants
156,192, 900
Grants related to
assets
156,158,192
income
192,193
Gross investment in the lease
280,300
Gross profit ratio
823,861
Guaranteed residual value
276

77
751
107
784
39

Fair
presentation
50
value hedge
430,468
value hierarchy
487,525
value model for investment
property
167,203
value through profit or loss 403,441,442
value
45,159,203,234
Faithful representation
35
Finance
income
302
lease accounting
301
Financial
433
asset
441,477
capital maintenance
46
instruments
435
liability
436,442
ratios
813,816,854,885
Financing activities
791
First-in, first-out method (FIFO)
857,895
Foreign
currency
738

Emile Woolf International

Hedges
accounting
effectiveness
of a net investment in a
foreign operation
Hedging
with derivatives
Held to maturity investments
High-geared
Historical cost
Holding company

465
467
473,474
465
439
407,441
872
44
577, 666

i
IAS 1 and group accounts
IAS 1: Presentation of Financial
Statements

997

537,575
43,55

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

IFRIC 12: Service concession

arrangements
IFRIC 13: Customer loyalty
programmes
IFRIC 14: IAS 19 The limit on
a defined benefit asset,
minimum funding
requirements and their
interaction
IFRIC 15: Agreements for the
construction of real estate
IFRIC 17: Distributions of noncash assets to owners
IFRIC 18: Transfers of assets
from customers
IFRIC 19: Extinguishing
financial liabilities with
equity instruments
IFRIC 20: Stripping costs in the
production phase of a
surface mine
IFRIC 21: Levies
IFRS 1: First Time Adoption of
International Financial
Reporting Standards
IFRS 2: Share-based payment
IFRS 4: Insurance contracts
IFRS 5: Non-current assets
held for sale and
discontinued operations
IFRS 6: Exploration for and
evaluation of mineral
resources
IFRS 7: Financial instruments:
Disclosure
IFRS 11: Joint arrangements
IFRS 14: Regulatory Deferral
Accounts
IFRS 15: Revenue from
contracts with customers
IFRS 15: The five step model
IFRS FOR Small and mediumsized entities (SMEs)
Ijarah
Impairment
loss on a disposal group
of assets
of financial assets
of financial instruments
of goodwill
Inception
and commencement
of the lease

IAS 8 Accounting policies,

changes in accounting
estimates and errors
51, 83
IAS 10: Events after the
reporting period
77
IAS 11: Construction contracts
125
IAS 16: Property, plant and
equipment
84,117,155
IAS 17: Leases
166,271
IAS 18: Revenue
105
IAS 19: Employee benefits
323,363
IAS 21: The effects of changes
in foreign exchange rates
699,737
IAS 23: Borrowing costs
149,187
IAS 26: Retirement benefit
plans
926,964
IAS 28: Investments in
associates and joint
ventures
597,635
IAS 32: Financial instruments:
Presentation
497
IAS 34: Interim financial reporting
62
IAS 36: Impairment of assets
195,231
IAS 38: Intangible assets
173,211
IAS 39 and hedge accounting
465
IAS 39: Financial instruments:
Recognition and
measurement
402,440
IAS 41: Agriculture
860,898
IAS 33 and diluted EPS
791,829
IAS 33: Earnings per share
811
IASB Conceptual Framework
30
IASB Framework
37
Identifying a finance lease
283
IFAS on profit and loss sharing
deposits
1011
IFRIC 1: Changes in existing
decommissioning,
restoration and similar
liabilities
142,178
IFRIC 2: Members shares in
cooperative entities and
similar instruments
466,504
IFRIC 5: rights to interests
arising from
decommissioning,
restoration and
environmental rehabilitation
funds
314,352
IFRIC 6: Liabilities arising from
participating in a specific
market: waste electrical
and electronic equipment
316,354

Emile Woolf International

998

869,907
118

380
120
467,505
122

420,458

182
313,351

879,919
349,389
891,945

265, 720

864,902
458,508
629
868,906
105,138
106,139
931
1007
262
233
482
463
619
274
274

The Institute of Chartered Accountants of Pakistan

Index

Income
Indirect method
Initial direct costs of a lease
Institute of Chartered
Accountants in Pakistan
(ICAP)
Insurance contracts
Integrity
Interest
cover ratio
rate implicit in the lease
Interim financial reporting
and impairment
Internally-generated intangibles
International GAAP
Inventory turnover
Investing activities
Investment property
Investor ratios
Irredeemable non-cumulative
preference shares
Islamic finance

38
771
277

3
945
1019

Manufacturer/dealer leases
Market risk
Material
items
non-adjusting events
Materiality and aggregation
Measurement
of revenue
Minimum lease payments
Most advantageous market
Mudaraba
Multi-employer plans
Murabaha
Musharaka

835,873
277
62
244
230
50
866
791
199
875
498
1003

Net
investment in the lease
profit ratio
realisable value (NRV)
Non-adjusting events after the
reporting period
Non-controlling interests and
the group statement of
cash flows
Non-financial information
Non-monetary items

591
591
593
593

l
Leases
payments made in advance
term
Leaseback
Legal obligation
Lessor accounting
Lessee's incremental borrowing
rate of interest
Leverage
Liabilities
Liquidity ratios
Liquidity risk
Loans and receivables
Low-geared

Emile Woolf International

56
78
43
40
105
279
482
966, 973
341
966
966, 973

j
Joint
arrangements
control
operation
venture

281
473

266
823
45, 858
78

749
844
953

237
261
256
284
296
266

Objectivity
Offsetting
Onerous contracts
Operating
leases
segments
Options
Ordinary share
Other comprehensive income
Over-estimate or underestimate of tax

241
834
38
832
473
403
834

999

981
43, 464
307
242
71
356
774
579
479

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

of financial instruments
Recoverable amount
Redeemable preference shares
Related
party
transactions
Relevance
Repayments
of government grants
on finance leases
Reportable segments
Restructuring
costs
Retirement benefit plans
Retrospective application
Return on
capital employed
shareholder capital
Revaluation
model
of property, plant and
equipment
Revenue recognition
and substance
from providing a service
Revenue
Reversal of an impairment loss
Rights issues of shares

p
Parent entity
Percentage
annual growth in sales
Physical capital maintenance
Post-employment benefits
Potential ordinary share
that are not dilutive
Pre- and post-acquisition profits
Preference shares: debt or
equity?
Present value
Presentation: taxation
Price earnings ratio
(P/E ratio)
Principal market
Profit/sales ratio
Proposed dividends
Purchase cost
Purchased goodwill and foreign
subsidiaries
Put option

539
825
47
329
775
799
582
459
44
527
773
773
482
823
78
855
715
400

q
Qualifying asset
Qualitative
characteristics of useful
financial information
disclosures
Quantitative
disclosures
thresholds (segments)
thresholds
Quick ratio

Emile Woolf International

9
68
35
160
745
72
308
555
926
85
819
821
125
128
109
108
103
207
788

151

Sale and leaseback

transactions
Sale and operating leaseback
Section 320
Securities and Exchange
Commission of Pakistan
Segmental information
Self-review threats
Separate vehicle
Settlement
of a transaction
value
Share
options
warrants
SIC 10: Government assistance
no specific relation to
operating activities

34
473
473
72
72
833

r
Ratio analysis
Realisable value
Receivables days
Recognition
criteria for intangible assets

402
198
403

814
44
827
40
178

1000

283
284
989
3
71
983
594
710
44
797, 798
795

162

The Institute of Chartered Accountants of Pakistan

Index

SIC 29: Service concession

arrangements: disclosures
SIC 31: Revenue Barter
transactions involving
advertising services
SIC 32: Intangible assets
Web site costs
Small and medium-sized
entities (SMEs)
SOCIE
Split accounting for compound
instruments
Statements of cash flows
Subsequent expenditure
Subsidiary
Substance over form
Swaps

Verifiability

36

877

105
184

Weighted average cost (AVCO)

method
Working capital
adjustments
cycle
efficiency ratios

893
57
461
729
124
539
242
400

858
737
830
827

t
Tax
base
computation
reconciliation
Taxation of profits
Timeliness
Transactions in own equity
Transitional provisions
Translation
of transactions
stage
Treasury shares
True and fair view
Types of lessors

497, 505
495
529
495
36
464
85
703
713
464
50
238

u
Understandability
Unguaranteed residual value
Users and their information
needs

36
240
31, 816

v
Value in use

Emile Woolf International

200

1001

The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Emile Woolf International

1002

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2016

ADVANCED ACCOUNTING AND

FINANCIAL REPORTING
STUDY SUPPORT MATERIAL